Structured Forms of Investment Strategies in Institutional Investors' Portfolios

Benefits of Dynamic Asset Allocation through Buy-and-Hold Investment in DerivativesThis 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):

- Such products allow investors to profit from the equity risk premium without being fully exposed to the downside risk associated with investing in stocks.
- As a result, typical institutional investors, with a strict focus on risk management driven by the presence of liability constraints, should ideally allocate a significant fraction of their portfolio to structured investment strategies.

**Key Points from the Study**

**Structured products and institutional investors**

*A growing market*

- Institutional investors in general and pension funds in particular have been affected by recent market downturns, some dramatically.
- An increasingly thorough range of structured products has been developed over the past few years, which allows investors to tailor the risk-return profile of their portfolio in a more efficient way than simple linear exposure to traditional asset classes.
- As in the hedge fund industry, it is expected that institutional investors will follow the early lead by the private banks and that significant inflows will occur over the next few years.

*Why Structured Products?*

- Structured products: strategies involving long and short positions on equities, indices or funds, using derivatives and leveraging effects, in risk-free assets and packaged into investment vehicles that are easily accessible by investors.
- Through investing in structured products, it may be possible for institutional investors to enjoy the benefits of dynamic asset allocation strategies while keeping the same investment throughout the period.

**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*

- A focus on the case of a single underlying asset, such as a stock index, with the following characteristics:
— 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 study can also be applied to using more complex structured products in response to specific constraints.

*The evaluation method*

- The method compares the efficient frontier (frontier which defines the limit of the maximum returns for a given series of risk levels) of an investment that includes stocks and bonds with one that includes in addition the Guaranteed Structured Product.
- The risk is measured by the CVaR level. As opposed to Value-at-Risk (VaR) which describes a maximum loss that will not be exceeded (with a given confidence level), the CVaR measure summarises the distribution returns that are below this threshold.
Thus taking into account both the existence of fat tails in the return distributions and institutional investors' aversion towards taking on extreme risk.

- We chose to proceed by defining continuous time processes for asset return dynamics and then simulated paths by using a discretisation scheme. On each path, we calculated the returns for stocks (including dividends), bonds and for the Guaranteed Structured Product. The scenarios for the total returns on each asset class were then fed to the optimization program, which allowed us to draw efficient frontiers.
- The optimization criterion is minimizing a expected 10-year loss for a given level of expected 10-year return.

**A significant improvement in efficient frontiers**

Graph A

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?**

Graph B

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**

- It is important to consider the impact of:
— market frictions

— heterogeneous expectations on volatility estimates

— feesFor 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.

- Because of weight constraints for structured products, it is not reasonable to expect institutional investors to allocate a dominant fraction of their portfolio to structured products.
- We tested the impact of imposing an upper bound on the allocation to the product.

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).

**Conclusion**

*An improvement in efficient frontiers*

- Such products allow investors to profit from the equity risk premium without being fully exposed to the downside risk associated with investing in stocks.
- As a result, typical institutional investors, with a strict focus on risk management driven by the presence of liability constraints, should ideally allocate a significant fraction of their portfolio to structured investment strategies.

*Generalization of results*

- While these results have been performed on the basis of a specific example, they can be generalized to a wider class of nonlinear payoffs. In particular, products with convex payoffs are ideal for institutional investors with a focus on the management of extreme risks.

*Prospects for the structured products market*

- As institutional investors have high demands in term of risk management, a trend towards greater transparency, liquidity and cost control has already taken place in the structured investment management industries, and substantial amounts of assets are shifting from traditional investments to structured products.

**This research was sponsored by SG CIB (the Société Générale group).**