This news service recently stirred the pot of controversy with an article casting doubt on the benefits of so-called "liquid alternatives" - such as funds offering daily liquidity but holding underlying assets that promise the kind of returns associated with hedge funds or private equity. Here's a response.

On 18 February this publication carried a guest article, "How Investors Should Think About Liquid Alternatives", by Christian Armbruester, chief investment officer at Blu Family Office. The article has prompted some pushback. Here, Guillaume Chatain, former managing director and head of equities at JP Morgan private bank in Asia, and founder and CEO of ResonanceX, a fintech firm. ResonanceX concentrates on bringing efficiencies and transparency to structured products and alternative investment.

The editors of this news service are pleased that a debate is taking place on this topic. We are grateful to Mr Chatain for his contribution; the usual editorial disclaimers apply.  Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

In a world where investors buy bonds for capital appreciation... and (as Citi Private bank suggested) invest in equities for yield, other high yielding instruments are providing significant diversification and enabling to improve the efficient frontier of most portfolios. And I’d like to make the case for defined outcome investing that is offered by "ill-famed" structured products.

Many will rightly roll their eyes when reading these lines, as they remember the scandals over products which have been sold in the past as “ultra-safe” by advisors who often didn’t fully understand them. But more recently the industry represented by issuers and distributors has been forced to learn from its mistakes by regulators and is now required to sell these products with much greater transparency, especially with regards to risk and fees embedded in each product.

So why does it matter now?
Following market stability and rally induced by central banks having reversed balance sheet normalisation policy last year, with the Fed in turbo expansion mode at the end of 2019, and having created one of the most accommodative global monetary conditions on record, we are now witnessing a shift in sentiment.

Having just lived through the fastest S&P 500 market decline from an all-time high in history in the last two weeks, one can wonder if investors and traders mood will remain in a buy-the-dip mentality as they have been conditioned to believe that central banks will come to the rescue, again and again, to suppress volatility and keep market prices elevated. Or will investors shift their mindset and start to look at ways to protect the downside and/or look for ways to add convexity in their portfolios…that is what I would put in layman terms: find ways to be less exposed to the downside provided by the market, while being able to capture a big chunk of the potential upside.

While this is typically achieved by using combinations of options via listed and OTC markets, these levered strategies are complex to put in place and require expertise, active management and careful monitoring because the clock works against you when you purchase options.

And this is where structured products, a carefully crafted combination of bonds and derivative instruments packaged into a security have the potential to help most investors add optionality in their portfolios. These products provide some sort of convexity, enabling investors to build protection or buffers while receiving upside participation or coupons, and giving away the higher returns they don’t expect.

Taking advantage of higher volatility regime.
As I’m writing this article, markets have been in disarray with the S&P 500 losing at some point more than 15 per cent from the February highs, and the VIX –a gauge of forward-looking short-term volatility, and a barometer for risk appetite – shooting-up from 15 to 50 in just a few days due to fears about lack of coronavirus containment. And this is a good environment for structured products which are mostly sellers of volatility through options that are embedded in their payoffs, enabling investors to take advantage of deeper buffers and/or higher yield than they would have received in very smooth markets.

To give an example, as of last Friday you could buy a product paying an annual coupon of 6 per cent with downside protection as long as the S&P 500 trades above 70 per cent of its current level three years from now. As of Monday morning, as S&P futures are 5 per cent in the red, the coupon is now close to 8 per cent per year.

Defined outcome investing.
But there is more to it. As an investment article wouldn’t be complete without a Yogi Berra’s quote, that successful financial planners would certainly agree with: “If you don’t know where you are going, you might end up somewhere else”. Having clearly defined goals helps investors build more successful portfolios and since you can tailor instruments based on your time horizon, willingness to take risk, and expectation of returns, pre-determined outcome investments are perfectly suited for inclusion in a goals-based portfolio. In a nutshell, these products - when created and distributed properly - can support investors with security, protection, predictability and transparency that has traditionally not been available in the marketplace.

So why aren’t these more popular?
Let’s address the obvious: structured products have lacked transparency and there have been mis-selling instances in the past. From risk-averse investors losing their entire principal following Lehman bankruptcy; to Asian investors being forced to buy stocks through “Accumulators”, nicknamed “I-kill-you-later” in the aftermath of the GFC…. And they are not only complex to create and to fully understand, but the post-trade activities also require constant monitoring that private banks and financial advisors are not able to provide at scale.

However, the overall benefits of these products that can be tailored to express the most nuanced investment views outweigh the risks, which are now clearly disclosed thanks to regulations contributing to greater transparency and a more controlled distribution process.

And this is no surprise to see that structured products have become more popular in Asia while the China/US trade dispute puts pressure on local markets, as their protective features help mitigate market uncertainty through deep levels of conditional protection.

With minimum investments being much lower than in the past, with better education and transparent price discovery process, one can now expect that these solutions will appeal to a larger audience globally.

The impact of technology
As a mentor likes to say, “Structured products are sold, not bought”. And it’s a fact that very few investors wake up in the morning or read market news thinking they should buy one. Furthermore, for many structured products investors, the customer journey, unfortunately, stops as soon as the investment has been made and only resumes after the trade settles and cash is returned at maturity. The latter is due to a life cycle management which is still mostly performed manually, involving chains of humans who don’t have the time nor the scale to deal with all the events taking place in investors’ portfolios.

But this is changing in a big way as technology is helping remove complexities and increase efficiencies. The shift towards digital banking enables migration of capital markets on platforms providing intuitive analysis of driving forces portfolios, transparent price discovery, and real-time alerts and notifications for an efficient life cycle management of the most complex products. And there will soon be automated solutions providing robust and personalised recommendations to increase the efficient frontier of any portfolio.

Conclusion
As your previous guest wrote: “It’s a big world out there. Don’t limit yourself to stocks and bonds”. There are other instruments available with a potential that has been unlocked by new technologies and evolving regulations. And they can now be fully tailored to every investor’s specific situation with small minimum investment size. One would argue that it is financial advisors’ role to understand and help investors understand how structured products work and behave over time, how the embedded optionality can help protect portfolios and offer attractive yield at the same time, and in particular how to use them strategically in volatile markets.

They provide a defined return if several conditions are met, and they can offer a more attractive and less uncertain outcome than many passive or managed solutions available on the marketplace, especially after a multi-decade rally in bonds and at a time when equity markets look increasingly unattractive.

Note: Any opinions expressed by ResonanceX or its staff do not constitute a personal recommendation to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when [making] investment decisions. In particular, the information and opinions provided in this article do not take into account your personal circumstances, objectives and attitude towards risk.