Nicolas Cagi-Nicolau, head of SocGen's private banking's structured products unit

As appetite for equity slowly returns to the world's markets, private banking clients remain shy of structured products. And if they are to be tempted back to this once-booming sector, there must be a shift towards more transparent and less complex products. Writer Silvia Pavoni

At the height of the financial markets, private banking clients were seduced by the seeming ability of structured products to provide both clever capital protection and higher returns. But as the financial crisis erupted, secondary markets quickly evaporated. Issuing banks would not buy products back and nobody could tell clients how much these illiquid products were now worth.

As a result, clients quickly moved funds into safer and more liquid assets and as the crisis unfolded, according to Société Générale, cash and cash alternatives soon accounted for an average 80% of its private banking clients' investment portfolios.

With market sentiment now much calmer and economic prospects becoming increasingly hopeful around the world, there is once again an appetite for equity and other asset classes. Although not quite reaching the levels of confidence seen in 2007, when equity represented 75% of the average portfolio's make-up, SocGen says clients have reduced cash and cash alternatives to about 15%, with equity products rising to 60% of the portfolio composition. Foreign exchange and commodities are the other most popular investment themes, accounting for 20% and 5% on average, respectively.

Changing attitudes

However, private banking clients are not rushing back to the structured products market. Nicolas Cagi-Nicolau, head of SocGen's private banking's structured products unit, says there has been a fundamental shift in client perception; they are now using structured products for protection of capital because of the stability of underlyings, not for their returns. "Clients have discovered that structured products are not an asset class but a tool," he says.

That clients use such products to seek both capital protection and stable investments is a given. But why use structured products at all if similar results can be achieved through more simple, transparent and liquid investment strategies?

In some cases it is cheaper. Gaining exposure to certain currencies, for example, can be costly given the taxation around capital flows imposed by some governments, so a structured product becomes cost-effective.

"You go into structured products either to gain exposure to something that is not available on the cash markets or as a means to gain such exposure in a cheaper way," says Bill O'Neill, chief investment officer for Europe, Middle East and Africa (EMEA) at Merrill Lynch Wealth Management.

For the most part, however, many argue that structured products are generally still expensive - and that they are often more beneficial for banks than clients.

"They are interesting products when it is difficult to reproduce a certain structure, or for retail clients that don't have access to advisory firms that would replicate the product with an investment strategy. [But] you pay for the origination of the paper, the structuring of the deal, who sells it and who prices it," says Carlo Michienzi, partner and co-CEO of asset manager BCM & Partners.

Some experts believe that the mark-up on structured products, through a series of hidden costs, accounts for about 5% of the note's value, making these products a good funding source for banks but a costly investment for clients.

One banker, who wishes to remain anonymous, says: "Pre- and post-Lehman, many banks use structured products as funding tools. There are specific banks for which it is a great way to cover their [funding] needs because you wouldn't see [the hidden fees] outright."

Despite the fact investors are still relatively uninterested in structured products on the whole, those that can provide a higher return for a lower cost are an easier sell in today's low interest rate environment.

Catherine Tillotson, managing partner of private banking consultancy Scorpio Partnership, says that in the current market even exchange-traded funds (ETFs) that offer a 4% return are appealing to ultra high-net-worth individuals (HNWIs), because the beta return they would get from their investments would not be too dissimilar from their managed investments. More importantly, there are no management fees to pay with an ETF.

However, Ms Tillotson is sceptical of claims that investors have a renewed interest in structured products. "Structured products are pretty low down in the list of things clients want right now. They're more interested in investing directly in equity, real estate and mutual funds. Over time you might see clients moving back into structured products, but with caution," she says.

There are also doubts about the ability of structured products to be simple enough for their associated risks to be fully understood by investors, and yet sufficiently ingenious to secure higher returns for clients and interesting fees for banks.

 

Rupa Ganatra, director of private banking solutions at RBC Capital Markets

Loaded dice

The distinctive features of structured products come from their derivatives component. This is what makes these products appealing and, in the most sophisticated cases, difficult to replicate using an investment strategy. But it is also what makes structured notes complex and difficult to understand.

"It is unlikely that the derivative will be a simple one that is traded on an exchange, as the returns would not appear tempting enough," says Simon James, founding partner of Gore Browne Investment Management. "More typically, they are over-the-counter options that are tailor-made for the product provider. There is not an open market in such options. They are provided by private contracts and so it is difficult to cancel or sell them before maturity."

The derivative component represents, on one side, a bet by sophisticated investors - such as hedge funds - that a certain event will happen and therefore trigger the derivative and, on the other, the bet by structured notes investors that such an event is unlikely.

While a client might think his views are aligned with the bank selling the product to him, the bank itself might have included a certain condition, which the private client would find unlikely to happen, because some hedge funds believe that an event would materialise. In this case, the structuring bank would take an opposite position to its client.

In a sense, private investors are playing with loaded dice. Mr James says banks structure such products to pay out only if the sophisticated investor is wrong, which they believe to be unlikely.

"To create an attractive headline rate of return it is normal for the product producer to include a range of conditions under which that headline return cannot be achieved. Such conditions are unlikely to appear in the headline and may seem to the non-sophisticated investor as unlikely to come to pass.

"Unfortunately, the creator of the derivative will have included them because sophisticated investors expect them to have a higher probability of occurring. At times of relatively high uncertainty and asset price volatility, the sophisticated investors are more likely to be proved correct," says Mr James.

The fraud lawsuit filed against Goldman Sachs by the US Securities and Exchange Commission has been a harsh reminder of how unclear these products and the role played by sophisticated investors can be. The allegation is that Goldman Sachs failed to tell investors that one of its hedge fund clients, Paulson & Co, had played a significant role in constructing a collateralised debt obligation the bank was selling, with the specific intention that Paulson would short it.

 

Bill O'Neill, chief investment officer for Europe, Middle East and Africa (EMEA) at Merrill Lynch Wealth Management

UCITS III to the rescue?

Given the mechanisms of structured products have not changed, many believe investors should remain cautious. The consensus is that clients want investment ideas - and clear, transparent, liquid investment tools.

"Since last year, we have been seeing increased interest again from private banks in the EMEA region for vanilla pay-offs linked to liquid, observable underlyings," says Rupa Ganatra, director of private banking solutions at RBC Capital Markets. "Numerous high-profile fraud events, including the Madoff [scandal], have highlighted the increasing need for sophisticated due diligence. There have been several examples where the underlyings themselves were very illiquid and also cases where some banks had launched 'black-box' underlyings, which were proprietary trading strategies of the bank itself."

Many in the market still fear that a product's risks will be misjudged, and clearly this still preoccupies regulators. The third version of the EU's Undertaking for Collective Investments in Transferable Securities directive, or UCITS III, is considered one of the most regulated wrappers in the investment market at the moment and it can also be applied to structured products.

The regulation requires certain levels of liquidity for the underlying assets and has a collateralisation mechanism in place that mitigates counterparty risk. It allows derivatives as underlyings, within limits, and requires diversification in the assets in which the fund invests. UCITS III also necessitates that the derivative component receives very frequent fair-value quotation that does not rely on market quotations by the counterparty, that its pricing model should use a recognised methodology and that the valuation must be verified by an independent third party.

Aside from the eligibility of assets, collateral and counterparty, the framework also imposes checks at custodian, administrator, manager and auditor levels.

The large distribution of UCITS III products might also mean the creation of a liquid secondary market is more likely than with other structured products.

Increased transparency, lower counterparty risk and possibly higher liquidity come at the expense of delivering speedy and bespoke solutions, however. Launching a UCITS III product also takes time. Building a UCITS platform can require an initial disbursement of £1m ($1.53m) and a team of structurers, lawyers and sales staff with the right skills. The launch of any individual fund could cost hundred of thousands of pounds, according to experts.

Once set up, the institution behind the product needs to size the market interest before its official launch, which can be a lengthy process. By contrast, clients could get their tailor-made traditional structured product very quickly.

"If a client called me now, we could create a tailor-made structured product and issue it within the same day, to the specific size of the lead order client," says Ms Ganatra. "UCITS III wrappers help mitigate counterparty risk but at the same time they're not a solution for the whole of the structured product market."

She says that while several banks have started issuing UCITS III structured product wrappers, she does not think they are going to replace structured products all together. "I think that [UCITS] offers another solution to investors, maybe more on the retail market, where there is less requirement for bespoke solutions, and it is more about a specific investment theme or underlying."

 

Emma Davidson, head of UK and Ireland sales for CitiFirst

Push for transparency

A number of such products are coming to market. In the UK, the first open-ended fund of this kind was launched by Citi's retail structured products division, CitiFirst, which entered the UK's intermediary market with a UCITS III structured product wrapper in February this year.

The fund is a five-year growth product linked to the FTSE 100. It has a potential annual return of up to 9.25% if the index is above where it started at certain observation points. Capital is protected provided the FTSE 100 never closes below 50% of the start level on any business day following the fund's inception. The vehicle was launched in February and currently has a £10m subscription.

The derivative component does not make this product particularly different from a relatively simple structured note, but its UCITS requirements impose lower risk and higher transparency.

Built largely for the retail market, the more sophisticated of these wrappers can still tempt HNWIs, thanks to such lower risks and higher clarity.

Under UCITS, the issuing bank would provide collateral for the derivative contract part of the product. This protects the fund in the event of a default by the bank and is held by the fund's custodian rather than the bank itself. Further counterparty risk mitigation can come from the high rating of the assets used as collateral.

"We have found that independent financial advisers that would traditionally sell actively managed funds have really liked our structured fund with its set of pre-defined returns, credit diversification and transparency," says Emma Davidson, head of UK and Ireland sales for CitiFirst. "[Some advisers] were sick and tired of certain fund managers overcharging and underperforming."

Ms Davidson also notes that Citi's product raised interest from HNWIs and the offshore market.

In general, there has been a push by international regulators towards transparency, in order to protect investors from tempting but complex products. But to make sure that banks provide products of the quality, level of risk and clarity that investors want, the additional push should come from clients themselves. Clients need to ensure they fully understand the terms of the structured products they are buying. If they do not and a product seems too good to be true, it probably is.

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