Optimal Portfolio Design – What the Research Says About Structured Products

In this document we explore key findings from two independent academic research papers that looked into the optimal allocation of structured products in an investor’s portfolio.

Structured Forms of Investment Strategies in Institutional Investors’ Portfolios:

One research study in the field of structured products is “Structured Forms of Investment Strategies in Institutional Investors” by Lionel Martellini, Koray Simsek and Felix Goltz, published by the EDHEC Risk and Asset Management Research Centre (2005). This research is essential for understanding the increasing role of structured products in modern investment practices.

The above graph illustrates the change in asset allocation with respect to the change in risk aversion, where 1 represents the most risk-averse investor and 10 the least. GSP refers to a Guaranteed Structured Product which is the equivalent of a Capital Protected Structured Product. The focus of the study was to determine what  proportion  of  their  portfolio  risk-averse  institutional  investors  should optimally allocate to structured investment strategies.

• For investors with a strong aversion to risk (points 1-3) the optimal allocation   to structured products ranges between 70% and 90%.

• For the more risk-seeking investors (points 5-9), structured products can   effectively replace a portion of bonds in the portfolio to reduce shortfall risk,   with optimal allocation levels ranging from 10% to 70%.

• Only a purely return-maximising portfolio, with no interest on risk control, would entirely exclude GSPs and consist solely of equities.

Some key findings from the study include:

• Study found that including GSP (Guaranteed Structured Products) into the portfolio has significant benefits, measured in terms of an increase in the return-to-CVaR ratio of the portfolio. This ratio by definition is the Expected return / CVaR at a confidence level α (typically 95%) – ‘How much return you’re getting for every unit of worst-case downside risk’.

• Structured products allow investors to profit from the equity risk premium without being fully exposed to the downside risk associated with investing in stocks.

• Given that a structured product can be viewed as a static packaging of some dynamic asset allocation strategy, institutional investors can enjoy the benefits of dynamic asset allocation strategies through the use of buy and- hold investment in structured products.

The Edhec study concluded that most institutional investors should optimally allocate a significant fraction of their portfolio to guaranteed structured products, especially if they have a focus on extreme risk management.

Who should buy structured investment products and why?

Another important contribution to the discussion on structured investment products is the paper “Who Should Buy Structured Investment Products and Why?” by Massimo Guidolin, Giacomo Leonetti, and Manuela Pedio (2024). This research delves into the characteristics of investors who are best suited for structured products and the underlying motivations driving their choices. By examining investor profiles and their preferences, the paper provides valuable insights into the suitability and strategic advantages of these products for different market participants. This work enhances our understanding of the role structured products play in personalised investment strategies.

This paper takes an ex-ante perspective, and they look to investigate under what circumstances different structured products may represent a valuable addition to the portfolio of a utility-optimising and informed retail investor.

Some interesting points from the paper include:

• A very valuable characteristic of Structured Products is having access to trade volatility risk and harvest the variance premium, where an investor who is restricted from short selling would not otherwise be able to. Explicitly, this means earning a return by effectively selling insurance against market swings, since investors tend to overpay to protect themselves from volatility.

• It is evident that the value of the early redemption feature (autocall) to the investor increases with the horizon. In fact, the longer the duration of the autocallabe note, the higher the probability that the structured product redeems earlier than its maturity especially in the presence of jumps, which are estimated by Dufays et al. (2023) to occur on average every two years