Blue Chip Issue 96

BLUE BLUECHIP

BLUE BLUECHIP CHIPINVESTMENT | IndicesIndex methodologies instructured productsThis piece aims to provide an understanding of how issuers select and build indices for structured products.Structured products combine traditional assets, typicallya bond or deposit, with derivatives such as options andswaps. This combination is designed to create payoffs thatcan preserve capital, enhance yield or tailor risk accordingto investor outlook.In South Africa, the market has matured rapidly since the early2000s; supported by strong local banks, an active stock exchange(JSE) futures complex and a conduct-focused regulator, theFinancial Sector Conduct Authority (FSCA).Why index selection matters“If you don’t know what’s inside the index, you don’t know the realbet you’re making.” – Howard Marks.In structured products, the underlying index determines thepayoff potential. Choosing the right index can lead to betteralignment with an investor’s risk-return objectives.In South Africa, many structured products reference the JSE orhybrid indices that include international equities or commodities.FSCA guidelines require issuers to explain how they choose ordesign these indices, promoting transparency.Criteria for selecting indices• Market relevance. An assessment of whether the indexrepresents a sufficiently liquid market to ensure accurate pricingand minimal tracking error.• Investor familiarity. Clients often prefer well-known benchmarkslike the S&P 500 and Euro Stoxx for reference purposes.• Risk profile and volatility. Indices with historically highvolatility may require more expensive option structures. Certainstructured products prefer volatility-controlled indices forstable, predictable pricing.• Dividend or financing considerations. In cases of uncertain orvariable dividend policies, decrement or excess return indicescan help standardise outcomes. If the product aims to reflect netreturns above a benchmark rate, an excess return methodologymight be preferred.• Regulatory and methodological transparency. Considerationsinclude index governance and whether the index providerpublishes rules and methodologies. For cross-border offerings,the consideration is whether the index meets the EU benchmarkor local FSCA disclosure standards.34 www.bluechipdigital.co.za

INVESTMENT | IndicesBLUECHIP• Product design goals: capital protection vs growth. A capitalprotectedproduct might opt for a lower-volatile index or adecrement approach. If the aim is to achieve higher couponsthrough yield enhancement, issuers might opt for excess returnor sector-focused indices with higher upside potential.Performance asset composition analysisEquity selection involves considering sector exposure, suchas financial, resource and consumer goods sectors, which candrastically alter risk and return. Geographic spread is anothercritical factor, with choices between purely local indices, such asthe JSE and global baskets.Weighting methodologies also play a significant role. Marketcap weighting assigns a larger slice to larger companies, equalweighting gives each company the same weight to reduceconcentration risk, and factor- or thematic-based weighting tiltstowards specific criteria, such as “value”, “momentum” or themeslike green energy, for example.Dividend policy is another consideration, where the impact ofprice return versus total return or any decrement mechanism onthe expected yield must be evaluated.Protection asset composition analysisBond or deposit selectionCredit quality is of paramount importance, with governmentbonds or top-tier local banks typically providing capital protection.The duration of the bond or deposit should align with the termof the structured product to ensure the principal remains secure.The creditworthiness of the issuer is essential; even for “protection”assets, there is a risk of default if the issuer is not financially stable.In South Africa, advisors meticulously review the bank’s creditrating and track record to assess its reliability. There is frequentlya cost-protection trade-off; allocating more capital to risk-free orlower-risk assets leaves less available for the option or derivativeportion, which can limit potential upside.EXAMPLES OF INDEX METHODOLOGYMETHODOLOGY EXAMPLE KEY FEATURESMarket-capweightedDecrementmethodologyVolatility-ControlledExcess returnJSE Top 40Top 40 Decrement 5%SWIX 40 with 10% voltargetCommodity or GlobalEquity BasketStraightforward approach, widelyrecognised. May be concentrated ina few large caps (like Naspers/Prosus,miners, banks).Fixes a 5% annual “dividend deduction”.Simplifies derivative pricing for capitalprotectednotes or autocalls.Adjusts exposure to SWIX 40 up ordown, keeping volatility near 10%.Helps achieve higher participationrates in structured products.Subtracts a local or internationalfinancing rate. Reflects true netperformance after "cost of carry".Index methodologiesFive equity-index constructions drive most South African notes:market cap, equally weighted, decrement, excess return andvolatility-controlled.Different indices offer unique pros and cons, and understandingeach helps ensure suitability.A market-cap index, such as the JSE Top 40, assigns larger weightsto bigger companies, making it easy to hedge as futures tradecontinuously. However, a dominant company like Naspers caninfluence the entire basket.An equally weighted index, on the other hand, ensures thateach share has the same weight, thereby enhancing diversificationand reducing sector biases; however, it requires more frequentrebalancing.A decrement index deducts a fixed dividend, for instance, 5%,before showing performance, which reduces the bank’s needto predict future dividends, thereby lowering option costs andincreasing participation rates.An excess-return index factors in a financing rate thattypically reflects the carrying costs of futures contracts, makingit particularly useful for hedgers as it accurately represents theiractual costs within the payoff structure.Lastly, a volatility-controlled index functions like an automatedsystem with built-in speed limits, reducing equity exposure duringperiods of high market volatility to maintain a risk level of around10%. This reduction in option costs allows the bank to offercomplete capital protection with a higher potential upside.Comparative narrative in the local contextMarket-cap options offer the best liquidity and provide astraightforward story, but they also pose concentration risk, makingthem the primary choice for first-wave capital-protected notes.Equal-weight strategies offer greater diversification, thoughthey come with higher turnover and slightly lower coupons andare typically used in “balanced exposure” barrier auto calls.Decrement structures enable higher participation but mayunderperform if dividend increases occur, so they are commonlyfound in five-year growth notes.Excess return products allow for precise hedging, althoughthey generally yield lower headline returns, making thempreferable for commodity-themed investments.Volatility control (vol-control) offers the lowest-cost protectionand strong multipliers but tends to lag during periods of rapidmarket gains. It is considered essential in fully protected globaltech products.In conclusion, the careful selection of an equity indexmethodology is pivotal in determining the success of capitalprotectednotes and other structured products within the SouthAfrican market. Each index type offers distinct advantages andconsiderations, from liquidity and diversification to cost and riskmanagement. By understanding and strategically leveragingthese methodologies, issuers can optimise their offerings tomeet the diverse needs of investors while adhering to regulatoryrequirements. As the FSCA mandates clear explanations forsynthetic adjustments, transparency remains crucial in ensuringinvestor confidence and the efficacy of products.www.bluechipdigital.co.za35