Do Autocallables have a place in your retirement portfolio?
- Noel Watson
- May 20
- 11 min read
Updated: Jun 11
Introduction
Before constructing a retirement portfolio, it's important to establish investment beliefs and principles. Following this, a portfolio can be constructed using a mix of growth and defensive assets aligned with a given financial plan and risk appetite. At Pyrford Financial Planning, our portfolios are built using a mix of globally diversified, low-cost index and factor funds. However, we believe that we should constantly challenge and question our beliefs. This blog looks at whether autocallables (a type of structured product) should be included in our client portfolios.
Structured product overview
A structured product is a packaged investment strategy typically incorporating several underlying assets, which may include instruments such as:
The purchaser of the structured product will often expect to receive a predetermined series of payouts linked to the performance of the underlying assets.
Our example below will demonstrate this.
Autocallable overview
An autocallable is a structured product that pays a coupon if the underlying asset(s) exceed a specified level at a specified time. If this occurs, the autocallable matures, and the principal is returned to the investor. We will construct a theoretical autocallable product to bring this analysis to life.
Our autocallable will have the following characteristics:
Underlying instrument: The underlying will be the S&P 500 index. We will be using the price-return index meaning dividends will be excluded. This is common for autocallables.
Term: The autocallable will run for a maximum of five years.
Observation points. There will be an observation point after 2, 3 and 4 years.
Coupon: A coupon will be paid if/when the index exceeds the specified level at an observation point, and the autocallable will be terminated. The coupon will be 6% multiplied by the number of years since launch. For example, if the index is above 90% of the starting index level at observation 3 (see screenshot below), the payout is 24% (4 years since launch x 6%).
Capital protection barrier: The product has a capital protection barrier of 65%. This is measured at plan maturity. If the index level is 65% of the start level or above, the investor gets back their initial investment plus a coupon of 30% (total 130% of initial). If the index level is below this, they receive a percentage of their initial investment. For example, if the index is 50% of the starting level at maturity (five years), the investor receives just 50% of their initial investment and no coupon payments.
Disclaimer: It is important to be aware that there are many different types of structured products, each with nuances and differing contract terms.
This blog focuses on autocallables, and our analysis is specific to our theoretical autocallable.
As always, do your own research.
How has our autocallable performed?
The S&P 500 was founded in 1957, and we can access the data using Slickcharts to analyse the historical performance of our autocallable.
Did we trigger the capital protection barrier?
As detailed above, if the capital protection barrier is triggered, the investor risks losing a large part of their initial investment. If we look at rolling five-year periods from the launch of the S&P 500 index to today, we can see that the worst outcome was from 1969 to 1974, when the price return index fell around 25%. This fall was not enough to trigger our autocallable's capital protection barrier, which is only triggered when losses of 35% or more are encountered at maturity.
However, we are able to go back further in time to 1926, when the Standard Statistics Company launched a 90-stock composite index, the precursor to the S&P 500. If we now analyse the data from 1927 onwards, we can see that things weren't quite so rosy for our autocallable during the Great Depression.
For example, if an investor were to purchase the autocallable in 1928 (starting index level 138), the price-only index level would have been 56 at maturity in 1933. This fall of 59% (the index values are rounded) breaches the capital protection barrier of 65% (which protects against 35% of the downside) and the investor would, therefore, have experienced a loss of 59%. The 1929 investor lost 56%, while the 1936 investor also had a poor outcome, with a near 50% loss.
Worst case outcomes of the autocallable versus total return investors.
We can compare the outcomes of the autocallable during these challenging periods with those of the (total return) index investor, who received dividends in addition to the price return. The starting and finishing years where the capital protection barrier is triggered are marked in red.
The starting year of 1927 is also highlighted. While the price return index was at 39% of its starting value after five years, after two years at observation 1, it was above 100% of its starting level, meaning it matured early. The investor received a 12% coupon along with the return of their initial investment.
The importance of dividends.
The difference in worst-case outcomes between the autocallable and total return investors is dramatic. For example, while the 1936 total return investor wouldn't have been happy with their 32% loss over 5 years, the autocallable investor, who had missed out on the dividends, is down an additional 17%!
What about the upsides?
From the above, we can see that for our theoretical autocallable, the worst-case outcomes are worse than for the total return index investor. What about the more positive periods? For our total return investor, there have been 61 years (given that we have data going back to 1927, that's over 60%) where the index investor has received more than 6%. There have been 37 years where the return is greater than 20%, and 19 with returns exceeding 30%. These outcomes compare to the maximum annual payout for our example autocallable of 6%.
For 69 of the rolling 5-year periods, the total return investor received returns greater than 30% (the payout of our autocallable at maturity, assuming it doesn't pay out earlier and is above the capital protection barrier).
A 96-year investing horizon.
We will now compare the autocallable investor who reinvests his money every time the autocallable matures with a total return investor. Both invest £100 in 1927, and the comparison ends in 2023.
The autocallable matures a total of 38 times:
The capital protection barrier was triggered twice (1929 and 1936 starting points, as detailed above).
In 28 of the scenarios, the autocallable matures after two years.
In 3 scenarios, the note matures after three years.
In one scenario, the note matures after four years.
In 3 scenarios, the note matures after five years (but is still above the capital protection barrier, so the 30% coupon is paid).
This range of outcomes gives us an average autocallable maturity of 2.52 years (96/38).
An overview of the first seven autocallable maturities is shown below.
1929: The index is up 21% at the first observation point, and the investor receives a 12% coupon along with their initial investment. The balance is £112
1934: The note matures. The index is below 65% of the initial barrier, meaning no coupons are paid, and the investor is down 56% on his £112 investment.
1936: The index is up 81% at the first observation point, and the investor receives a 12% coupon along with their initial investment.
1941: The note matures. The index is below 65% of the initial barrier, meaning no coupons are paid, and the investor is down 49% on his £70 investment.
1943: The index is up 34% at the first observation point, and the investor receives a 12% coupon along with their initial investment.
1945: The index is up 49% at the first observation point, and the investor receives a 12% coupon along with their initial investment.
1949: The index is down 3% at the third observation point, and the investor receives a 24% coupon along with their initial investment.
The difference in outcomes at the end of the 96 years is dramatic. The autocallable investor has a balance of $3,296 versus the total return investor of $947,949.
In the screenshot, you can see where the challenge for the autocallable investor lies. Over the final decade, the total return index investor more than tripled their money ($304,290 grew to $947,949). However, the autocallable investor was limited to having 12% returned every second year, and their investment hasn't even doubled ($1,870 grew to $3,296).
It's worth again pointing out that our autocallable is theoretical and had autocallable products existed back in 1927, the real-world gap may well have been closer - for example, because the coupons were sometimes greater than 6%. If we increase the coupon from 6% to 14.3%, the final balances between the autocallable and total return investors is broadly similar at the end of 2023.
It's also worth (again) emphasising the importance of dividends (which the autocallable investor misses out on). A tool from the excellent Of Dollars and Data blog shows that $100 invested in 1927 grew to $26,833 without dividends and $879,915 with dividends included by 2023! On an annualised basis, the returns are 6% vs 9.92%.
(Note that the OfDollarsAndData numbers differ slightly from ours; our dataset shows $27,010 and $947,949.
Counterparty risk.
We've discussed the influence of market returns on the payout of our autocallable. Another risk to consider is counterparty risk. The investor is effectively lending money to the issuer of the structured product, and if the issuer defaults, there is the risk that the investor does not get all of their money back.
It's possible to measure the perceived risk of default using Credit Default Swaps (CDS). For example, the Goldman Sachs 5Y CDS is currently trading at 64.73 basis points (100 basis points is 1%). This means you pay 0.6473% of the notional amount of protection each year to protect against default. The challenge is that it's difficult/impossible for retail investors to purchase CDS protection, so this risk will typically have to be accepted rather than insured against.
Challenges of autocallable investing.
We wanted to cover the historical outcomes and counterparty risk before discussing the many challenges of autocallables, for reasons which will become apparent.
It's very difficult/impossible to evaluate historical autocallable outcomes.
We are fortunate enough to have over a century of historical market returns to evaluate how a given portfolio consisting of equities and bonds would have performed, particularly during challenging periods. With autocallables, we aren't as fortunate for several reasons:
While we gave the impression of being able to evaluate historical outcomes above, the reality is that the autocallable coupon amounts and observation index and capital protection barrier levels are very much dependent on market conditions at the time, particularly market volatility. For example, an autocallable launched in a benign period will likely have a different profile than one launched in 1932.
Our example autocallable was based on an index that had data going back to 1957 (and further if we accept a broadly similar index). Many autocallables do not have anywhere near the level of data. For example, the FTSE 100 was only launched in 1984, so it's challenging to evaluate how the autocallable would have performed during periods such as the Great Depression.
Some autocallable underlying indices are bespoke, with permutations including an equal-weighted index and/or one based on a total return index with a fixed amount taken off each year. Note that the performance of these bespoke indices can trail even the price return index, meaning it can be more challenging to achieve the necessary index levels to achieve coupon payouts and clear the capital protection barrier. The Central Bank of Ireland sent a guidance letter in 2023 asking firms involved in this space to highlight this risk.
The downsides can become apparent just when you don't want them to.
In point 8 of our investing beliefs, we state that:
"Assets must give acceptable risk vs. return in all stages of the market cycle".
As we saw above, our example autocallable gave a worse outcome at certain points versus the total return index during the Great Depression - a period when you really wanted them to be working.
Similarly, the risk of the issuer defaulting increases during times of market stress. For example, the 5Y CDS spread of Goldman Sachs was over 400bps during the Global Financial Crisis. However, at least it survived; many banks failed. The Great Depression was worse.
The profile of payoffs isn't what many investors expect or are looking for.
There are two aspects to this:
The upsides of the autocallable are limited versus the potential downsides. For example, our example autocallable gave a maximum 6% upside per year, but ran the risk of:
Losing over 60% of the initial investment during periods such as the Great Depression.
Potentially losing all of an investor's money if the issuer defaults.
The chance of either happening may be considered remote, but the investing style could be summarised as:
A small difference in the underlying asset can lead to a big difference in payout. Take the case of two investors, both investing £100,000 in our example autocallable at different times. Both investors' autocallables last until maturity (i.e. don't kick out early).
Investor 1's index level at maturity is 66% of the starting level, and he receives £130,000 (the initial investment of £100,000 + 5x6% coupon).
Investor 2's index level is slightly lower at 64%. This means he doesn't receive any coupons, and the capital protection barrier is breached. Therefore, Investor 2 receives just £64,000 (64% of the initial investment).
A 2% difference in the finishing index level meant that Investor 1 finished with over twice the balance of Investor 2!
The issuer is incentivised to optimally structure the product.
Our example autocallable was structured to ensure the capital protection barrier wasn't triggered at any point over the (initial) period analysed. Given the vast differences in payoffs identified above, we would expect the issuer to ensure this was the case with real-world autocallables, and it's therefore worth evaluating worst-case outcomes that aren't shown in the issuer's literature. This can be done either by looking further back in time or, if this is not possible, using Monte Carlo modelling.
Autocallables are complex instruments and can lead to suboptimal outcomes, even for clever people.
Pricing these products can be very difficult and time-consuming (given the many permutations of autocallables), with many investors lacking the knowledge, data, or tools to determine the chances of various payoffs occurring.
Understanding how much you are likely to pay can be difficult.
There are several entities that will take a fee for the service they are providing:
Distributor: Sells the autocallable to intermediaries (e.g. financial advisers).
Plan manager: Designs and arranges the autocallable.
Administrator: Provides administration services.
Counterparty: Structures the autocallable.
The total costs we have seen tend to be in the region of 5-7%. These fees tend to be one-offs, and the challenge is knowing how long to spread these costs over as we don't know in advance when our autocallable will mature. Using our example autocallable's average maturity of 2.52 years gives a cost of around 2-2.8% pa. A 2021 study of Yield Enhancement Products found annual fees to be 6-7%. However, the average maturity in their sample was one year, which indicates that the one-off costs are broadly similar to our analysis.
There is no guarantee that you can sell your autocallable or the price you may be offered.
While there are clearly defined rules regarding what an investor might receive and when (for example, a coupon of 12% and original capital returned at the two-year observation point if the index is at the starting level), things are less clear should the investor need to sell before this point. The counterparty is not obligated to provide daily liquidity nor what they might bid for your autocallable should you need to sell.
Conclusion.
Based on the above, we'd struggle to see where the autocallable structured product might fit into our client portfolio. Given the limited upside (in our example, 6% pa), it doesn't qualify as a growth asset, and the potential losses would preclude it from the defensive bucket. Other challenges mentioned above, for example, high fees and difficulty evaluating historical payoffs would also be blockers. We'd suggest that, as with Buffered ETFs, they are a solution looking for a problem.
Want to find out more?
If you'd like to learn more about designing and implementing a robust retirement portfolio, please get in touch.
About us.
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
Our office telephone number is 01932 645150.
Our office address is No 5, The Heights, Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
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