It would be hard to criticise an investor whose first instinct was to allocate a significant proportion of their portfolio to the S&P 500. According to Bloomberg data, the main US index has returned 11.3% annualised over the last 20 years – a period that takes in both the global financial crisis and Covid.
A quick look at S&P500 price/earnings ratios, however, tells us valuations are currently relatively high – at 28x versus an average of 20x over the last two decades, again according to Bloomberg.
So valuations are elevated relative to their long-term average, while market concentration, geopolitical uncertainty and questions over the durability of AI-led growth are encouraging a reassessment of the traditional risk-return trade-off.
Investors would therefore do well to be asking themselves if the conditions that supported such strong returns over the past 20 years will persist.
Predictability of outcome
Clearly, allocating to the S&P 500 has worked over the last two decades – albeit with some setbacks along the way – and yet past performance does not tell anyone what the next two decades will look like.
Investors wary of the possibility that future growth may not play out as hoped, or those looking for other ways to achieve equity-like returns, have options available to them in the form of defined outcome investments. These are designed to offer a predefined return across a specified range of market outcomes. Investors can therefore balance the return they are seeking against the level of market risk they are prepared to take.
“Market concentration, geopolitical uncertainty and questions over the durability of AI-led growth are encouraging a reassessment of the traditional risk-return trade-off.
The objective here is not to capture every percentage point of upside – it is to generate an attractive return across a wider range of possible market outcomes.”
Structured notes can be tailored to different investor objectives. One of the most popular forms is the autocall, which offers a predefined annual return if certain market conditions are met and can mature early. More specifically, the most popular type of autocall has been the defensive autocall linked to one or more developed equity markets.
These are defensive because the defined coupon or coupons will be paid even if the underlying equity markets fall to a certain degree – pick your range – over the life of the investment. To make investing in these autocalls easier, funds containing investments that offer autocall-like payoffs have been accessible for the investor for more than a decade.
Limiting downside
A typical defensive autocall with two equity indices – say, the Eurostoxx50 and the S&P500 – as the underlyings currently offers an annual coupon of around 10%. This is less than you would have received from simply investing in an S&P500 ETF over the longer term – indeed, structured investments like autocalls naturally cap the upside.
That is the trade-off at the heart of defined-return investing – in a strongly rising market, investors may be better off simply owning equities. Yet the objective here is not to capture every percentage point of upside – it is to generate an attractive return across a wider range of possible market outcomes. Foregoing some potential upside may give investors more comfort that an attractive return can still be achieved, even in choppy or moderately falling markets.
For this typical defensive autocall linked to the Eurostoxx50 and the S&P500, as long as neither index has fallen by more than 25% at the relevant observation point, the investor would receive the 10% annual coupon. There is, of course, no free lunch. Investors can miss out on substantial gains if equity markets rise strongly, while losses can still occur if markets fall beyond the protection built into the strategy.
For some, this can be as much a behavioural benefit as a financial one: a wider range of acceptable outcomes may make it easier to remain invested through periods of market volatility.”
The investment journey therefore tends to be more predictable and smoother than the autocall’s underlying equity markets. This should be caveated with the likelihood that, if equity markets fall sharply – as they did in Covid, for example – the prices of autocalls can also fall sharply in the short term.
Yet the key point here is that the final outcome depends on where markets sit relative to the predefined levels over the life of the investment, rather than on short-term market moves alone. The defensive autocall therefore works in a wide range of equity market outcomes.
If the investor wants a higher return, they can opt for a narrower range thereby taking on more downside risk. For some investors, this can be as much a behavioural benefit as a financial one: a wider range of acceptable outcomes may make it easier to remain invested through periods of market volatility.
Planning with clarity
A greater degree of predictability like this can enable investors to plan with more clarity over the longer term – something that can be especially beneficial to individuals approaching or in retirement, when predictability and downside protection is even more important.
The shift does not mean investors have stopped wanting growth – rather, some are becoming more conscious of the path taken to achieve it. Sacrificing some potential upside is becoming an acceptable potential price to pay for greater resilience and a more predictable investment journey.
Jim May is a fund manager at WisdomTree
