John A. Prestbo of Dow Jones Indexes looks at some of the trends, opportunities, challenges and misconceptions in relation to using indexes as underlyings for structured products.
Date: Nov 2011
For example, Dow Jones has a steady business in structured products licenses on the Dow Jones Industrial Average (DJIA), he said, plus the firm is seeing expansion into other asset classes such as commodities, combinations of equities and commodities, and to some degree, equities and fixed income.
As a result, the firm is in close contact with the structured products desks at the various investment banks, to offer them what Prestbo said they think they can attract investment capital with.
Some of the newer indexes are dividend based, for example, which hold up very well, he explained, when the market as a whole is not doing well – and can be seen as defensive elements to those structured products which don’t tend to sell well in market downturns.
The impact of volatile markets
Prestbo said the firm creates products that are aimed at bolstering investors when times are tough.
A new type of structure emerging, he said, are target volatility indexes, which target a specific level of volatility which the customer can tolerate, and within which mixtures of cash and equities are adjusted to achieve that volatility. This is a product which came out of the 2008 crisis, said Prestbo.
Misconceptions around using indexes
According to Prestbo, the main misconception that investors have around the use of indexes as underlyings for investment products is that all indexes are not alike, even if they purport to be measuring the same thing.
In the US, for example, the DJIA and the S&P 500 both take very different approaches to measuring “the market”, he said, explaining that although people understand that 30 stocks is fewer than 500, there are more differences than the obvious.
For instance, the DJIA is price-weighted whereas the S&P 500 is weighted by market capitalisation, said Prestbo. Plus, he added, while they both tell the same story about the stock market, they are not telling it in the same way.
For example, when the market hit a bottom in early 2009 and then started going up again, smaller stocks initially felt the biggest impact of the inflows of capital back into the market. Yet the DJIA doesn’t have any small stocks, while the S&P 500 does – so in 2009 and 2010, the S&P 500 beat the DJIA. In 2011, however, large stocks have come back into favour, which is better for the DJIA.
Although these are subtle changes to some people who play the broad US market, they play strongly at different cycles of the market, said Prestbo.
Issues to consider with indexes
Knowing the differences between the indexes that underly what are seemingly similar products is one thing, said Prestbo, but investors also have to understand the differences in the products which are based on those indexes.
In the US, for example, products can be registered on various acts of the securities regulatory regime, and behave differently under certain circumstances.
Yet governments have different rules and regulations about these kinds of products, so knowing this is particularly important to those investors which might go outside of their own market to put money into one of these vehicles.