The rise in interest rates has considerably reshaped the landscape of financial investments
Structured products with capital protection are now popular with investors
The climate of economic and geopolitical uncertainty is underpinning this enthusiasm
Can the new capital-guaranteed ETFs compete with structured products?
CHART OF THE WEEK: "Evolution of the first ETF with 100% capital guarantee"
FINANCIAL MARKET ANALYSIS
Over the last thirty months, investors have witnessed a significant rise in interest rates (see Fig. 2). This increase, the result of central banks' fight against inflation, has radically reshaped the financial investment landscape: the field of possibilities has widened. Bonds are no longer considered low-yielding assets but are once again attractive. Similarly, capital-guaranteed structured products, which combine capital security with potential gains, are popular.
For the record, capital-guaranteed structured products consist of a zero-coupon bond and an option. The zero-coupon bond has two advantages. Firstly, it guarantees repayment of the principal at maturity. Secondly, in a positive interest rate environment, its price is lower than the initial capital, which makes it possible to finance the option. A call option gives the opportunity to participate in the rise of the underlying asset, while a digital option allows investors to receive coupons. This structure is therefore capable of generating performance without taking any risk (other than the default of the bank issuing the product). Readers who like shortcuts should remember that investors exchange the fixed return on a bond for a variable return linked to the performance of another underlying asset. By doing so, they hope that their investment decision will enable them to collect more than the coupons they would have received from the bond.
Given the construction of capital-guaranteed products, the higher the rates, the lower the price of the zero-coupon, and the more appealing these structures. For example, an investor can expose his portfolio to the EuroStoxx index and participate in 130% of its rise over the next three years, while preserving his initial capital if the European market were to fall. In a climate of economic and geopolitical uncertainty, capital-guaranteed products are a popular alternative.
The enthusiasm is such that providers of Exchange-Traded Funds (ETFs) are seeking to enter this market. Since 2022 and the popularity of 'buffer' ETFs, they have been offering more and more 'defined return' funds that provide partial protection against capital loss. This protection against market downturns is provided in exchange for dividends and part of the potential gains: performance is capped. With 64 Buffer funds and 15 billion in assets, Innovator Capital Management is a major player in this segment. Its flagship range, such as Power Buffer (PSEP US Equity for September), aims to protect investors against the first 15% of market losses. Beyond that point, the ETF no longer guarantees the capital. First Trust (BUFR US Equity), Allianz (NVBW US Equity) and the world's leading asset manager BlackRock (IVVB US Equity), are following suit (see Fig. 3).
Last July, Innovator took things a step further by offering an ETF indexed to the S&P 500 with 100% capital protection (Innovator Equity Defined Protection ETF, TJUL US Equity, see chart of the week). Potential gains are capped at between 15% and 18% depending on market conditions, in particular volatility levels and prevailing interest rates, over a two-year period, i.e. 7.1% to 8.8% a year. Other funds of this type are due to be launched every six months.
Guaranteed-capital ETFs have several advantages :
▪ As with a structured product with capital guarantee, the investment is fully protected against loss, an attractive benefit for risk-averse investors.
▪ By simplifying the holding of this type of strategy, this offering is aimed at a broader segment of investors, particularly retail investors.
▪ Thanks to the use of flexible options secured by the Option Clearing Corporation, the world's largest clearing house, counterparty risk is reduced.
▪ Because of their exchange-traded nature, their liquidity is important. This can be an advantage for investors who value flexibility and the ability to react quickly to changing market conditions.
On the other hand, there are a number of dissuasive factors :
▪ Contrary to what the name suggests, capital protection is not 100%. Transaction and management fees are not considered, and they are relatively high for an ETF: 0.79% per annum in the case of the Innovator fund.
▪ More importantly, capital is only guaranteed for investors who subscribe at a lower price than on the day the fund is launched and who hold the fund until the last day of the performance period, which in the case of Innovator is two years.
▪ From a technical point of view, in the event of a major crisis, when put option prices are high, managing liquidity and the collar or call spread strategies on which the structure is based could be difficult.
Beyond all these factors, favourable or not, the key point is that these funds offer no flexibility, either in terms of structure or potential returns. However, this is what investors who design structured products are looking for in the first place. They tailor them on a case-by-case basis, including specific features, to meet specific investment objectives.
ETFs offering protection against capital loss represent a significant advance for retail investors. Those who have not had access to this type of strategy and who are risk averse may decide to invest some of the cash stagnating in their portfolios in such ETFs.
However, ETFs will not compete with structured products among investment professionals. Their design has disadvantages compared with structured products, particularly in terms of flexibility.