Renewed appetite for structured solutions as worries disappear

July 5, 2010

With equity based investments back in demand, structured products are once again attracting investors, although concerns about liquidity mean transparency and simplicity are at a premium.

Sales of structured products have soared this year. Société Générale, for example, traded three times the amount of structured products in January and February compared with the same period last year. At this stage of the market cycle, structured products are perfectly positioned for allaying the cautious investor’s fear of capital loss on the one hand, and the more aggressive investor’s desire for gearing on the other, at a time when decent returns are hard to come by.

One factor in the revival is renewed appetite for equity based investments.
Before the crisis, equities were the most common underlying in structured products, representing 60-70 per cent of all launches, but according to experts at Société Générale Private Banking, equities represented only 5-10 per cent of launches in the last quarter of 2008. Now investors are coming back to equities, and are happy to use products such as capital protected notes to limit their downside risk in this market, with the result that equity underlyings have again risen to account for 50-60 per cent of launches.

Providers are devising structures specifically to entice investors back into equity markets, such as market timer products that optimise the entry point, using the most beneficial position in the first three to six months in the calculation for the maturity payment. These suit investors worried about the markets near term.

But with no interest rate rises in sight and a paucity of growth outside of emerging markets, products are being developed to extrapolate above inflation returns across a variety of asset classes. Developments in the fixed income space include the popular floored floaters with a variable coupon, typically over five years. Providers are getting round low interest rates by structuring funds with longer maturity or with partial rather than total protection. Constant proportion portfolio insurance (CPPI) products still work in a low interest rate environment as they are open-ended, and they are increasingly used for risky assets such as natural resources and sustainability.

Meanwhile the widespread unease around counterparty risk post-Lehman and the very specific scepticism about the transparency and liquidity of structured products are both beginning to wane. Where clients are suspicious of structured products, it is not so much around their risk/return characteristics, but more ‘What am I paying for the pleasure of participation?’.

The main attraction of structured products is you can alter the risk profile of the investment and quantify your maximum loss at the outset. We also have clients who like to gear their investments – giving up a dividend stream can provide upside gearing on a commodity or an equity index. These tend to have one-for-one downside participation.

One issue that still deters some investors is lack of liquidity, particularly those who have experienced gates with hedge funds and been locked into private equity deals. Consequently, there is demand for the highest degree of transparency and simplicity, and products listed and quoted on an exchange, especially in the Western Europe private banking market.

It helps that some of the funds have outperformed index trackers, and most actively managed funds, over the longer term. Kleinwort Benson, which launched defined return funds into the wealth management industry back in October 2005, reports that its Gresham US Accelerator Index Fund, launched in November 2007, has been in the first quartile consistently since launch.

Another appealing feature of funds is their eligibility for offshore bonds and funds of funds. They say this has been a key driver for the Morgan Stanley FTSE100 Accumulated Income funds, where a significant portion found its way into offshore bonds.
Aviva Investors has offered a series of Defined Returns Funds since May 2009, which are products linked to the FTSE 100 index.

The Defined Returns Fund 3 launched in January 2010 will pay 18.75 per cent at maturity in three years if the index is equal to or above its initial level.

The funds have the same return profile at maturity in the event of a fall in the index, providing limited capital protection, so if the index falls up to 50 per cent from the initial level, investors receive their capital back at maturity. However if the index falls by more than 50 per cent at maturity then investors will lose capital on a 1:1 basis ie if the index at maturity has fallen by 60 per cent then investors will get back 40 per cent of their capital.

According to the structured solutions director at Aviva Investors, there is strong interest in the UK for defined return funds, but less of an appetite in the US, continental Europe and Asia, where instead there is more demand for participation in the upside, such as CPPI, with diversification across asset classes.

What the experts see is differences in risk appetite – the UK market likes to invest more in equities and we are selling more CPPI / Tipp [time invariant portfolio protection] products than formula-based products. In France investors prefer full capital protection and we are currently marketing a CPPI fund based on a basket of actively managed equity funds with full capital protection and a rachet of 100 per cent of NAV reached at end of each quarter. In Belgium, and to an extent Germany, there is more appetite for riskier and exotic products with barriers rather than full capital protection.

AXA IM offers Tipp funds in Germany for instance, which are generally exposed to longer term mega trends such as infrastructure, the aging population, natural resources rarefaction and sustainability. These do not carry a formal and full capital guarantee, but are open-ended and can therefore be marketed all the time.

Structured products will continue to evolve to embrace a wider set of asset classes, such as currencies or emerging market equities where access can be challenging. Barclays Capital, for instance, is using its iPath ETF brand to develop product ranges that fill gaps in the market, for example, emerging markets, foreign exchange and in the commodities arena to replicate single commodities or sectors – which is not allowed under the current Ucits III regime. They foresee that BarCap will also offer enhanced structures in commodities in the second quarter to overcome the negative roll yield problem of commodities trading in contango.

In practice, structured products are predominately tactical plays, and ideas are often driven by specific market insights. For example, when Kleinwort Benson launched a product linked to the FTSE 100 Dividend Index which represents the cumulative value of cash dividends declared by constituents of the FTSE 100 Index, it was because their analysts had noticed a specific opportunity.

It was an opportunistic trade, because when estimates of dividends were announced in the middle of last year, Benson analysts noticed these companies were undervalued and would be likely to rally. The expected level of dividends has increased significantly since the dark days of mid 2009.

However, as management charges reduce, some appropriately constructed products may be suitable as the core of a portfolio and a few have already made it to the drawing board. Aviva, for instance, is working on three or four funds across Europe that consist of a diversified portfolio of equities, credit, commodities and real estate. They will be actively managed, with pre-defined exposures – for example, 50 per cent of the market’s upside after five years.

Another perceptible trend is towards providers assisting with end-client education, and arranging the decision-making so that products are built around their macro-economic recommendations. Société Générale has revamped its structure so that products recommended are always in line with the house macro view. For instance they do not believe that inflation will be a worry for two years but could rise strongly thereafter, and to protect clients, whose businesses could be seriously affected, they have developed an inflation product which provides a fixed coupon for the first two years and subsequently a floating coupon linked to inflation in years three to five.

Structured products are used as a means of implementing an investment decision as it allows investors to alter the risk profile of a conventional investment, perhaps to reduce or eliminate downside risk, to obtain gearing or increased participation. For example, the Japanese equity market has been a graveyard for investment for nearly 20 years so providers have used a partially principal-protected product that limits investors’ loss to a maximum of 5-10 per cent on the downside for a geared participation in the upside, and giving investors the ability to hedge back into their base currency.

Another example is Schroders Private Bank’s bullish outlook on emerging market currencies. The bank has created a geared note which invests in a basket of emerging market currencies such as the Korean Won, Taiwanese Dollar and Chinese Renminbi with downside risk limited to 10 per cent.

Counterparty risk is still a real concern, and the industry has stepped up its due diligence, but there may now be overkill in some quarters because a number of private banks took the decision not to work with certain providers. For example in the last three months, some private banks have put Morgan Stanley back on their panels, but some providers are being squeezed out of the market.

Morgan Stanley is launching a collateralised wrapper ‘Smart’ as a gold standard, in which can be embedded the client’s choice of collateral. This will be one wrapper alongside other wrappers on its platform and should be launched in two to three weeks. Some 40 per cent of the market will only trade collateralised – while the rest is open to credits ratings of single A or above. Specialists claim that by introducing the Smart wrapper, Morgan Stanley become much more competitive in the market.