Stock market turbulence has not swayed high-net-worth investors away from structured products in emerging markets, which bring them excellent returns, but they are being forced to adjust to the new environment, writes Michael Marray.

In spite of the turbulence on global stock markets, many high-net-worth (HNW) private banking clients continue to be interested in buying structured products based on the medium-term performance of emerging markets equities.

Over the past four years, BRIC (Brazil, Russia, India, China) became an important investment theme, and high returns were generated via the standard structure of 100% capital protection achieved via zero coupon bonds, with the remaining cash being used to buy options on baskets stocks or indices.

This long bet on equities gave HNW investors a simple and compelling story driven by macroeconomic factors, and achieved excellent returns. But private banking clients who had grown used to high returns with very little downside risk are being forced to adjust to the new, riskier environment.

Stock index falls

Many emerging markets stock indices have experienced sharp falls during 2008. And higher volatility has made the options more expensive, making it harder to structure an attractive pay-off with full capital protection. Not only are pay-offs getting lower, but also some of the capital protection has to be given up should stocks seriously underperform.

In such uncertain market conditions, some of the more sophisticated private banking clients are beginning to turn towards some component of market-neutral or non-directional products within their overall portfolios. These are often based on long-short trading strategies, where the outperformance of one index versus another, such as Russian equities versus the S&P 500, can generate a return regardless of whether both markets are rising or falling.

It is a well-established strategy among hedge funds but during the long bull market that ended last summer, most HNW individuals preferred to stick with easy-to-understand long strategies. “Market-neutral emerging markets products were completely absent until recently because we were in bullish markets and there was not much point in trying to be smarter than the market,” says one arranger.

Market-neutral products

Necessity is now forcing investors to take the time to look at the more complex market-neutral products, which were initially developed by structured products arrangers for their institutional clients, but are now being marketed in the private banking space and even at the retail level.

Since the second half of 2007, market-neutral aspects have been added to many developed market structured products and sold in markets such as the UK, Germany and Switzerland. HNW private banking clients have bought products based on large-cap stocks outperforming small-cap stocks, or the Euro Stoxx outperforming the S&P 500. The outperformance of the high dividend DivDAX versus the DAX was another theme on offer.

Much more recently, private banking accounts have looked at emerging markets products with a market-neutral pay-off. BNP Paribas has even structured a product at the retail level, for distribution in Italy. Italian investors are generally known to be willing to look at new and innovative products, and were receptive to a non-directional strategy with emerging markets stocks as the underlying.

“A retail network was looking for a product for their Italian retail clients based on emerging markets equities. They were not overly bullish, so they did not want to play emerging markets outright, but instead play emerging markets versus developed markets,” explains Wojtek Nabialek, head of structuring at BNP Paribas in London. “So we structured a basket of emerging markets indices protected by a short position on the S&P 500.

“We also included a feature that, should the S&P 500 fall by more than a certain amount – in this case set at 15% from inception – instead of a pay-off linked to outperformance, the product will pay a fixed return via a coupon activated in a bear market,” says Mr Nabialek. “You may believe emerging markets should eventually outperform, so being short the S&P 500 is a good loss mitigation, but you may not necessarily expect emerging markets to outperform in a bear market because during a big sell-off they tend to be quite closely correlated, so we included this bear protection feature.”

Other products

Elsewhere in the market, there has been a product based on the outperformance Russian stocks versus Euro Stoxx marketed to HNW private banking accounts. And another possibility being worked on is looking at the outperformance of US stocks with strong emerging markets operations versus the broader S&P 500.

However, non-directional products are still in the early stages of development in the retail space and are mainly sold to institutional clients. One bank estimates that only 1% of total UK retail structured product accounts were invested in non-directional products in 2007 – though the figure was 5% for Italy and 10% for France.

Most products still tend to be bullish bets on the future growth potential of emerging markets, even if in the short term they are falling simultaneously with European or US equities.

The Next Eleven

Brazil, Russia, India and China are still important, though these days there is less use of BRIC as a buzzword in private banking, as products have expanded to add more countries.

The so-called Next Eleven, a grouping initially put together by Goldman Sachs in 2005, are also being promoted as countries with a good macroeconomic story and solid growth prospects in coming years. These are Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey and Vietnam. Some are currently very difficult to invest in, such as Iran, while others are hard to access, such as Bangladesh.

There is also growing interest in the Gulf Co-operation Council (GCC) countries.

Stocks are typically grouped together in regional or global baskets, perhaps together with BRIC indices or baskets of stocks, because they are seen as cheaper in terms of value. There may also be sectoral themes, such as stocks exposed to the vast infrastructure requirements in countries such as China, or regional and global groupings.

“Investors would probably not mix GCC with India and China because the drivers of economic development are not the same, so we would tend to do an Asian infrastructure basket or a GCC basket,” says one structurer. “There is also interest in commodities products linked to the story of growing demand from China.”

Burak Ciceksever, an emerging markets structurer at Barclays Capital, says: “Equities is usually the first product that investors look at in a new market, and they have had excellent returns. But equity markets eventually become crowded by foreign investors, and investors are now also looking at other types of structured product,” he says.

“Retail investors are very interested in the commodities story. And we are also offering investors a range of Global Emerging Markets Strategy (GEMS) Diversified Money Market Indices, which are rolling money market investments in synthetic local currency deposits in a diverse group of emerging markets,” he says.

“Investors are looking for access to new markets,” says Laurence Black, product developer at ABN AMRO. “And we are currently getting a number of calls from clients looking for access to Africa, while there is continued demand for products based on countries in south-east Asia.”

ABN AMRO has a number of products based on the Next Seven Countries grouping, comprising Pakistan, Vietnam, Indonesia, Philippines, Turkey, Egypt and Mexico.

“Investors are looking for well-researched themes based on factors such as gross domestic product growth prospects, levels of direct foreign investment and political risk,” says Mr Black. “And, from the point of view of the structurer, we have to look carefully at the level of access to the local stock market and market liquidity if we want to offer access to our clients.”

BRIC demand

For the most established countries of the BRIC group, products based on a single country or even a thematic investment within a single country, may be popular. “We are continuing to see a lot of demand for China-based products, such as broad index-based structures based on FTSE Xinhua Greater China indices of Hong Kong traded securities,” says Gavin Rankin, head of products and services consulting at UBS Wealth Management in the UK.

“There are also thematic plays, such as Chinese infrastructure, and there was a lot of demand for Greater China securities, which stood to benefit from the high level of infrastructure investment leading up to the Olympic Games.

“In the Indian space, there is not so much emphasis upon broad equity growth or themes such as infrastructure, but instead we see a lot of structures playing off the growth stories of individually picked Indian equities, via American depositary receipts,” he adds.

“Investors are looking at factors specific to those companies, and may buy products such as reverse convertible structures, where they get paid an enhanced coupon as long as the basket of stocks does not trade below a given strike price,” says Mr Rankin.

One factor to which investors are paying more attention is currency, both in terms of FX-related products and simply looking at the upside and downside of the currency in which a structured product is denominated.

“In the Middle East, until last year almost all structured products were denominated in dollars; but there has been a lot of talk about currencies in the region being de-pegged, and currency considerations are becoming more important for investors,” says Mr Black. “We are now seeing certificates referenced in Dubai dhirams or the Kuwaiti dinar.”

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