Protect Against Volatility With Structured Solutions

Structured solutions can help investors stay focused on their portfolio objectives and not feel compelled to react every time the market hits a bump in the road.

After a remarkably calm 2017, volatility has returned to the markets despite a generally positive economic environment. As of July 31, 2018, there have been 36 days in which the market has closed either up or down 1%; in 2017, that happened only eight times.

Still, since the 10% correction we saw back in March, the S&P 500 has grown by 9.49% total return as of July 31, 2018 thanks to a strong second quarter earnings season and continued economic growth.1 Equities, particularly small cap equities, have performed well (the S&P SmallCap 600 index up 12.03% year-to-date, through July 31, 2018) and the current bull market remains on track to become the longest economic expansion in U.S. history.

In such a volatile environment, many investors may be hesitant to put their money to work — especially if they have recently experienced a significant liquidity event, such as selling a business or offering it to the public through an IPO. The length of this bull market may also give investors pause. While we believe investors should maintain a well-diversified portfolio based on their objectives, there are strategies that allow investors to gain exposure to the potential growth in the market while protecting against volatility. "Structured solutions" provide exposure to the potential returns of an index or basket of securities and may limit the potential downside. These types of solutions can be a great way for investors to put their cash to work while maintaining their peace of mind. Before we delve into these solutions, however, let's first examine what's contributing to the current market volatility.

Uncertainty Drives Volatility

Why are investors more skittish? Well, to begin with, some of the good news we've seen this year (such as corporate earnings performance following the 2017 tax bill that led to 78% of S&P 500 companies beating their first quarter estimated earnings) was probably already priced into the market. In fact, it's likely that optimism around corporate earnings contributed to the strong equity market returns we saw in 2017. The 12% correction we saw in the first quarter — a reaction to an unexpected increase in wage growth that raised inflation concerns — dampened that optimism and revealed a sense of uncertainty hanging over the market.

Right now, many investors feel like they have more questions than answers:

  • Will the tax legislation passed at the end of 2017 ultimately be successful? What will companies do with their tax savings — buy back shares, pay down debt or reinvest?
  • How far will the Trump administration go in applying tariffs to goods from China, Canada, Mexico and the European Union and what impact could retaliation have?
  • Does the continued flattening of the yield curve indicate a coming recession?
  • Which party will control Congress following the U.S. midterm elections, and could a change in control derail the implementation of fiscal stimulus?

These unanswered questions are weighing on the minds of investors and have left the market climbing a steep wall of worry, making it more reactive to certain data, as we saw in the reaction to the wage growth increase in February.

While answers are sure to be forthcoming for some of these questions, we do not expect this political and economic uncertainty to ease in the next 12 to 18 months. Nevertheless, we believe that fiscal policy in the U.S. will create strong demand for the near term and that the expansion will continue through the rest of 2018 and 2019, though perhaps at a slower rate. Despite continued yield curve flattening, we continue to believe recession fears are premature. The trade tensions between the U.S. and its trading partners should ultimately result in an agreement on tariffs, but this could take time.

While we are confident in the positioning of our investment portfolios, which includes a modest overweight to equities and underweight to bonds, we also believe it's important to incorporate alternative investments to help buffer market volatility and rising rates. While a properly diversified portfolio is an essential element of an investment plan, customized structured solutions can be another way to help reduce overall portfolio volatility while potentially adding returns.

For investors with significant amounts of cash on the sidelines, a structured solution may provide the flexibility and risk management needed to get back into the market. This investment allows an investor to put money to work in a more volatile environment by limiting the downside otherwise associated with investing in equities. It can be a better strategy to employ a structured solution rather than waiting for all of these headwinds to get resolved, given the opportunity cost of missing out on potential gains in this strong economic environment.

What Is a Structured Solution?

A structured solution is a note that is similar to a bond in that the investor lends his or her money to an investment counterparty bank for a fixed period of time. In exchange, the bank provides the investor with exposure to an underlying market index, such as the S&P 500, while offering to shield the investor against losses up to a certain point and, in some cases, offering a return greater than that of the index.

For example, consider an S&P 500 Buffered Risk-Enhanced Return Solution (BRERS). The "note" is issued by a counterparty bank, offers an enhanced upside return of 1.5 times greater than the S&P 500 (though capped at 18.25%) and reaches maturity after 20 months. It aims to reduce volatility compared to traditional equity positions by providing a 10% downside buffer.

What this means is that if the S&P 500 generated a 15% return, the holder of a BRERS structured note would enjoy an 18.25% gain. However, if the S&P 500 exceeded 15%, the BRERS investor would not see any further gains. On the other side, the BRERS investor could endure up to a 10% drop in the S&P 500 without seeing any loss of principal, and would enjoy reduced losses should the index drop further. For instance, a -20% return from the S&P 500 would be reduced to just a -10% return from BRERS.

Given our expectation for mid-single-digit equity market returns over the next 12 to 18 months, the structure of a BRERS solution can boost investor returns while minimizing downside risk. There are, however, some potential risks to consider:

  • Daily pricing. The BRERS does not move in lockstep with the underlying index on a daily basis and, due to option pricing, will be valued at intrinsic value only at maturity.
  • Issuer default. Because the strategy is structured as debt, it is similar to holding a bond.
  • Limited liquidity. While liquidity can be sourced from the issuers and the secondary market, it is not guaranteed and investors must be prepared to hold the note through maturity.
  • Dividends and gains excluded. The strategy provides the performance of the price return of the underlying security only.
  • Tax considerations. Typically, gains from a structured solution are treated as long-term capital gains if held for more than one year. However, investors should review the prospectus included in each deal.

Structured Solutions Can Provide Peace of Mind

We continue to believe global growth and robust corporate earnings will help drive equity gains in 2018 and beyond. That said, there are a number of headwinds facing the market and there's always the potential for negative surprises — say, a prolonged period of escalating trade tensions or a surprise outcome in the U.S. midterm elections — that could exacerbate volatility even further. In addition to a well-diversified investment portfolio, investors may benefit from incorporating customized hedging strategies like structured solutions that provide equity market participation and capital preservation in more volatile markets. By doing so, investors can stay focused on their portfolio objectives and not feel as compelled to react every time the market hits a bump in the road.

  • 1. Since March 23, 2018.

  • This white paper is the property of BNY Mellon and the information contained herein is confidential. This white paper, either in whole or in part, must not be reproduced or disclosed to others or used for purposes other than that for which it has been supplied without the prior written permission of BNY Mellon. This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. The Bank of New York Mellon, Hong Kong branch is an authorized institution within the meaning of the Banking Ordinance (Cap.155 of the Laws of Hong Kong) and a registered institution (CE No. AIG365) under the Securities and Futures Ordinance (Cap.571 of the Laws of Hong Kong) carrying on Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities. The Bank of New York Mellon, DIFC Branch (the “Authorised Firm") is communicating these materials on behalf of The Bank of New York Mellon. The Bank of New York Mellon is a wholly owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients only and no other person should act upon it. The Authorised Firm is regulated by the Dubai Financial Services Authority and is located at Dubai International Financial Centre, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the Federal Reserve and authorised by the Prudential Regulation Authority. The Bank of New York Mellon London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon is incorporated with limited liability in the State of New York, USA. Head Office: 225 Liberty Street, New York, NY 10286, USA. In the U.K. a number of the services associated with BNY Mellon Wealth Management's Family Office Services– International are provided through The Bank of New York Mellon, London Branch, 160 Queen Victoria Street, London, EC4V 4LA. The London Branch is registered in England and Wales with FC No. 005522 and #BR000818. Investment management services are offered through BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA, which is registered in England No. 1118580 and is authorised and regulated by the Financial Conduct Authority. Offshore trust and administration services are through BNY Mellon Trust Company (Cayman) Ltd. This document is issued in the U.K. by The Bank of New York Mellon. In the United States the information provided within this document is for use by professional investors. This material is a financial promotion in the UK and EMEA. This material, and the statements contained herein, are not an offer or solicitation to buy or sell any products (including financial products) or services or to participate in any particular strategy mentioned and should not be construed as such. BNY Mellon Fund Services (Ireland) Limited is regulated by the Central Bank of Ireland BNY Mellon Investment Servicing (International) Limited is regulated by the Central Bank of Ireland. BNY Mellon Wealth Management, Advisory Services, Inc. is registered as a portfolio manager and exempt market dealer in each province of Canada, and is registered as an investment fund manager in Ontario, Quebec, and Newfoundland & Labrador. Its principal regulator is the Ontario Securities Commission and is subject to Canadian and provincial laws. BNY Mellon, National Association is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. BNY Mellon is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept any responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. Trademarks and logos belong to their respective owners. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2018 The Bank of New York Mellon Corporation. All rights reserved.