The ideal portfolio structure It has ever been difficult to find out how the ideal structure of the portfolio of an investor, be he of private or institutional nature, should look like. Very few investors actually know about the shape of the expected return distribution they really prefer. Many sophisticated questionnaires aim to determine the risk / return profile of the investor. However, these two values are not sufficient to give a complete representation. A risk / return profile typically assumes that with higher risk, an investor may expect a higher return, but also that the losses could be higher. Hence, the classical categorization of investors assumes a normal distribution of returns. But what if, for example, an investor would like to keep the chance of higher returns while limiting his risk? Such return distributions with classic investments like equities or bonds are extremely rare, and yet investors often ask for it. Advisers are often quite helpless in such situations.
Three strategies The following describes a simplified method that allows an investor to implement his desired return distribution in a portfolio context by using the appropriate investment instruments. The investor is confronted with the choice of three strategies: 1. "Cut losses and let profits run" 2. "Buy low, sell high" 3. "Buy and hold" These familiar slogans, all hinting at wise yet nebulous strategies, can in truth be very accurately differentiated. In Strategy 1, the investor takes frequent small losses but may book occasional large profits. People who choose this strategy are dependent on safety and do not want to (or cannot) suffer large losses. In Strategy 2, the investor takes a lot of small gains, but accepts the occasional large loss. This strategy is the most active of the three, where timing plays an important role and which is often counter-cyclical. In Strategy 3, the investor is willing to take the fluctuations of the market into account, as he is persuaded that the underlying asset will generate a good return over the long run. This is the most passive of all 3 strategies. If an investor can opt for one of the three strategies, then an important step in the choice about investment vehicles to select for the portfolio will already be made. Only the 3rd strategy ("buy and hold") can be implemented with the traditional portfolio consisting of equities and bonds. In fact, it is the only one where the return prospects are normally distributed. The other two strategies have asymmetrical (non-normal) return distributions. To understand the concept, the so-called "higher central moments” of a return distribution must be introduced. These are namely the skewness (or skew, 3rd moment) and kurtosis (or height / pointiness, 4th moment) of the distribution. These designations are not very common among investors, but can be readily explained by way of example. Let us return to the investor, who would like no risk, but leave the door open to the chance of high returns. In principle, he wishes for nothing else than to replace negative return occurrences with zero and leave positive return occurrences as is. In a return distribution, replacing all negative values by a single one creates a peak at that level, and raises the kurtosis: the distribution becomes taller, pointier. At the same time the distribution loses its symmetry: since all the negative points disappear and the positive points stay, the return distribution becomes right-skewed (on a graph, the right tail of the distribution is longer than the left). In all logic it will cost something to reduce or even eliminate the possibilities of a negative return on investment. If it were free, everybody would do it. How much it costs is uncertain and depends on market conditions. So what would be a good description of this investor’s strategy? Well, the return distribution fits the first strategy, "cut losses and let profits run". The slogan description is probably better understood by the average investor than if the talk is about higher central moments of a return distribution. To round up the picture, the 2nd Strategy, "buy low, sell high" is identified by a left-skewed, high kurtosis distribution. Matching instruments Now it’s time to determine the selection of products that fit the chosen strategy. Here, structured products can be useful. Not coincidentally, structured products have been categorized in three major categories: capital guarantee, yield optimization and participation. Capital guaranteed products can’t be redeemed below their capital guarantee levels (unless the issuer goes bankrupt). All cases of negative returns are replaced by the level of capital guarantee (this sounds familiar). In theory, the cost of converting the negative returns to the capital protection level reduces the average return on the investment. As long as the product has unlimited upside potential, the chance for high positive returns remains open. Hence, capital guaranteed products have generally right-skewed medium-high kurtosis return distributions. In the case of yield optimization products, all returns that would be above a certain cap (e.g. a coupon) are replaced by the level of that cap. Negative returns are possible. To compensate for this increased risk, the investor receives a premium, which can be compared to a sold insurance premium. It therefore stands in contrast to the capital guaranteed product in which protection is bought. Yield optimization products have left-skewed return distributions with (sometimes very) high kurtosis. Participation Products have similar return distributions as their underlying assets. Both "tails" (extreme negative or positive returns) remain open. Despite minor distortions at certain points of the return distribution (such as at the barrier level of a bonus certificate), participation products return distributions can be considered as more or less normal. Conclusion The question "Who needs a structured products?” can now be answered as follows. The first strategy, "Cut losses and let winners run", can be implemented through capital guaranteed products. For the second strategy, "Buy low, sell high", yield optimization products can be considered. Ultimately, the third strategy, "buy and hold", is best achieved by means of classical instruments such as equities and bonds, but also through participation products. Of course, this is all very high level and a portfolio must be defined with more detail, but the foundations of the portfolio structure have been laid. Everyone who can identify his chosen strategy with one of the 3 slogans has also found out which product category is suitable for him. Andreas Blümke (Original text written by the author in German for B2B Magazine)