From new recipes to house specialities, demand for structured products is as strong as ever. Natasha de Teran investigates what is on the menu for investors and what tastes are being catered for.
Christophe Mianné, global head of equity derivatives at SG CIB, describes the equity derivatives business as being very much like the pharmaceutical industry: one in which players can either invest in research and development (R&D) and base their business on sophistication and innovation, or run a volume-based, generic business.
From the outset, SG positioned itself at the value-added and higher-margin end of the business, and has employed large numbers of product engineers to help achieve this aim, says Mr Mianné. The firm prides itself on its creativity, although the equity derivatives sector in general is characterised by innovation: new product forms emerge with almost relentless regularity. Recently, new forms of structured products have dominated product development.
Growth drivers
Christian Kwek, European head of institutional structured product sales at BNP Paribas, says the reason for the growing popularity of equity derivatives lies in the adaptability of the products. Structured products have a chameleon-like quality that easily adapts to the prevailing investment conditions. “The appetite for structured products will remain strong, whatever the market conditions – it will simply be a question of adapting the product types to suit the market dynamics,” he says.
Laurent Le Saint, head of equity derivatives financial engineering, alternative investments, at SG, says that another reason behind the growth of structured products has been that their take-up has broadened beyond the traditional client base. “Traditionally, the bulk of business has been with private banks, family investment offices and independent advisers. But there is growing potential for increased uptake of these instruments by institutional investors,” he says.
Laurent Le Saint: a broadening client base is a driving force in the growth of structured products
He believes that the market is at a turning point: many investors that used to invest only in products with high-level capital guarantees are now keen to employ banks’ structuring capabilities more widely to capitalise on other opportunities. “I think they now understand the [structured] asset class better and, as a result, I expect we will see less insistence on full capital protection products and more use of other dynamically managed structured products, which can offer them better returns, and equally tailored exposure,” he says.
Product development
Of the structured products that caught the public imagination in 2004, Mr Le Saint says that take-up of Constant-Proportion Portfolio Insurance (CPPI) products will continue to grow for the rest of this year, particularly options-based CPPI products. Because these and other forms of portfolio insurance products provide higher exposure than simple zero-coupon-plus-call structures, they have traditionally been very popular with institutional investors and private banks as well as a favourite structure for many hedge fund investors, he says.
The continued appetite for last year’s products does not mean that structuring engineers have been resting on their laurels: other exotic pay-offs are in the pipeline. These include single underlying derivatives (exotic options on fund of funds) as well as multi-underlying structures (correlation pay-offs on multiple, single strategy indices like the MSCI hedge fund sub-indices, for instance). Mr Le Saint says that he is also seeing serious interest in zero coupon plus call products, which provide exposure to underlying portfolios of hedge funds. “These are all attractive to those investors who are looking for ‘alternative’ exposures to alternative investments,” he says.
Joachim Willnow, head of equity derivatives at Nomura, believes there is likely to be growing demand for structured fund of hedge fund products with additional leverage and/or capital guarantees built in. “Many of the larger hedge fund groups had been giving 10%-12% returns on 3%-4% volatility over the past few years, but their returns are now in the 5%-6% range on the same volatility levels, so naturally investors are seeking to leverage up,” he says.
The hunt for income
On a more general level, Johan Groothaert, global head of the investment products group at Deutsche Bank, expects the structured product market will be driven by the search for income. “Until a few years ago, there was sufficient supply of income, so everyone was looking for growth, whereas now the real problem is the lack of income. That is why we continue to see a lot of structured products emerging on structured credit and rates. Even if you look at the equity structures, they all play on the income story offering high coupons. That will continue to drive the market in the coming year.”
Andrea Morresi, head of equity derivatives investor marketing for EMEA at JPMorgan, points to how different parts of the market are looking for different results from their structured investments. “Real money investors are looking more and more at total return-type products, such as those products linked to hedge funds, or funds or funds, or even equity-hybrid products. On the retail side, clients are looking at innovative products that are more dynamic than those they have looked at previously. They want products linked to rotating indices or to performance-linked baskets of different indices.”
Single products
Appetite for less-structured new products is also healthy. According to Mr Kwek, the new variance swaps (forward contracts linked to the future realisation of variance levels in share prices) and dividend swaps (swaps that are linked to the dividends paid out by the referenced shares or baskets of shares) have been among the hottest products for almost a year now. He expects this popularity to continue as the range of buyers expands.
Dividend swaps were a dealer-led invention. Pierre-Yves Morlat, global head of equity derivatives arbitrage at SG CIB, says that SG’s dealers came up with the products when they were seeking to hedge the implicit dividend risk that they were holding on their books. “The market simply developed off the back of that, as hedge funds and proprietary traders took to the trading opportunities immediately. They realised that dividend swaps are a good method of playing on a country, index or a single company’s future earnings potential.”
Pierre-Yves Morlat: there is still potential for growth of the dividend swap market in Asia and Europe
Although the dividend swap market is already well developed, Mr Morlat says there is still plenty of potential for further growth in Asia. And in Europe, the next logical step would be for sectoral index dividend swaps to take off, he says.
Beyond variance and dividend swaps, Mr Willnow says that one of the more interesting topics is the surge in interest in volatility-linked products. “The exchanges have started to make equity volatility far more visible through their indices and futures contracts and, as a result, volatility is now beginning to establish itself as an asset class in its own right”, he says.
Some cross-asset products have already emerged, such as the equity default swap (an equity-based form of the credit default swap). Dixit Joshi, head of equity derivatives at Barclays Capital, says he expects to see yet more cross-asset products emerge between assets. “We have already seen how debt and equity have come closer over the last few years and I expect that, as this trend continues, we will see the emergence of more and more products that meld the two.”
Corporate activity
On the corporate side, Russell Schofield-Bezer, head of corporate financial engineering group for EMEA at JPMorgan, says that share buybacks – which are very much part of the deleveraging cycle and thus in vogue at the moment – are driving the bulk of corporates’ equity derivative-related activity. “Many corporates are cash rich at the moment, and need to decide whether to reinvest, to hold the cash on balance sheet, to pay down credit or to buy back their own shares,” he says.
Looking further ahead, Mr Schofield Bezer is less clear about where growth will come from but he is certain that the clients, not the products, will drive the market. The corporate side of the market will thus be powered by innovative solutions tailored to specific demands and situations. “In general, corporates are very anti-product-pushing; they are looking for total solutions that address everything, including any related accounting issues,” he says.
Mr Kwek is also unwilling to predict future developments. “The structured product business today is very balanced between retail, private banking, pension funds and hedge fund areas, and it is difficult to say which of those groups will be the bigger driver and which products will take off faster. But we are constantly offering all of our clients new ideas, which means the business grows and moves in different directions.” If nothing else, one thing is certain: by this time next year, there will have been a whole new equity derivatives vocabulary to learn.
