Most equity structured products are linked to indices, often using well-known benchmarks such as the S&P-500, Eurostoxx-50 or FTSE-100. These indices are rules based, calculated real time and, importantly, have liquid futures and options as hedging instruments and therefore they are a natural choice for most structured products providers. As such the use of index linked structured products dominates in most markets, followed by high capitalisation stocks which would also be well-known to investors.

The use of fund underlyings has become more popular in recent years as a way to provide alternative choices to indices and to leverage the track record or rationale of a fund which the structured product distributor might want to use. In each country there will be several active funds that attract large amounts of assets under management and the strong performers of these will be good choices to consider for structured products. They will be well known in the market by distributors, advisers and because of likely press coverage many investors too.

Fund-linked products: Regional analysis

France is the largest market for structured products linked to funds accounting for over half of all sales for products linked to funds. The most common fund linked product payoff types are autocall and income autocall with most products being capital at risk. The range of funds is large. In France alone there are 47 different funds in use spread over the 462 products giving investors a wide range. The top funds in this region by product issuance are Solys Euro Evolution I Fund, Solys Quadrant Europe Fund and the LFDE International Selection Fund - Class I.

Switzerland, Brazil and Sweden are other markets where both active funds and structured products are popular and accordingly there are many structured products linked to them. In these markets participation products are the most common. They can be capital protected or a tracker style product with capital risk. A recent example from Sweden is the BNP Paribas BNP FO Hälsovård NOK 5198 (SRP ID 47609506) which is 100% capital protected and pays 115% of any rise in a basket consisting of three funds; SEB Lakemedelsfond Fund, HealthInvest Sustainable Healthcare E Fund and DNB Health Care S Fund at the end of the three year term. By using a capital protected structure this product gives access to these funds whist reducing the associated risk to the investor. Here the issuer will have to manage exposure to each fund and also manage the correlation risk between the three underlyings.

Generally structured products will link to the “accumulation” version of the fund which reinvests any fund distributions (dividends). Increasingly decrement versions are also being used to boost headline rates in line with their general popularity. Annual fees of up to 1% p.a. are standard in the active fund world to pay for the cost of management, and since these are continuously deducted from the fund price they will be an extra drag on performance which are not present in index linked products.

Technical considerations and hedging challenges

One key difference between using indices (and their associated ETFs) and actively managed funds is the ease with which hedging can be done. Because benchmark indices and large stocks have very liquid markets, delta hedging is cheap and straightforward. To hedge the fund underlying the structured product provider would often need a relationship with the fund manager to provide cheap access to the fund so that hedging costs would not be excessively high. The structured product provider would also want to have some idea of future fund strategy particular in regard to likely volatility and if appropriate dividend yield as this will affect product pricing.

Hedging volatility risk for such underlyings is also difficult and in general no direct instruments would exist. Alternative approaches would be to use suitable proxy indices if there is good correlation, try to arrange offsetting risks from a flow of business (for example issuing capital at risk and capital protected products together) or to issue products with relatively low volatility risk at outset, such as a twin win, defensive autocall or digital.

Mutual funds make an obvious choice for structured product providers looking to expand from vanilla equity underlyings. The products give investors exposure to manged strategies and allow for risk return profiles not available through direct investment in the underlying fund.