Volatility is a statistical measure of the tendency for the value of an asset’s price to move in either direction away from its average price over time.
If an asset has high volatility the price of the asset will be spread over a greater range of values, whilst low volatility suggests that the price deviates across a smaller range. An Absolute Return Fund such as the Janus Henderson Fund shown in blue below has low volatility, whilst an Emerging Markets Fund such as the UBS Fund shown in red has high volatility. This is because there are greater swings in price from the returns over a given time period.
Source: FE Analytics, Total Return, Bid-Bid
The price of a structured investment is in part determined by the implied volatility of the underlying asset. Implied volatility is a measure of the expected range of price movements in the near future. For the probability models used to price the Financial Derivative Instruments (FDIs) present within structured investments, the implied volatility looks at the 34% most likely price movements in either direction, giving a span of the 68% most likely potential price movements at a given point in time.
The sensitivity to volatility of the FDIs within a structured investment is known as Vega. Academic studies suggest that the Vega within a structured investment is typically less than that of the underlying asset, and their pricing therefore tends to be less volatile than that of the underlying index. This is distinct from the additional risk exposure taken through the adoption of counterparty credit risk, and interest rate risk which also contribute towards the pricing of the structured investment.
Janus Henderson – UK Absolute Return I Acc Share Class in GBP. July 15th, 2014 – July 15th, 2019.
UBS – Global Emerging Markets Opportunity P Acc Share Class in USD. July 15th, 2014 – July 15th, 2019.
Jonas Larsson, (2009), Risk Analysis of Structured Products.
Mohamed Osman Abdelghafour, (2009), Structured products: Pricing, hedging, and applications for life insurance companies
As an example, below we show the secondary market bid pricing of two structured investments, which showed lower volatility than the underlying asset. These two structured investments are options 1 and 2 of the Mariana Capital 10:10 Twin Option FTSE Kick-Out Plan October 2015 and these are shown against the returns of the FTSE 100 Index and FTSE 100 Total Return Index.
Source: FE Analytics, Lowes Financial Management Ltd
Whilst the performance and volatility at the beginning of the term is similar, we see that over time the volatility of these two structured products is less than that of the FTSE 100 Index. A prime example was at the beginning of 2018, when we saw the FTSE 100 (the two blue lines) fell much more than the two structured products. Helped, in part by the position of the FTSE 100 prior to the retracement, both Option 1 (green), which required no growth in the Index to trigger an early maturity and Option 2 which required at least 10% growth had lower volatility in comparison to the underlying index.
Volatility within the Lowes UK Defined Strategy Fund
As well as affecting the pricing of a structured investment, volatility also affects the potential returns offered by structured investments. This can be demonstrated by comparing two strategies contained within the Lowes UK Defined Strategy Fund (the “Fund”) which, despite having the same shape (i.e. same maturity reference level being the initial level; frequency of early maturity observations and capital protection barrier) began at different times, when volatility in the FTSE 100 and index position was very different.
Strategy 1, issued by Citigroup Global Markets Ltd offered a 16.6% return for each year held, maturing on the first of the pre-defined observation dates that the FTSE 100 Index was above the initial index level (6721.17).
Mariana Capital 10:10 Twin Option FTSE Kick-Out Plan October 2015, Options 1 and 2.
Strategy 10, issued by Morgan Stanley has similar maturity parameters albeit with an initial index and maturity trigger level of 7203.29 but offered a lower potential 10.75% return for each year held.
Whilst these two strategies had some differing factors not least, differing counterparties, the large variance in return offered can largely be attributed to the volatility of the underlying asset (the FTSE 100 Index) at the time they were structured. Volatility was much greater in December 2018, when strategy 1 was created, but had fallen by the time Strategy 10 was introduced. For more details on the specifics of all of the fund strategies utilised in the Lowes UK Defined Strategy Fund and referenced in this article, please visit UKDSF.com/Portfolio.
So, whilst structured investment terms can vary according to volatility in the underlying measure, over the medium to long term their pricing tends to be less volatile than the underlying index itself. It is this that Lowes Investment Management Ltd (as investment manager) plans to take advantage of within the Lowes UK Defined Strategy Fund. Recycling existing investments when volatility leads to better returns being offered, whilst benefitting from the reduced volatility in the pricing of the underlying strategies as the portfolio matures. This strategy is completely at the discretion of Lowes Investment Management Ltd as investment manager to the fund, and other factors may mean that this strategy is not the chosen course of action.
If you would like to know more about the Lowes UK Defined Strategy Fund, please visit the Fund website UKDSF.com/Literature for the Key Investor Information Document (“KIID”), Prospectus, and Supplement or call Lowes Investment Management on 0191 281 88 11.
The Lowes UK Defined Strategy Fund is a sub-fund of the Skyline Umbrella Fund (ICAV) and is regulated by the Central Bank of Ireland. The KIID, Prospectus, and Supplement can be accessed by visiting UKDSF.com/Literature and are only available in English.
Lowes Investment Management Ltd, Fernwood House, Clayton Road, Newcastle upon Tyne, NE2 1TL. Authorised and regulated by the Financial Conduct Authority.