Structured Forms of Investment Strategies in Institutional Investors' Portfolios
Benefits of Dynamic Asset Allocation through Buy-and-Hold Investment in Derivatives
This research examines the proportion of buy-and-hold investors' portfolios that should optimally be allocated to structured products. It is the first ever academic study to explore this topic. The findings, targeted to institutional investors, are relevant to all investors seeking to optimize the Risk-Return ratio of their portfolio.
The benefits of structured products are based on two fundamental results from modern portfolio theory:
— Structured products accentuate diversification benefits through the access that they give to risks and returns that investors find difficult to manage, or indeed to find.
— Structured products correspond to dynamic forms of allocation which are known to be more general than, and therefore superior to, static allocation.
This research examines the proportion of buy-and-hold investors’ portfolios that should optimally be allocated to structured products and is the first ever academic study to explore this topic. Through investing in structured products (strategies involving long and short positions on equities, indices or funds, using derivatives and leveraging effects, with risk-free assets and packaged into investment vehicles that are easily accessible by investors), it may be possible for institutional investors to enjoy the benefits of dynamic asset allocation strategies while keeping the same investment throughout the period.
The authors conclude that the addition of a guaranteed structured product into an investment which includes stocks and bonds leads to an improvement in efficient frontiers (the best risk/return combination):
Key Points from the Study
Structured products and institutional investors
A growing market
Why Structured Products?
A simple structuring methodology that can be generalised to a wider class of non-linear payoffs
Characteristics of the Guaranteed Structured Product (GSP) used for the study
— Guarantee of the capital invested at the initial date
— Maturity of ten years
— Pay off equal to the highest value reached by the underlying stock index (annual observation dates).
The evaluation method
Thus taking into account both the existence of fat tails in the return distributions and institutional investors' aversion towards taking on extreme risk.
A significant improvement in efficient frontiers
Efficient frontiers in an expected return -CVaR space with and without Guaranteed Structured Products (GSP). Note that negative CVaR values express negative losses, i.e., positive returns. For example, point 1:
— Expected Return= 100%
i.e. an investment of 100 euros/dollars will become 200 euros/dollars on average.
— CVAR(95%)= -10%
i.e. the average return of the 125 worst scenarios (5%*2500) is equal to +10%.
Our results show considerable improvement in the efficient frontiers depicting the risk return trade-off of the investor when the latter invests in the Guaranteed Structured Product
Which asset allocation for structured products?
One may observe the change in asset allocation with respect to the change in risk aversion. These allocations correspond to portfolios labeled on the two efficient frontiers above. The GSP helps risk-averse investors increase their returns by replacing the stock allocation in their portfolio and helps risk-seeking investors to decrease shortfall risk by replacing the bonds in their portfolio.
For investors with a strong aversion to risk (points 1-3) the weight of the structured product takes on values between 70 and 90 percent. On the other hand, risk-seeking investors (points 5-9) can actually decrease their shortfall risk exposure by replacing the bonds in their portfolio with a structured product. For this group of investors, optimal allocation to the structured product ranges from 10 to 70 percent. In fact, only the most risk-seeking investors (point 10) would have a zero allocation for a structured product and invest 100% in stocks.
Robustness of diversification benefits
— market frictions
— heterogeneous expectations on volatility estimates
For the structured product, as a result of the fees, the stock and bond indices become more attractive and replace part of the allocation of the structured product. The allocation decrease of the structured product, however, is relatively small.
Overall, these results strongly suggest that adding even a limited fraction of the overall allocation to structured products allows for significant benefits, measured in terms of an increase in the return/CVaR ratio of the portfolio, a measure of risk-adjusted performance (Table C).
Changes in the values of the objectives and the optimal asset allocation in the presence of weight constraints on GSP allocation. Numbers are not annualized. A 0% upper bound implies that GSP is not included in the opportunity set (point E in Graphs A and B).
An improvement in efficient frontiers
Generalization of results
Prospects for the structured products market
This research was sponsored by SG CIB (the Société Générale group).