While there are upside risks to this forecast over the coming 6-12 months, there are also multiple downside risks due to headwinds such as high inflation, central bank tightening, an expected decline in earnings, and recession risks.
In this uncertain environment, investors are looking for solutions that can deliver at least some return, while also providing some protection against downside risk.
Digital notes are one potential solution: a type of structured investment that offers a fixed return at maturity as long as the underlying index doesn't close below a certain level. For example, the note may have the following terms:
- Underlying index: S&P 500 Index
- Fixed return: 10%
- Downside trigger: -20%
- Maturity: 54 weeks
If we look at the hypothetical performance of a digital note with these terms going back to 1978, we can see that the note would have only triggered the 20% downside threshold in 4% of the 54-week rolling return periods, whereas a direct S&P 500 investment would have experienced a loss in 19% of rolling return periods. In the other 96% of periods, the digital note would have provided a 10% return.
In order for the S&P 500 index to outperform the digital note in this environment, the S&P 500 needs to trade more than 10% higher than its current level, rising above 4,400. This outcome would be consistent with our bull case scenario, where inflation pressures dissipate more quickly than expected, US economic growth remains durable, and China manages to reopen its economy sustainably.
When considering how structured investments could fit within your portfolio, the appropriate amount and type of structures should take into consideration your objectives as well as your willingness and capacity to accept relevant structured investment risks, such as issuer and underlying asset exposure risk, as well as a sacrifice of some liquidity (there is a limited secondary market for structured investments).
If you would like to know more about structured investments, and how they might fit into your portfolio, reach out to your financial advisor, who can help you to put these considerations into context. You can also ask your advisor for a copy of our report, Structured investments: Considering outcome-oriented investments, published 23 March 2020.
Main contributors: Daniel J. Scansaroli, Justin Waring
Content is a product of the Chief Investment Office (CIO).
Original report - Structured investments: Digital notes for a sideways market, 11 January, 2023.