Investors still find products appealing

May 19, 2010

Europe, home to the most developed market for structured retail products, is expected to stage a modest recovery in 2010, but sales will still not match the 2007 peak. The underlying securities markets remain volatile while regulators are taking a closer interest in industry practices.

Gross sales are expected to rise by about 8 per cent this year from the 2009 figure of $228bn (£150bn, €173bn) compared with increases of 14 per cent in the Americas and 9 per cent in the Asia-Pacific region. Last year European sales fell 21 per cent.

The Europe-wide trend concealed very different developments in different national markets. In the two largest markets, Germany and Italy, sales fell 17 per cent and 20 per cent respectively, to $59bn and $49bn. Spain was the biggest loser with sales down 44 per cent to $23bn while the UK was the most buoyant, recording an increase of 50 per cent to $21bn.

There were substantial differences across the different market segments. Products that declined most in volume were those that did not offer capital guarantees or were short volatility; those in markets that faced regulatory changes such as the Italian index-linked life insurance business; and those from issuers that had credit spread issues at the time of the crisis.

Investors were unsettled by the Lehman Brothers default and the realisation that they had been unwittingly exposed to unknown counterparties in the transactions they had entered into. The quality of advice to retail investors also left much to be desired.

In the UK, a review by the Financial Services Authority of advice given to investors in structured investment products found that in 46 per cent of cases in its sample the advice given was unsuitable. In a further 23 per cent of cases it was unclear whether the advice had been suitable, often because customer records were inadequate.

Yet the appeal of structured products to investors remains strong. When interest rates are very low investors are looking for alternatives, and structured products are seen as a way of getting a potentially better return while still protecting your capital. Investors are cautious and are attracted to the capital-protected element of the products.

The recent recovery in volumes has two main drivers. On the demand side, it is linked to trends in the equity markets, which have been positive, and on the offer side, banks that withdrew at the climax of the crisis are back in this market promoting structured products. But they are still by no means back at the volume levels of 2007.

When the European market does recover, the products on offer will differ somewhat from those being sold in advance of the 2008 bust. Investors are seeking greater transparency in the offering – including full disclosure on counterparties to the deal – and simpler product structures.

Complex pay-off arrangements that depend on opaque price triggers or impose seemingly arbitrary caps have fallen out of favour. Investors simply want attractive investment ideas that generate a decent return.

At the same time product originators take heart from client interest in less conventional underlying investments. During the first stage of the financial crisis, investors clung to plain vanilla underlyings such as the FTSE 100, the Euro Stoxx or the S&P 500 indices. But in recent months there has been a slow return to alternative asset classes and to thematic investments including sustainable assets, infrastructure and BRIC stocks (companies in Brazil, Russia, India and China).

The three key themes in investing are simplicity in terms of structure, transparency and regulation. One result of these factors has been a shift to listed platforms, including a strong growth in demand for exchange traded notes. However, some experts say the value of a listing depends on the rigour of the market authorities involved.

What is certain is that regulation will play an increasing role in the fortunes of the sector. Financial markets across the board are under scrutiny and the retail structured products niche is no exception. Regulators around the world are taking a hard look at the quality of the service provided and at the protection provided to the retail investor.

The European Commission is attempting to bring coherence to a raft of already existing regulation so as to establish an effective regulatory framework for packaged retail investment products (Prips). In the field of product information, it believes that the Key Information Document developed as part of the revised Ucits directive provides a good benchmark for disclosure practice.

The Mifid (Markets in Financial Instruments) directive, meanwhile, contains rules covering sales, including conduct of business, inducements, suitability and conflicts of interest. But the rules often differ according to the legal form of the product and the sales channel and this patchwork of legislation does not provide a coherent and effective regulatory framework for Prips. The Commission is preparing legislation to remedy this lack.

In the UK, the Financial Services Authority put the squeeze on firms marketing structured products to retail investors and three went into administration. It is tightening its controls and will undertake follow-up assessments during 2010 to ensure firms are meeting its advice standards and are designing and marketing products in an appropriate way.

Experts claim there is much more uncertainty this year. They are forecasting a moderate recovery but warn that the impact of pending regulatory changes could significantly alter the outcome.