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Structured equity changes the shape of the return we receive from equities. A standard equity investment will increase (or decrease) $1 for every $1 increase (or decrease) in the equity markets. Many investors do not wish to have 100% exposure to the equity markets, so they diversify with bonds, cash and other alternative assets. While asset diversification will work to dampen equity volatility under most conditions, it does not do so under all. Equity returns can be shaped more explicitly using structured equity.
The precise manner in which an investor shapes their equity exposure is determined by a number of factors…
- Downside Protection: What market falls do you want protection against – the first 30%, the first 40%, the first 50%?
- Exposure: How much return do you want to earn if the equity market rises? Structured equity can help a portfolio obtain a given return through a more than one-for-one exposure to equity market gains. Leverage effectively allows returns to accelerate over a particular range.
- Upside Participation: If the equity market rises by a certain amount, how much more return is required? Can an investor afford to give up all returns above this level, or a proportion of them in order to purchase some downside protection?
The diagram below illustrates the way these factors determine the shape of the payoff: