When Indices Are Cut: What Withdrawals Teach about Risk-Control Index Design

In an platonic world, the set of indices underlying a stock-still tabulate annuity (FIA) would remain unchanged throughout the product’s lifespan. Tutors would do their research, make recommendations, and protract to track the same set of indices.

In reality, however, carriers sometimes withdraw an tabulate from remoter investment, citing “capacity issues.” This can rationalization frustration and wound among tutors and raise questions from investors, expressly when they have put substantial effort into understanding an tabulate that has been delivering good returns.

How can tutors explain to their clients that, irritating though it may seem, carriers are in fact behaving responsibly by making such decisions?

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Defining Capacity

In a wholesale sense, capacity refers to the resources under management (AUM) vastitude which a strategy cannot unzip performance over time matching its stated return objectives or expectations. Reaching topics is a reason a hedge fund may tropical a fund to new investors, so protecting the interests of existing investors. In the specimen of the risk-control indices used in FIAs, the considerations are similar, although not identical.

When a carrier issues an FIA, it usually engages one or increasingly banks as hedge providers to offer the options on the indices that etch the FIA. The hedge providers trade the components of these FIA indices in the markets, replicating the indices’ performance and “delta hedging” the options they have sold to the carrier. The icon unelevated illustrates the relationship.

The Different Entities Involved in an FIA

Diagram of The Different Entities Involved in an FIA
*When the tabulate sponsor is a bank, these are usually the same entity.

If this hedging worriedness makes up a significant fraction of the daily trading in a particular component of an FIA tabulate — for example, a stock or an exchange-traded fund (ETF) — it may have a material effect on the component’s price. If, say, a hedger needs to buy $100 million of a stock, and the stereotype daily volume traded is $200 million, the hedging would represent 50% of the usual daily liquidity. This hedging worriedness may feed when into the level of the FIA tabulate itself, potentially to the detriment of the performance of the FIA — and the retirees who have bought it.

Both the carrier and the tabulate sponsor should wish to stave this situation — the carrier for the sake of its end clients, and the tabulate sponsor for the integrity of its index.

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Hitting Capacity

The topics of an tabulate is not a hard-and-fast number, but rather a guideline value at which the required hedging worriedness may have a non-negligible effect on tabulate performance. In the specimen of an FIA index, topics is unscientific by the hedge provider at the time it agrees to start selling the options to the carrier.

So how might issues occur?

The simplest specimen is when an FIA sells very successfully. This is likely driven by strong performance of one or increasingly of the risk-control indices used in the FIA, attracting inflows. The carrier must buy increasingly options from the hedge provider, which in turn must hedge a greater volume. Everyone is happy, until the required hedge value of one of the FIA indices approaches the topics of that index.

And what well-nigh waffly market conditions? The risk-control indices used in FIAs tend to be well-balanced of other indices, ETFs, stocks, and futures. Component liquidity can transpiration markedly over time. An underlying ETF may see reduced volumes if it underperforms and investors withdraw; or an underlying future may wilt thinly traded, with reduced unshut interest. In both cases, the waif in liquidity can reduce the topics of the risk-control index.

ICLN: An Illustration

In the ETF world, the iShares Global Wipe Energy ETF (ticker: ICLN) offers a good example of an tabulate topics issue. The ETF was launched in 2008, but as investors responded to the sustainability narrative and wipe energy became a key initiative of the Joseph Biden administration, the US ETF’s AUM surged from virtually $700 million to well-nigh $5 billion, while the respective European version tracking the same tabulate moreover grew to virtually $5 billion. The ETF was moreover a popular underlying for US structured products, creating a subconscious demand for the stocks. The issue was that the underlying tabulate only had 30 constituents, two of which were small, illiquid stocks listed in New Zealand.

When it came time to rebalance, the ETF needed to sell 40 to 50 times the daily liquidity of these two stocks. That would have driven significant price movements. After consultations, the tabulate sponsor, S&P, took a drastic step: It redesigned the tabulate and increased the number of stocks to a target of 100.

While this example applies to an ETF, not an FIA, it demonstrates how waffly market conditions and demand can create serious topics issues in index-linked products.

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Design Matters

So, if tabulate topics is not a pre-set, hardcoded amount, how can carriers weightier stave future topics issues when selecting risk-control indices?

Index topics depends primarily on the liquidity of the underlying instruments: usually other indices, ETFs, stocks, and futures. Careful selection is therefore essential. But tabulate topics moreover depends on the weighting mechanism that allocates to these instruments, the rebalancing mechanism that implements these weightings, and the risk-control mechanism that maintains the index’s volatility at its target level.

The demand for an index, its performance, and market conditions all transpiration over time, challenging product builders and their hedge providers to guarantee provision of an tabulate over the annuities’ longer time scales. Carriers need to take detailed aspects of tabulate diamond into consideration when performing due diligence on proposed risk-control indices.

With towardly scrutiny, they can maximize the chances of lamister topics issues in the future.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / GoodLifeStudio

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Jay Watson

Jay Watson is managing director and throne of analytics at The Tabulate Standard, the leading provider of tabulate evaluation ratings and forecasts. He was previously managing director and throne of multi-asset tabulate structuring EMEA at Barclays in London. He has a doctorate in theoretical physics from Oxford University.

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