Structured products are a result of investors becoming moresophisticated and demanding. Now banks are happy to tailor investments to meet a client’s every wish. Joanne Hart reports.
Investing in financial markets used to be relatively simple. There were equities, there were bonds and there was property. Most investors kept the majority of their portfolio in equities complemented by a sprinkling of bonds and a smattering of property. But the investment world has changed radically in recent years. Equity markets have, at times, proved gravely disappointing and funds have suffered serious losses.
Low interest rates and low inflation have reduced returns in the debt markets and the desire for yield has encouraged investors to look at a much wider range of asset classes than ever before, including alternative assets, such as private equity and commodities.
Technology has allowed investors to track and monitor investments more effectively and the entire landscape has encouraged investors to become more sophisticated in their views and more demanding in their needs.
The structured way
Such an environment encourages the creation of new solutions – and structured products were born.
Structured products can be defined, quite simply, as esoteric, tailor-made products, designed to enhance yield, reduce risk or hedge against specific exposures.
They cover a range of asset classes and a range of maturities and they are one of the fastest growing areas in the investment world.
Mass produced
While some products have been virtually mass produced for the mass affluent, the part of the market attracting most attention is the highly bespoke area, where products are created to satisfy the particular needs of particular clients. Broadly speaking, these investors fit into two categories: either they want to reduce risk or they want to increase it. Structured products can cover both these requirements.
“If an investor wants to reduce their risk, we can create a three-year product for them, for example, that gives them 100% of their money back and a percentage of any upside, perhaps around 75%,” says Daniel McNeill, executive director, product development group for equity exotics & hybrids at JPMorgan.
“If an investor wants to increase their risk, if they strongly believe in a particular sector of the market for instance, we can leverage the upside and the downside. So, if the underlying assets fall 1%, investors lose 1.5%, but if the price rises, they might get two times their exposure,” he adds.
As investors seek to manage risk in a more sophisticated fashion, they invariably consider yield enhancement, hedging or diversification.
They may choose to take on more risk in return for the possibility of higher returns; they may be keen to cover themselves against a particular risk or they may want to broaden their exposure so as to spread risk over a wider range of asset classes.
“Generally speaking, different types of customers have different needs. High net worth individuals and their advisers will often have particular views on a sector or a geography and they will ask us to structure a product around those views. Institutions will often
have particular requirements, such as the need to find non-correlated investment opportunities. Corporates will often have specific issues they need to address, such as how to hedge within new accounting regulations,” says Peter Corner, head of structuring at Commerzbank Corporates and Markets.
Simple ideas
Mr Corner suggests that high net worth individuals and private banks tend to look for relatively simple products, such as notes built around the idea that the Brazilian market is enjoying a strong run or the US property market is going through a weak patch.
There is also a tendency for these investors to look for relatively short-term products – say six months to a year – so they can take advantage of a particular trend at a particular time and then move on to something new.
“Private clients have been asking for alternative asset classes such as private equity so, thanks to a partnership with a leading private equity fund manager, we created notes that provide exposure to the firm’s flagship funds, normally only accessible to institutional or ultra-high net worth investors,” says Pierre Bes head of private banking coverage for Europe at Barclays Capital.
JPMorgan’s Mr McNeill echoes this theme. “Last year, high net worth individuals were very keen on commodities. This year, private equity and leveraged buy-outs (LBOs) are in vogue,” he says.
“We went to our research team and asked them for the most likely LBO candidates in Europe and we created an index of possibles. If you look at potential LBO stocks, they tend to be flat if they are not bought out but rise sharply if they are, so we created a product around this idea.”
Particular sectors also move in and out of fashion and structured products are created around these trends. Alternative energy, nuclear energy and infrastructure are some of the industries favoured by private banking clients.
“We have to try and predict the next big thing and structure notes around it. I think luxury goods shares could be a coming theme and also the second generation of emerging markets after Brazil, Russia, India and China – places like Vietnam, Turkey and Mexico,” says Mr McNeill.
Give and take
The point here is that structured product teams have to be both proactive and reactive. “There is always a degree of give and take. We go and see clients with ideas but we also see what they want and try and create products to suit their particular needs,” says Kara Lemont, European head of interest rates and foreign exchange structuring at BNP Paribas.
Institutional clients, for instance, are frequently looking for products that will complement, rather than mirror, existing investments. BNP Paribas has responded to this need by creating hybrid products, where the risk is linked to a number of different asset classes.
“This involved a huge investment on our part but it means we can be that much more innovative and cutting edge,” says Ms Lemont.
The bank has recently created notes that offer hedge funds and other sophisticated institutional clients direct exposure to volatility, correlation and dispersion.
“Clients will often be exposed to volatility and correlation without being consciously aware of it. These notes make that exposure explicit. Dispersion is a way of measuring the performance of individual stocks in a basket of stocks versus the performance of the basket itself,” says Jean-Eric Pacini, head of structured products sales in equity derivatives at BNP Paribas, London.
Commerzbank, meanwhile, has been offering institutional clients notes where the risk is linked to the performance of funds that buy life assurance policies.
“The performance of these funds does not correlate with debt or equity products so the notes offer institutions some useful diversification,” says Mr Corner.
Banks such as Commerzbank and Barclays Capital have also structured products linked directly to real estate.
“The notes offer exposure directly to property valuations. The market is very small at present but it is growing fast,” says Mr Corner.
“We have created an index that enables private banks to offer their clients an opportunity to gain exposure to property without the constraints of direct investment. The index is dynamic and allocates between geographies, sectors and sub-asset classes of real estate with the aim of generating absolute returns with low volatility. The impact of market downturns is limited and opportunities in each market cycle are captured,” says Mr Bes.
Bespoke structured products used to be the preserve of the very brave or the very sophisticated but these days their appeal is growing. The latest converts include listed companies, which have been using these instruments to enhance returns on surplus cash or to help them manage risks arising from new accounting regulations.
Wider opportunities
“A few years ago, you would only talk to corporates about debt and equity products or about swaps from fixed to floating and vice versa. Now they are open to a far wider range of opportunities and they are prepared to look at different asset classes too,” says Vincent Berard, deputy head of interest rate and foreign exchange structuring at BNP Paribas.
“We recently launched a product linked to alternative trading strategies. It looks for inefficiencies in the market but it is packaged in a low-risk way and offers returns about 2% above base rates. It has caught the imagination of corporates with excess cash on their balance sheet,” says Mr McNeill.
Structured products can also help companies with hedging needs.
“Corporates are keen to use these products to cope with issues arising out of regulations such as IAS 39. We go and see them with a top accountancy expert and a derivatives structurer and we sit down with the corporate treasurer and the finance director and work out a solution on a piece-by-piece basis. I don’t believe you can do it any other way as each company’s circumstances are so individual to them,” says Mr Corner.
Drop in price
Such personal attention does not come cheap but intense competition across the structured products market means that prices have come down significantly in recent years. At the same time, transparency has increased so, even though these products do not carry explicit fees, clients can compare pricing on offer from different firms.
Most participants believe, however, that clients are concerned by a variety of factors apart from price.
JPMorgan’s Mr McNeill says: “Price used to be the most important factor but service is paramount now. I would say it is 70% service, 20% price and 10% innovation.”
“Clients make choices according to whether they have a relationship with you already; the ideas and service that you offer them and the price,” says Ms Lemont.
All market participants believe that this segment of the market will continue to expand over the next few years, moving into new parts of the world and covering an increasingly wide variety of asset classes. “The investment world is becoming more sophisticated and clients are becoming more specific about what they want. Structured products answer their needs,” says Mr Corner.
