When Indicators Are Cut: What Teaches About Withdrawal Risk-Control Index Design

In a standard world, the set of underlying indicators of a fixed index annuity (FIA) will remain unchanged throughout the lifetime of the product. Advisors will research them, make recommendations, and keep track of the same set of indicators.

In reality, however, carriers sometimes withdraw an index from further investment, citing “power issues.” This can lead to frustration and frustration among advisers and raise questions from investors, especially when they have tried hard enough to understand an indicator that is providing good returns.

How can advisers explain to their clients that, while it may seem boring, carriers are actually acting responsibly by making such decisions?

To define power

In a broad sense, power refers to assets under management (AUM) beyond which a strategy cannot achieve performance over time in line with its stated return goals or expectations. Reaching capacity is one reason a hedge fund can close a fund to new investors, thus protecting the interests of existing investors. In the case of risk-control indicators used by the FIA, the considerations are similar, though not identical.

When a carrier issues an FIA, it typically hires one or more banks as hedge providers to offer options on FIA-compiled indicators. Hedge providers trade the components of these FIA ​​indicators on the market, replicating the effectiveness of the indicators and selling “Delta hedging” options to the carrier. The image below illustrates the relationship.

Various entities involved in the FIA

Images of various entities involved in an FIA
* When index sponsors are a bank, they are usually the same entity.

If this hedging activity produces a significant fraction of the daily trading on a particular component of a FIA index – for example, a stock or an exchange-traded fund (ETF) – it can have a component effect on the value of the component. If, say, a hedger had to buy a stock for 100 million, and the average daily amount was $ 200 million, then hedging would represent 50% of the normal daily liquidity. This hedging activity could return to the FIA ​​index level, potentially damaging the performance of the FIA ​​- and retirees who bought it.

Both the carrier and the index sponsor should avoid this situation – the carrier is in the interest of its end clients and the index sponsor is for the integrity of its index.

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Heating capacity

The strength of an indicator is not a solid and fast number, but a guide quantity where the necessary hedging activity can have a negligible effect on the performance of the index. In the case of an FIA index, the potential of a hedge provider is estimated when it agrees to start selling options to the carrier.

So how can there be a problem?

The simplest case is when an FIA sells very successfully. This is probably driven by the strong performance of one or more risk-control indicators used in the FIA, which attract flows. The carrier must buy more options from the hedge provider, which must hedge a larger volume. Everyone is happy until the required hedge amount of one of the FIA ​​indicators comes close to the capacity of that indicator.

And what about changes in market conditions? The risk-control indicators used in the FIA ​​consist of a combination of other indicators, ETFs, stocks and futures. Material fluidity can vary significantly over time. If an underlying ETF works less and investors withdraw, the volume may decline; Or an underlying futures could be a thinly traded, with low open interest. In both cases, the loss of liquidity can reduce the strength of the risk-control indicator.

ICLN: An Image

In the ETF world, the iShares Global Clean Energy ETF (Ticker: ICLN) provides a good example of an indicator capability problem. The ETF was launched in 2008, but as investors responded to the description of sustainability and Clean Energy became a key initiative of the Joseph Biden administration, the US ETF’s AUM increased from about $ 700 million to about $ 5 billion, while the corresponding European version is tracking the same. The index also rose to about $ 5 billion. ETFs were a popular undertaking for U.S. structural products, creating a hidden demand for stocks. The problem was that the underlying index contained only 30 components, two of which were small, liquid stocks listed in New Zealand.

When it comes time to balance, ETFs have to sell 40 to 50 times the daily liquidity of these two stocks. That would drive significant price movements. Following the consultation, the index’s sponsor, S&P, took a drastic step: it redesigned the index and raised the number of stocks to 100.

Although this example applies to an ETF, not the FIA, it demonstrates how changes in market conditions and demand can create serious power issues in index-linked products.

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Design subject

So, if index power is not a pre-set, hardcoded quantity, how can carriers avoid future power issues when selecting risk-control indicators?

Index strength depends primarily on the liquidity of the underlying instruments: usually other indicators, ETFs, stocks and futures. So careful selection is essential. But the strength of the indicator also depends on the weighting mechanism that applies to these instruments, the rebalancing mechanism that applies these weights, and the risk-control mechanism that maintains the volatility of the index at the target level.

The demand for an index, its effectiveness and market conditions change over time, challenging product manufacturers and their hedge providers to ensure the provision of an index on an annual long-term scale. Careers must take into account the detailed aspects of index design when performing due diligence on the proposed risk-control indicators.

With proper screening, they can maximize their chances of avoiding future power issues.

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All post author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not reflect the views of the CFA Institute or the author’s employer.

Image Credit: © Getty Images / GoodLifeStudio

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J. Watson

J. Watson Managing Director and Head of Analysis Index standard, Leading provider of index rating and forecasting. He was previously the Managing Director and Head of EMEA, a multi-asset index at Barclays in London. He holds a doctorate in theoretical physics from Oxford University.

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