As stock markets in the US surge, many increasingly cautious local private investors are turning to options and derivatives to protect against changing sentiment.
There has been an explosion in funds in the US that use options in one form or another to act as a hedge, be that through so-called covered call writing, or more structured defined outcomes. Options are hugely popular on US retail platforms such as Robinhood but derivatives are also finding their way into more mainstream products, such as exchange traded funds.
These products are finally becoming available in the UK via ETFs. Arguably the most popular strategy is covered call writing, which involves owning a portfolio of, say, US equities linked to a benchmark and then selling options that cap those shares’ gains in price terms — giving away, say, any monthly price return above a 2 per cent increase.
US firm Global X has two products in the UK that do exactly this, for either the S&P 500 (ticker XYLU) or the Nasdaq 100 (ticker QYLD). JPMorgan has also weighed into this space in the UK with an active ETF called the JPM Global Equity Premium Income UCITS ETF (ticker JEPG), which aims to deliver a consistent income of 7 to 9 per cent a year while also owning stocks that closely track world equities indices.
The idea behind all these covered call strategies — UK giant Schroders has been offering this via its Maximiser range of unit trusts for decades — is to provide an enhanced income, which in turn might mean reducing downside volatility. The snag is that these funds using options will always underperform a simple strategy of buying and sitting tight in the underlying index, as long as it continues to rise.
Options and derivatives also find their way into another strategy involving ETFs, both in the US and the UK, which can loosely be called defined outcomes investing. There are dozens of these funds in the US but at the moment only one in the UK, again from Global X, called the S&P 500 Annual Buffer UCITS ETF (ticker SPAB). Its strategy is to protect against the first 15 per cent of losses on the S&P 500 from the purchase of what’s called a put spread (an option), while also capping your upside exposure.
According to Global X, this idea of fixing your upside and limiting your downside (to a certain level) has proved hugely popular in the US — it reports that assets under management in the US for such defined outcome strategies soared by more than 10 times in the past five years (admittedly from a low base), while in 2023 alone they nearly doubled.
This strategy doesn’t seem to have attracted too much money in the UK just yet but its time might come if the US market momentum stalls.
Another explanation for the lukewarm uptake is that the UK already has a set of solutions called structured products. These, rightly in my view, had a dismal reputation when they were sold before the 2008 global financial crisis via high street banks and building societies. But the sector has cleaned up its act in recent years and started to produce some very decent, stable returns, through market ups and downs.
The most popular product is something called an auto call or kick-out plan, which uses a benchmark index, usually the FTSE 100 (in one guise or another) and then promises to pay a fixed return — usually between 5 and 10 per cent a year, if after one year that index is at or above that opening level. There are other variants on the theme and it’s important to say that because these products can, at first sight, seem a bit complicated, the vast majority are sold via independent financial advisers. More and more advisers use these structures as something of a hybrid strategy sitting between bonds and equities.
Crucially, since the global financial crisis, returns have been solid. Ian Lowes, an adviser based in the north-east, runs StructuredProductReview.com, which has been tracking the growing array of defined outcomes products. According to his latest report, more than 96 per cent of the 629 plans that matured during 2023 gave positive returns for investors. The average annualised return has been 6.51 per cent over a term of 3.14 years.
That sums up nicely how these products sit within a spectrum of returns — you’d have made much more from straight equity investing but with a structured product you’d have received a less volatile, steady return that was above those on offer from most (but not all) bonds.
It’s also important to say that there’s counterparty risk as the options bundled up inside the products involve big investment banks. And most of these structured products do involve potential risk to your capital, usually kicking in if the reference index falls by, say, 30 to 50 per cent over the period of the plan (usually between three…
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