In an ideal world, the set of indices underlying a fixed index annuity (FIA) would remain unchanged throughout the life of the product. Advisors would research, make recommendations and continue to track the same set of indices.
In reality, however, operators sometimes withdraw an index from more investments, citing “capacity issues.” This can cause frustration and distress among advisors and raise questions for investors, especially when they have put considerable effort into understanding an index that has delivered strong returns.
How can advisors explain to their clients that, irritating as it may seem, carriers are behaving responsibly by making these decisions?
Definition of capacity
In a broad sense, capacity refers to assets under management (AUM) beyond which a strategy cannot achieve a return over time that matches its stated performance goals or expectations. Reaching capacity is one reason why a hedge fund can close a fund to new investors, thereby protecting the interests of existing investors. In the case of risk control indices used in AIFs, the considerations are similar, although not identical.
When a carrier issues an AIF, it usually engages one or more banks as cover providers to offer options on the indices that make up the AIF. Hedge providers trade the components of these FIA indices in the markets, replicating the performance of the indices and “delta hedging” of the options they have sold to the trader. The figure below illustrates the relationship.
The different entities involved in an FIA
If such hedging activity represents a significant fraction of the daily trading of a particular component of an FIA index (for example, an exchange-traded fund (ETF) or shares), it may have a material effect on the price of the component. If, for example, a hedge needs to buy $100 million of a stock and the average daily traded volume is $200 million, the hedge would represent 50% of the usual daily liquidity. This hedging activity can feed back into the level of the AIF’s own index, potentially to the detriment of the performance of the AIF and the retirees who have purchased it.
Both the operator and the index sponsor should want to avoid this situation: the operator for the sake of its end clients and the index sponsor for the integrity of its index.
The capacity of an index is not a hard and fast number, but rather a guideline amount in which the required hedging activity can have a non-negligible effect on the performance of the index. In the case of an index FIA, the capacity is estimated by the hedge provider at the time it agrees to start selling the options to the carrier.
So how can problems occur?
The simplest case is when an AIF sells very successfully. This is likely to be driven by the strong performance of one or more of the risk control indices used in FIA, which attract inflows. The carrier must purchase more options from the coverage provider, who in turn must cover a larger volume. Everyone is happy, until the amount of coverage required of one of the FIA indices approaches the capacity of that index.
And what about changing market conditions? The risk control indices used in AIFs are usually composed of other indices, ETFs, stocks and futures. The liquidity of the components can change significantly over time. An underlying ETF may see reduced volume if it underperforms and investors pull out; or an underlying future may become thinly traded, with reduced open interest. In both cases, the drop in liquidity can reduce the index’s ability to control risk.
ICLN: an illustration
In the ETF world, the iShares Global Clean Energy ETF (ticker: ICLN ) provides a good example of an index capacity problem. The ETF launched in 2008, but as investors responded to the sustainability narrative and clean energy became a key initiative of the Joseph Biden administration, the ETF’s AUM of US rose from about $700 million to about $5 billion, while the corresponding European version was tracking the same. The index also grew to $5 billion. The ETF was also a popular underlying for US structured products, creating hidden demand for the stock. The problem was that the underlying index only had 30 components, two of which were small, illiquid New Zealand-listed stocks.
When it came time to rebalance, the ETF needed to sell 40 to 50 times the daily liquidity of these two stocks. This would have caused significant price movements. Following the consultations, index sponsor S&P took a drastic step: redesigning the index and increasing the number of stocks to a target of 100.
Although this example applies to an ETF, not an AIF, it demonstrates how changing market conditions and demand can create serious capacity issues in indexed products.
Design is important
So, if index capacity is not a predetermined, hard-coded quantity, how can operators avoid future capacity issues when selecting risk control indices?
The strength of the index depends primarily on the liquidity of the underlying instruments: typically other indices, ETFs, stocks and futures. Therefore, careful selection is essential. But the ability of the index also depends on the weighting mechanism that it assigns to these instruments, the rebalancing mechanism that implements these weights, and the risk control mechanism that keeps the volatility of the index at its target level.
Demand for an index, its performance and market conditions change over time, challenging product manufacturers and their hedge providers to ensure the provision of an index over the longest time scales of annuities Operators should consider the fine-grained aspects of index design when performing due diligence on proposed risk control indices.
With proper screening, they can maximize the chances of avoiding capacity issues in the future.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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