Autocallable ETFs, products designed to generate income using structured notes tied to equity benchmarks, have attracted nearly $1 billion in assets in less than a year.
The growing popularity of this niche corner of the ETF market reflects rising investor appetite for complex income strategies wrapped inside ETFs, according to Mike Loukas, CEO of ETF issuer TrueShares.
“The willingness of banks to embrace the ETF wrapper as an alternative to traditional structured notes has been a game changer,” Loukas told Benzinga. The format offers several advantages over traditional structured notes, including improved liquidity, lower minimum investment requirements, greater tax efficiency, and reduced counterparty risk.
Autocallable strategies are generally tied to equity indexes such as the S&P 500, and make use of structured notes and options to offer high yields. The “auto call” option enables the note to call early if the index reaches certain levels.
Critics of the boom argue that it is product innovation chasing flows. Loukas, however, argues that the demand for the products is legitimate.
“The early inflows certainly support that notion, but the size of the large, deep addressable market that is already familiar with how structured notes/autocallables work, and has past investment experience with them, is the factor that underpins my belief that these ETFs are an answer to concrete demand from investors and advisors alike,” he said.
Still, he cautioned that the investor must also understand the “mechanics” behind the strategies. Counterparty risk is present in the underlying structured notes, while “mark-to-market” valuation of the notes could also cause volatility even when the end result is not compromised.
Macro Forces Shaping The Category
The current state of interest rates has also contributed to the attractiveness of these products.
Income generated by autocallable ETFs is partly derived from collateral invested in Treasuries or other income-producing assets. Aggressive measures to lower interest rates could impact the income calculation, Loukas says. But other factors are also at work.
Volatility is another factor that is at play.
There are also strategies that aim to dynamically manage volatility risk. TrueSharess products, such as the TrueShares S&P Autocallable High Income ETF (BATS:PAYH) and TrueShares S&P Autocallable Defensive Income ETF (BATS:PAYM) are able to change the exposure to the notes several times a day in order to maintain targeted volatility levels.
The structure of the market is also an important factor in the performance of autocallables. Loukas pointed out that these types of products perform best in a sideways or slightly positive trending market.
Even during sharp drawdowns, losses typically aren’t realized unless the underlying benchmark remains below a principal barrier at maturity, which often occurs three to five years after issuance.
Imagaine a sharp, fast drawdown, such as a 20% correction in a quarter. “The reference index stays above the coupon threshold of the portfolio notes (the level above which the note continues to pay),” noted Loukas. “The net effect is a mark-to-market change in the value of the note.”
“Losses typically aren’t realized unless the note remains below the principal barrier at maturity, which is generally 3-5 years. Both PAYH and PAYM are designed to dynamically adjust to such drops to protect the cash flow. Further, they both employ an always on hedge to mitigate significant drawdowns in adverse environments.”
Despite the rapid growth, Loukas believes the category still has room to expand.
Capacity limits may eventually emerge. The bigger constraint, however, is likely regulatory diversification rules tied to counterparty exposure rather than limitations in options markets.
Looking ahead, Loukas believes structured-outcome ETFs could become a permanent fixture in portfolio construction.
“Structured outcome investments are an extremely versatile and effective portfolio construction tool in all environments,” he said. “As such, I believe they will take their place as a core pillar.”
Other Notable Autocallable ETFs
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