Three Years of Innovation: The Rolling Buffered Notes

By Joe Halpern, Portfolio Manager of the Catalyst Exceed Defined Risk Fund and Exceed Defined Shield Index Fund

Downside protection in a portfolio is a key need for many clients. Whether simply due to a conservative investor approaching retirement (e.g., 55 – 65+ group) or views that the market may be long in the tooth after one of the longest bull markets in the last century, a strategy that provides some hedge to a negative market has an important position in a portfolio allocation. Equally important in both scenarios provided is the behavioral need associated. Investors approaching retirement are at a sensitive point in their investing period as their nest egg is most likely at its largest size with withdrawals to fund lifestyle choices around the corner. Perception of a late in the cycle equity position may shake some out of the market prematurely. A strategy that provides the necessary hedge as well as a level of definition is key in maintaining positions in the market.

One of the most popular strategies within the industry is the buffered note, which provides 1st loss protection to a specified level with returns up to a maximum cap on a referenced market, such as the S&P 500. Historically, advisors have used the product in a number of ways, including:

• Core conservative equity position with satellite positions that are either more aggressive or conservative dependent on the client risk tolerance
• Partial replacement of fixed income given the low yield environment
• Replacement of alternative strategies such as market neutral, long-short and other hedge equity solutions that typically have less definition

In September 2014, Exceed partnered with Nasdaq in introducing a truly innovative approach to the structured notes market. There are two major innovations applied to the traditional structured note format:

1. A traditional structured note consists of a senior, unsecured bank issued credit and an over the counter portfolio of options. The index strategy uses listed S&P based options in place of the over-the-counter (OTC) options and publicly issued, Investment Grade credit securities (IG Bonds) in place of the private bank issued senior, unsecured notes – essentially achieving the same exposure with a more competitive and liquid approach.

1. The strategy then ladders the replicated notes quarterly and rolls them at maturity – resulting in 4 rolling, laddered series allowing for an open ended format rather than a term based product like traditional structured notes.

The benefits of the structured note product is the high level of definition and therefore confidence in the expected return. This benefit should not be overlooked as most strategies have a hard time providing this sort of definition, especially when a hedge is being offered. A structured note uses options to contractually lock in this definition, so lacking a default by the issuer (which we will get to), the expected outcome should occur.

Now there are a few detriments to the product as provided by the traditional issuer, some of which are detailed below:

• Lack of liquidity: Exiting a note early will cost the investor due upfront fees and additional spreads typically assessed by the issuer. A Variable Annuity is a long term contract with material fees for exiting early and limited availability of alternative strategies on the current variable index annuity platforms.
• Concentrated credit risk: A note is a senior unsecured debt obligation of the issuer (i.e., an IOU). If the issuer goes bankrupt, as was the case with Lehman Brothers, the owner gets a fraction of the notes value back.
• General complexity: Beyond a lack of standardization in the industry making it at times hard to analyze exactly what the exposure is, there are potentially high minimums, high costs, access issues, implementation issues, and a general lack of transparency.

These are all either solved or materially improved through our approach as follows:

• Liquid: A mutual fund structure allows entering and exiting at a daily net asset value (NAV). Furthermore, as will be seen, off-the-shelf, liquid securities are used in place of traditional over the counter, bank created securities which should allow for a more competitive, liquid environment.
• Mitigated Credit Risk: Our strategy tracks a portfolio of short term investment grade bonds allowing for mitigated, diversified credit risk.
• Standardized: A consistency unmet by the current industry in regards market exposure, low minimums, access and fees via a mutual fund structure and high levels of transparency due the index and associated product.

Furthermore, by laddering and rolling a portfolio of buffered strategies, similar to the way a bond fund ladders and rolls a particular bond strategy, a number of other improvements are provided, namely:

• Easy implementation within a model portfolio
• Diversification of market entry and exit
• Managed approach to laddering a portfolio

With all material innovations, investors need the opportunity to kick the tires and understand how the product will actually work. Closing in on three years of live performance, we now have the opportunity to support some of the assertions provided early on with performance data. Interested parties can plug in the indexes for themselves into Google Finance to see for themselves how the indexes have fared over time:

• EXPROT seeks to provide an annual floor of 12.5% in return for participation up to a 15% cap on the S&P 500. This strategy is most similar to collar strategies and tail risk protection strategies with the additional benefit of increased definition.
• EXHEDG seeks to provide an annual 10% buffer with 1.5x upside to a variable cap on the S&P 500. This strategy is most similar to the buffered note. The buffered strategy is extremely popular with issuance in the billions annually, through either bank issued notes or insurance issued variable indexed annuities like the AXA Structured Capital Strategies
• EXENHA seeks to provide no downside protection but 2x up to a higher cap on the S&P 500. This strategy is most similar to some of the leveraged notes that have become popular over the last couple of years amongst the traditional bank issuers.

Additionally, a recent in-depth analysis of the EXHEDG strategy illustrating how our approach actually plays out in the market is available on our insights page.

To learn more about the indexes and associated products please reach out to Nasdaq, CATALYST or EXCEED.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.