Autocallables are ideal for medium-term optimists

The US investor’s weekly Barron’s isn’t renowned for its sense of humour but I couldn’t help but wonder if its editors were joking when they ran an article asking “Are You Ready for Dow 20,000?” Yes, that’s four zeros on the end, not three!

James Finucane, a highly respected stock strategist, has apparently been looking at the charts and reckons that the market has beaten itself up too badly, resulting in a series of buy signals. Finucane – who, according to Barron’s, was a world-class pool hustler in his youth – suggests that global governments have a “clear incentive to promote growth” whatever the cost, and that their support should act as a cushion for the huge wall of liquidity looking to move back into the market.

He estimates that “money market cash has soared to $3.45 trillion vs $2.2 trillion at the market low of March 2003”.

Of course, there are plenty of bearish arguments to counter this view. But Finucane does an enormous service to all adventurous investors waiting for the markets to recapture their nerve. So, in that spirit, I’ve also been thinking about how to buy a long-dated option on a rise in global markets in the next few years – at a relatively low price and with relatively low risk.

My cunning plan features an old friend of this column: autocallables. These strange, rather inelegantly-named structured products are listed on the London stock market and were first mentioned here in November 2007. At the time, they seemed an ideal kind of defined-return product for markets trading sideways.

Fast forward six months and markets have been trading in anything but a sideways direction. With the FTSE 100 down 20 per cent on its high of last year, the autocallables issued by the market leader – Merrill Lynch – have plunged in price. But such weakness is anything but surprising.

Autocallables typically try to structure a defined return based on a simple investment proposition. Typically, they pay a coupon of anything between 11p and 18p if an underlying index – usually the FTSE 100 or the DJ EuroSTOXX 50 – has stayed the same or risen higher in the first year. If the index is below that initial level, the coupon isn’t called and the autocallable rolls over to its next anniversary (called the observation date) at which point you either get all the accumulated coupons or you move on to another year.

These products can usually keep rolling over for a total of five years – by which time a coupon of anything between 55 per cent or 90 per cent can be paid provided the index is above that initial level.

If, after five years, that initial level still hasn’t been achieved, you get your initial 100p returned as long as a barrier level hasn’t been breached – that barrier is usually set at 50 per cent of the index initial level. If that barrier is breached, your initial 100p investment falls 1 per cent for every 1 per cent drop in the index.

So, in effect, these autocallables are highly geared options on the FTSE 100 and Euroland DJ EuroSTOXX 50 indices. If the markets fall violently, they will lurch in price – but the reverse is also true over the medium term.

For example, take the Merrill Lynch M024, based on the DJ Eurostoxx (see www.londonlisted.ml.com). As I write this, the index is at 3,681, which is 12 per cent below the initial level. This product is structured to pay out 118.2p (100p initial price and 18.2p coupon) at the end of August this year if the underlying index rises 12 per cent to 4,175. With M024 priced at 94p currently, that would result in a tasty gain of 24 per cent.

The only problem is that there’s about as much chance of this happening as there is of a snowstorm in hell. However, there is a better chance of the index recovering in just over 2.5 years time – i.e. by August 2010. It would only require an average annual compounded return of 4.4 per cent. And if the index manages this, the autocallable will return 154.6p against the current 94p. That equates to a return of 62 per cent – giving gearing of not far off five times the underlying index.

Merrill’s Capital Accumulation V shares offer a similar proposition (see www.definedfunds.ml.com). Issued back in September when the FTSE 100 was at 6306, they pay a coupon of 14.5p on 100p. Again, I can’t see this index back at that initial level until 2010. But, if it gets there, it would only require an annual compound return of less than 3 per cent. And that would trigger a 46 per cent return in total – again, a massive gearing on the underlying index.

Safer options are now available in the form of the more recently issued Capital Accumulation VI and VII shares. These boast a slightly different structure in that every year – the anniversary or observation date – the initial level required to trigger the 11p per £1 coupon actually falls. With both these shares, the February 2009 FTSE 100 level required for the payout is about 5,300, dropping to just 3,525 by 2012.

I think that these autocallables are now an even cheaper option on future market optimism.

Of course, all bets are off if markets really are to crash by more than 50 per cent. However, if that happens, we’ll probably be joining Finucane in wondering how our predictions went so wrong – and wandering into the nearest pool hall.