The next generation of custom indices

Structured product providers have been offering custom strategies to investors for some time. These have been made available either in delta-one format, or wrapped within a structured product to allow for some element of capital protection or yield enhancement. In the past, custom indices on offer have ranged from research-led stock selection screens, to rules-based strategies designed to extract returns from specific biases or anomalies in the market.

Whilst most of these strategies continue to perform well and generate interest from investors, the range and type of indices on offer has expanded significantly given the shift in markets and investor sentiment over recent years. Providers now offer more bespoke versions of their indices for clients, including the introduction of specific volatility targets, or absolute return versions, as well as indices that access non-traditional asset classes, such as volatility. In this article we will look at some of the new strategies that have launched in the market and how they are helping investors meet their investment goals.

First Generation Strategies: Building track records and still generating interest.

Before looking at some of the recent strategies that have come to market, it’s important to revisit some of the strategies launched 3 - 5 years ago. Many of these strategies are based on well-known investment fundamentals, such as value or growth screening. For example, Morgan Stanley’s Target Equity Index Family, first launched in 2007, is based on research by our European Equity Strategy Team that aims to identify high quality companies that might appeal to private equity and corporate buyers, using selected valuation metrics.

Other strategies are based on anomalies in markets, such as Morgan Stanley’s EFRB (Enhanced Forward Rate Bias) Index. Forward rate bias – the bias that forward rates do not accurately predict future interest rates – is a persistent anomaly in interest rate markets. This index aims to exploit this bias in the yield curve by capturing both over- and under-estimation of future interest rates via long and short positions.

Despite rather erratic markets in the past couple of years, these types of strategy are generally performing well against broader market benchmarks, and generating improved returns for investors over a 3 – 5 year investment horizon. However, given the increased levels of uncertainty in markets, investors’ needs have changed, and custom index providers such as ourselves have created new custom indices to reflect that.

Tailoring existing indices to better meet investors’ requirements.

One effect from the recent turbulence in markets is an increase in volatility. Many equity indices have swung from highs to lows, with significant movements being recorded in relatively short spaces of time. In times of high volatility, gaining exposure to custom indices via structured products can be expensive: as volatility increases, so can the cost of purchasing the derivatives that provide the exposure. This relationship has given rise to a new breed of custom index, where exposure to the index is systematically adjusted to maintain a constant level of volatility – ‘Target Volatility’ indices. For example, we can apply this to our Target Equity Indices, where we can set a volatility target of, say, 15%, and dynamically allocate between the index and a riskless asset in order to maintain a constant strategy volatility to match the target. Therefore, as volatility increases (typically in bear markets), the exposure of the strategy to the index is reduced.

Similarly, as volatility falls, exposure increases once more. The overall effect versus a non-volatility controlled version of the same investment strategy is a smoothing of returns: the strategy will typically outperform in bear markets and underperform in bull markets.

Investing in volatility itself

As well as impacting the cost of gaining exposure to custom indices, volatility has had a much broader impact on investors. It tends to be inversely correlated with market performance, with volatility increasing as markets fall. This is because as future market trends become uncertain, one would expect prices to be more sensitive and any movements to be more severe.

As a result, investors have actually been looking to gain long exposure to volatility. Due to its inverse relationship with market performance, a long volatility position can be added as an overlay to a long equity portfolio to hedge against market shocks.

There are many ways investors can gain long exposure to volatility: volatility options, variance swaps, VIX futures, ETFs and actively managed funds. Structured product providers have also created some interesting and innovative solutions in this space, by launching custom indices with similar exposure.

One thing investors need to watch out for in long volatility strategies is negative carry. Whilst long volatility positions can provide protection against sharp market falls, their value is gently eroded during normal market conditions. This is where gaining exposure via custom indices could be more optimal for investors: Long volatility indices can dynamically adjust exposure according to market conditions, to ensure full exposure in volatile markets and reduced exposure during normal markets (and therefore be less impacted by the negative carry).

Morgan Stanley has recently launched a net long volatility strategy, VolNet Hedge. As well as adjusting exposure according to prevailing market conditions to reduce carry, the strategy also includes embedded risk management techniques and a short volatility overlay to help reduce this negative carry further. Custom indices offering exposure to volatility have been some of the most popular launches in the past couple of years, and are a strong example of how these rules-based indices can provide much more than access to specific market themes or pricing anomalies: instead, investors are starting to look to these indices to gain exposure to non-traditional assets for their diversification and hedging benefits.

Choosing the right index

Regardless of whether an investor is looking for a value strategy, volatility controlled exposure, or a long volatility position to hedge an existing portfolio, there is an ever-increasing choice of custom index solutions in the market to choose from. In fact, the difficulty may sometimes lie in deciding which of the available strategies is best suited for an investors’ requirements. Below is a list of questions that investors should be addressing when selecting a custom index:

• Is the index methodology well-defined? Does it follow clear rules? There should be a detailed description available from the index provider explaining the methodology behind the index.

• Have the assets underlying the strategy been screened for liquidity? An index is liquid when its constituent stocks are liquid and the more liquid an index, the more investment options will be available to invest in such index, including via structured products with capital protection.

• Are there any sectors / regions / assets excluded from the index? Understanding whether specific market segments have been excluded can help to understand performance biases and also to select an appropriate benchmark for comparison.

• How frequently does the screening take place? As the past 12 months exemplify, market conditions can change quickly, and stocks with favourable characteristics now may not have favourable characteristics in 6 months time. So it is important that the index is dynamic and rebalanced regularly.

• What is the past performance of the index? There is usually a wealth of performance data available on custom indices, including many years of past performance. Although past performance shouldn’t be used as a guide to the future, most investors are interested in how a particular strategy performed in the past. However, it’s important to differentiate between actual and simulated performance, as well as checking for consistency over different parts of the market cycle.

Getting flexible exposure via structured products

Once investors have selected a strategy and are satisfied with the information available on the index, the next stage is selecting the type of exposure to the index. For investors looking for direct 1:1 exposure, a fund (potentially a UCITS III fund), ETF or Tracker Certificate may be the answer. However, many custom indices are also available via structured products.

These allow investors to combine exposure to the index with additional features such as capital protection or leverage. The payouts available depend on the complexity of the strategy and its liquidity. A custom index that simply selects a basket of stocks – similar to a benchmark equity index – should be flexible in terms of payouts and therefore allow access to more structured wrappers. For a more complex strategy, or one that has less liquid constituents, it may be that only direct 1:1 exposure is available.

Summary

Investors have more choice than ever when it comes to underlyings for structured products. The first generation of custom indices have built strong track records and are still appealing to investors today. In addition, development of new custom indices is anything but stagnant, and providers have adapted and added to their offering to reflect the changing needs of their clients. This includes tweaking existing strategies to help clients achieve more cost-effective exposure, as well as entirely new strategies that meet different investment objectives, such as hedging an existing portfolio against market shocks.

To find out more, contact us at info@morganstanleyiq.com

Morgan Stanley