Celebrating the uber fashionable autocallable ETF

Timo Pfeiffer, Solactive’s CMO, talks autocallables in this out of the Off the Record podcast. ETFs are no longer just about beta – they’ve become a delivery mechanism for structured payoffs, Pfeiffer says.

This episode is brought to you in partnership with Solactive. 

Transcript

Beverly Chandler

Hello, my name's Beverly Chandler and I welcome you to this edition of Off the Record, the podcast for ETF Express in partnership with Solactive. I'm here with Solactive CMO Timo Pfeiffer, and we're here to discuss that most fashionable of subjects, autocallable ETFs. We're seeing just more payoff-based ETFs like defined outcome, buffers, and now these autocallable-styled strategies. Why is this such a big topic right now?

Timo Pfeiffer

Hello. Hi, Beverly. Thanks for having me on the podcast; it’s been quite some time since I think we did the last one, and I'm sorry I missed your events over I think in London and Toronto earlier this year. So good to be back here. You've just labelled autocalls as fashionable and indeed it is a hot topic. It is a big topic. It is, I like your terminology, fashionable. Where does this come from? I think to a large extent driven by activity in the US where this has originated and started pretty much about a year ago on summer 25. I'm actually myself just back from a trip to the US and Canada where this has really been a topic across banks, ETF issuers with a lot of activity and new launches. The wider space of option-based ETFs, some numbers, some statistics, right now has about, I think it's close to 300 billion in terms of assets. There is one of the largest ones by JP Morgan, a call override, defined outcome ETF: JEPI. I think that alone has 40 or 45 billion in assets. And that space keeps growing. I mean, the wider ETF market, let's say it's no longer a niche, it's really hit center stage.

Beverly Chandler

And how do autocallables fit into the broader landscape of payoff-based ETFs?

Timo Pfeiffer

So I have just mentioned defined outcome, that JEPI ETF as one example, there's dozens of more. One of the key headlines, I think, and the reasons is at the end of the day, income. Some sort of yield. That's really what investors are looking for, to generate some sort of predictable, expectable income through the ETF exposure with some structured products, some option-based strategy behind it.

Beverly Chandler

But how do these differ from sort of normal, as it were, defined outcome buffer ETFs?

Timo Pfeiffer

So autocallable ETFs in a sense combine a downside protection and let's say even more, that's the intention, predictable yield that I just talked about to basically hit investors account and generate those. So it's probably, let's say, and I'll have to explain some of the basics, one step more, let's say, predictable formulaic.

Beverly Chandler

So exactly, let's get into the mechanics because some people are going to know the name. I'm actually going to ask you something else because I'm calling them autocallables. You're calling them autocalls. Is there a difference between the two or is it just nomenclature?

Timo Pfeiffer

Yeah, no, You are right in calling them autocallables. That's the right terminology. And that probably gets us to, let me try in simple words to explain what it actually is. So I've talked about yield. So the goal is to hit a return, a yield, an income of, I give some numeric examples, let's say 8 to 10%. That's the goal. That's what you're looking for when you get into an autocallable. The mechanism is relatively simple that on a given point, let's say in a point in the future, in one year's time, you basically simply check if the underlying index, the equity market is up. And as long as it's up just by a tiny bit, you basically trigger, you generate that return of I talked about 8 to 10%. In case the market is not up in a year's time, you do exactly the same mechanism the following year. So let's say next observation in two years' time and basically look again at an 8 to 10% in my example annualized return. Now, as that sounds probably attractive from a simple yield and return perspective, in exchange for generating this return, investors are accepting a downside risk, again based on the equity market. In a more extreme scenario, I give again some numeric examples, probably in a drop of the market of more than 30 or 40%, so 60 or 70% of the downside. At maturity, so typically an example in five years time, you are protected as long as the market does not fall by more than my 30 or 40% in the example. And if it does, and that's the flip side, you are effectively accepting or suffering those losses. Now you've asked about the terminology, autocallable. That's basically a, let's say, automatic trigger option to autocall to early terminate the product in that event after year one, that the 8% return is triggered. So basically the product calls automatically, so stops its life.

Beverly Chandler

So in the event of some sort of market happening, the product stops its exposure to equities?

Timo Pfeiffer

So basically you get the 100, your initial investment, plus in my example, 8% coupon returned early and repaid, and the product, an individual autocallable, terminates. That's the basic principle.

Beverly Chandler

So is it like a supercharged buffer product?

Timo Pfeiffer

I don't know if you want to call it supercharged buffer product. It's an evolution thereof. It's one step further. It has differences to a buffer product. I just try to get the basics of the autocall across. Not really supercharged, there's differences. So you accept the downside risk, you translate this into a higher return yield potential.

Beverly Chandler

Okay, let's move on to this sort of history here with autocallables. They used to be sold as banknotes. Why are ETFs entering the picture now? Why is it suddenly all happening in ETFs?

Timo Pfeiffer

I would rephrase slightly when I say they used to, they are still being predominantly sold as individual autocallable notes issued and offered by banks. That is happening around the globe. That is not unique to the US. That happens here in Germany on the ground. That happens in Europe. That happens in Asia. As a matter of fact, it reminds me a bit, maybe we could cut this later, about my age. It must have been like 2003, 2004 when I was working in my case at Deutsche Bank. And greetings at this point to a guy called Alex over in Hong Kong. I remember he at the time shared some term sheets, some explanation of a new product that we all found exciting and looked at it and thought, how does this actually work? How can this be? So that's back in 2003, 2004, when from my personal perspective, I came across the first autocallable note. That popularity of the payoff, as I described earlier, has grown ever since. And since many years till today, is overall the most popular structured product offered and issued by banks and as individual notes. I've checked a bit ahead of that because I talked about it a lot. Me as a very simple German retail investor, I've just browsed the web very briefly on some search engine. If I were to buy an individual autocallable note as Timo right now, I could basically choose from about 15,000 that are listed on the exchanges right now. So the point is, they are massive, they are round and predominantly in banknotes and ETFs coming new.

Beverly Chandler

And what do ETFs bring to the party?

Timo Pfeiffer

So when I just looked at individual notes that are issued by banks, it's just an individual product. The way they are being offered and packaged in ETFs is basically not just an individual autocallable structure, but a portfolio, a variety, a range thereof, which basically can bring, let's say, risk reduction in terms of diversification. So it's not just this individual and individual timing and individual exposure, but diversified across the portfolio. Plus, Timo did a bit of Googling, and I just said I got to 15,000. It would take me a lot of time and looking at it and I don't really want to pick one from 15,000. So the convenience factor that you can have by offering them, let's say packaged in an ETF is for sure one of the main benefits I would see with ETFs entering that space.

Beverly Chandler

And also presumably the usual advantages of ETFs, so liquidity maybe and accessibility.

Timo Pfeiffer

Exchange listing, liquidity, what I've just described in creating such a portfolio of autocalls for sure is cheaper to be done in an ETF consistently rather than any investor trying to replicate this individually.

Beverly Chandler

And looking, because we, as you know, we do US and European awards, but our US awards last year were dominated by options-based products. That was definitely the flavor of the year in America. So they do seem to be ahead in payoff-based ETFs. But how do you see the US-European comparison?

Timo Pfeiffer

No doubt that, I mean, we can say this for the ETF market and the size and the adoption thereof, that the US are ahead overall. And other parts of the world following this trend catching up for sure. That same holds true 100% when I think of option-based ETFs in more general. And I have talked about that first launch on the autocall ETF side about a year ago. So true, there are local differences in the individual markets and regions. For the US, for example, the tax benefit, short term versus long term, capital gains of an ETF play a role as well and fuel further that adoption. That's different in other parts of the world, for example, here in Europe. Then you have market structure. I talked about my 15,000 here in Germany. You don't have this everywhere. So the dynamics and the structure of a structured product with it versus an ETF market for sure play a role. Investor-based, let's say retail versus institutional, is it more of an advisor-driven market or online brokerage, self-directed market? All these factors play a role, but bottom line, US ahead as we speak and much larger and faster adoption of option-based ETFs in general. Europe and other parts of the world, from my perspective, following, it's happening now, today, left, right and centre.

Beverly Chandler

And we have in Europe a longer history with autocallables as a concept, is that right?

Timo Pfeiffer

So I talked about 2003, 2004, that to be very fair came out of Asia. That was the origin. I think actually Singapore, some wealth management. Then very quickly as notes, as bank issue notes got adopted and grown big here in Europe, UK, Germany, France, very big, Switzerland and really all other markets. I'm talking a structured notes adoption, but have grown. If I think of Canada, if I think of the US since many years, as the most dominant structured product and payoff in the market for sure.

Beverly Chandler

So how are these autocallable ETFs implemented technically? How do they exactly work?

Timo Pfeiffer

So now, well, good question. Now we're looking under the hood. I hope I try not to be too technical and confuse. So clearly there's the role of the ETF issuer that, like with any ETF, launches, structures the ETF, let's say the shelf, the wrapper. To get the exposure to not just one autocallable or any option-based payout, the ETF issuer typically gets and generates the exposure, so the investment, through a swap, so a derivative structure that they enter into with the bank; the bank that can generate this return profile, and provide this exposure back to the ETF issuer. And most often, for sure, when they are index-based and passive ETFs, the index, if you like, is the engine behind it, is at the core of it, following, let's say, implementing those rules, this mechanism of regular observations, return being triggered or not, basically in a systematic rules-based format. So 3 roles, ETF issuer, what you see, what you know; exposure generated with and through some bank typically, and that can really be any of the large investment banks globally; and if I look under the hood, the index as, let's say, the engine, the core behind it.

Beverly Chandler

And that's your business, of course, at Solactive. You are index providers. It's your home turf. So why are indices so central to autocallable ETFs?

Timo Pfeiffer

I have, so you just said a home turf indeed. I talked about, personally about another time of my career on a trading floor where, for sure, autocallable notes have been the most popular, probably the product, or for sure the product I've seen most often, traded, structured most often, and that's not team individual, but in the industry. So we're marrying this home turf with now today's index world. Which role does the index play? It's relatively straightforward to monitor, observe, understand, and follow an individual of those payouts. It becomes, let's say, a lot of work if you want to do this systematically in an index format, let's say one new structure, one new autocallable every week. Throughout the year, you quickly get to a portfolio of 50 plus. And triggering and monitoring the events, the observations, do I get the coupon? Does the product terminate early, autocall, or does it continue at maturity after five years, ten, or? Are we close to the downside risk or is this far away? All of this work, all of this mechanism, all of this observation, calculation at the end of the day, starting off with an individual of those structures and then building this portfolio is the work under the hood and most convenient, most transparent to be translated and structured in an index format, a selective XYZ autocallable index, as I described it.

Beverly Chandler

So let's take a look at different market environments. When do autocallable strategies work best and then when don't they?

Timo Pfeiffer

In simple words, as they are typically equity-based, it helps when the equity market goes up. And to your earlier question, for sure, that has been another helpful driver in the last couple of years, generating the popularity and generating very, very positive experiences and returns, bottom line for investors' portfolios. I've talked earlier about you generate a yield already if the market is just up a tiny bit, let's say by a cent, the individual stock or underlying index. So a slightly moderately positive market environment is best and already sufficient to generate the return. In a massively bull market environment, I don't know, the market up 25% in a given year, yeah you would be better off with a direct equity investment, but that's an individual very positive bullish year. A mildly moderate continuously bullish environment is positive and good for such autocallable structures, and now I have not mentioned the risk that is existing in a 30-40% market drop. However, up until that level, so in a more moderate market setback, you are protected and have this protection of your investment as well. So long story short, a mildly moderate positive equity market is the best environment for such a product in total.

Beverly Chandler

And the less friendly market environment, a short, sharp, fast sell-off, market crash.

Timo Pfeiffer

A drop, be it fast or be it steady or a longer period that brings you close and closer to that downside risk, that barrier, that threshold that can put you into loss territory, that's of course the negative scenario and the risk associated with those structures. I probably should not be saying this standard phrase of there's no free lunch, but of course that pickup in return comes through the downside risk that investors are taking on in those extreme market drops.

Beverly Chandler

So what needs do autocallable ETFs really meet and what do you think people misunderstand? There's a lot to misunderstand, I think. Let's go through it. Key points here.

Timo Pfeiffer

So key points, what people are looking for is, I repeat, income, let's say predictable income and yield that you can structure. I have always talked about 8 to 10%, but you can structure this more aggressively, let's say 12, 15 which comes in exchange at a higher risk, so lower protection. And on the other side of the spectrum, you can target, let's say, just 6% yield, which comes with more protection. So you can pretty much tailor the risk return profile, as I've just explained, by dialing up or down the risk, translating into the respective yield. The one headline is yield income. You've asked about what can go wrong and the risks, not to be mistaken, and it has to be very clear, transparent, and for everyone entering that there is a downside risk that you are accepting in the scenario we just talked about, which is a dropping, a significant, a decline in the equity market and the underlying mechanisms. Also, I think the benefit is that the transparency and basically the rule-based mechanism and implementation put when buying, be it an individual note by a bank or be the exposure in an ETF wrapper, it's helpful from an educational perspective to familiarise yourself and us as an industry to do education around the mechanisms and functionality of those structures. If those are well understood, there's a lot of benefits in it.

Beverly Chandler

So do you think we'll see a growth of retail investing in autocallable ETFs or do you think it's going to be institutions or wealth managers?

Timo Pfeiffer

So from a client base, just number just on top of my head that I got back from the US where just last year, 25, about 140 billion have been issued as bank issued autocallable notes. That compares with assets right now in an ETF wrapper for autocallables of about 42 to 3 billion in total as of right now. So that gives a bit of the perspective of the size. Getting back to this 140 billion, that is typically a retail, a wealth management an advisor driven market. So many of those products get actually bought through distribution networks, private banks, advisory channels. With the adoption in ETF wrapper, I am convinced, I'm quite certain that the percentage of retail investors buying this both in the US as well as here in Europe, I talked about exchange listings here in Germany. If I can get this in one umbrella, one shelf, one wrapper called ETF with the convenience coming with it, I'm convinced I can foresee the adoption and percentage of retail investors. Going after the yield, going after the income I've described by accepting downside risk in the equity market is for sure going to grow, my view.

Beverly Chandler

Yeah, and looking forward also, do you think there could be other developments in the market? So I think maybe I think you mentioned to me when we were talking before about multi-asset underliers. Is that a possibility?

Timo Pfeiffer

So for sure, with the adoptions taking place and taking on different type of underlyings, I have so far only talked about equity. That can be an individual stock or typically a broad US large cap index. But that can likewise be gold. That could likewise be a cryptocurrency. That can likewise be a combination thereof if you asked about multi-assets. Probably not all of this might make sense and come at the right time, given market environment, but I see the largest part and percentage of equity underlyings, as you see in the structured product and structured note markets since many years. I expect the same in the ETF space, with some variations. I've talked about some of the underlying, probably sector exposures, thematic exposures to come and happen as well. We've talked about option override, defined outcome, so simple call selling strategies being the most popular. Now we talked a lot about autocallables as basically the next frontier happening. We could spend three more podcasts on different type of payouts and structured product variations thereof, there's really no limit. I expect some more of those beyond autocallables to also enter the space in ETF. So underlying diversification, different type of payouts, and overall continued adoption in the market is the look to the future, if you like.

Beverly Chandler

So there's a lot to talk about going forwards and we've already spoken about a lot. I think you've actually managed to explain this new sector to me, just about. I still wouldn't want to write one, but I'm very happy to have some idea of what they are. And I hope that's true for our audience as well. They're kind of a tough subject to approach and not what you'd expect within the ETF industry, but it sounds like you think it's going to get even more interesting going forwards. I just want to thank you for being my guest today, Timo Pfeiffer of Solactive, and I want to thank you, the audience, for listening. Remember to subscribe and leave a review, and feel free to contact us at podcast@chandlerpublishing.com. This has been an Off the Record recording from ETF Express in partnership with Solactive.

Outro

Off the Record is brought to you by Chandler Publishing, production by Imogen Rostron, music by Otto Balfour, and hosted by me, Beverly Chandler. Thank you to our guests on this episode of Off the Record and to you for listening. We look forward to you joining us next time.