Azad Mahavar, head of structured products for the UK market at BNP Paribas in London

A growing number of institutional investors are using structured products to generate extra yield, but they are demanding greater transparency and liquidity of structured products than ever before. Writer Michael Marray

The way in which institutional investors use structured products has changed since the global financial crisis. In 2005 or 2006, they were using them primarily as access plays, getting alternative risk exposure to commodities, or as hedge fund strategies which included investing in highly illiquid sectors such as private equity and real estate.

But the liquidity crisis of late 2008 and early 2009, when many hedge funds blocked the redemption of funds, left institutions extremely sensitive to liquidity concerns. Product underlyings are now more likely to themselves be in liquid assets such as equities, commodities and foreign exchange (FX), allowing the structured product arranger to guarantee daily liquidity for any institution that suddenly needs cash. That can be provided bilaterally by the arranger, but there is a growing trend for structured products to be listed on exchanges in order to maximise liquidity, while also benefiting from more regulatory oversight.

Transparency trend

Transparency is the other key theme in the current market. Investors want to be able to understand the way in which pay-offs and fees are calculated, and some of the long and complex mathematical formulas that used to be common in structured product term sheets are no longer acceptable.

The transparency theme has also reached back-office processes. The Madoff scandal in the US has led to more money flowing into managed accounts, where the investment bank providing the managed account oversees the portfolio and monitors risk positions, reducing the danger of either outright fraud or excessive risk taking.

"In today's market, there is much more focus on counterparty risk and liquidity from the viewpoint of both institutional and private banking clients," says Willi Bucher, head of distribution and marketing for structured products at Julius Baer in Zurich.

"Providing investors with good secondary market liquidity during the life cycle of a structured product has clearly gained in importance since the financial crisis," says Mr Bucher.

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Richard Ager, director of equity and funds structured markets at Barclays Capital in London

Selling call options

In the equities segment, which still dominates asset allocation among pension funds and asset managers worldwide, there is a new emphasis upon playing volatility, either as a hedging mechanism or as a bet to generate yield. More institutions are willing to give up some of the upside of a sudden upward surge in stock prices via options pay-offs which generate yields.

"We put together a lot of bespoke products for institutional clients and one clear trend is volatility hedging," says Azad Mahavar, head of structured products for the UK market at BNP Paribas in London. "Discretionary portfolio managers and pension funds suffered a lot during the financial crisis from the high correlation of different assets and the increased volatility of their portfolios."

Such investors are increasingly making asset allocations to volatility trades. For example, covered call strategies are now quite common in the asset management space, with investors taking a long position in an index such as the FTSE 100, while also selling call options to generate a premium. The investors are capping their upside, for example giving up any gains of more than 5% in one month.

"Covered call strategies are well established, and investors are interested in enhanced versions of these products, where we sell a call every day instead of once a month, which means that the product is re-set on a daily basis according to market conditions," says Mr Mahavar. "The product has one-third of the volatility of the FTSE 100, but a similar long-term performance."

Other banks such as UBS are also marketing a range of enhanced covered calls and sales of this type of product are expected to grow in the coming years.

"A major concern among institutional investors is the general low level of yields, especially long-dated rates," says Markus Zbinden, head of interest rate risk management products for institutional clients in Switzerland at UBS Investment Bank. "This has serious implications for investors such as life-insurance companies or pension funds with long-term commitments, who can no longer hit their yield targets."

"These investors are looking to generate extra yield by using structured products with simple pay-offs which are also highly liquid," says Mr Zbinden. "They do not want products with long lock-up periods and the overall allocation to alternatives is still being reduced. They also want to mitigate counterparty risk, which is less of an issue than it was 12 months ago, but still remains an issue."

"We have recently introduced the Evolution Buy-Write Strategy which invests in the Euro Stoxx 50 Index and writes short-term calls, and has a good track record compared to traditional buy-write strategies which were seen in the market four or five years ago," says Thomas Wicki, head of equity risk management products in Switzerland at UBS Investment Bank.

In a buy-write or covered-call strategy, a long position is bought in an underlying index, but shorter-term calls are then sold, generating a premium for the investor. If the call is set at a high strike, then equity-like market performance is the main aim. But if a low strike is used for the call, this generates higher premiums, so the structure performs more like a bond.

However, buy-write strategies have traditionally been slow to react to fast-changing market conditions. Arrangers have therefore been working on a range of enhancements, including using options with shorter tenors.

The UBS Evolution Buy-Write Strategy features dynamic strike adjustments using a proprietary Dynamic Equity Risk Indicator, which actively selects option strikes to perform in both bull and bear markets. The notional is split into five tranches, and one tranche per day during the five-day working week is rolled using an option. This has an averaging effect and prevents the investment from depending arbitrarily upon a snapshot of the market, which can be the case on traditional buy-write strategies that roll once per month. Having a daily roll means that the structure is reacting faster to market conditions.

Trading volatility

Highly sophisticated investors are also looking for pay-offs purely based on the Chicago Board Options Exchange Volatility Index (VIX).

"We are seeing growing interest in the implied volatility space from institutional investors," says Richard Ager, director of equity and funds structured markets at Barclays Capital in London. "In the US, we had success in 2009 with iPath VIX Exchange-Traded Notes, and we are looking to replicate that success in Europe," he adds.

The S&P 500 VIX Short-Term Futures Index is designed to provide access to equity markets volatility through CBOE Volatility Index futures. This index offers exposure to a daily rolling long position in the first- and second-month VIX futures contracts, and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve.

The iPath ETN based on the VIX underlying gives investors transparency and second-market liquidity. Investments offering volatility exposure can have various uses within a portfolio, including hedging, directional or arbitrage strategies and are typically short- or medium-term in nature.

There is a clear trend towards investors wanting to buy listed structured products, which not only come under the oversight of national regulators, but also offer better overall transparency and liquidity.

"Liquidity is very important to buyers such as asset managers, and as a result, we are seeing a growing number of institutional investors buying structured products that are listed on exchanges," says Alexandre Houpert, head of listed products for northern Europe at Société Générale in London.

"Trading listed products is a very simple process for the back office and investors like the convenience of being able to buy and sell structured products using the same brokers that they use to buy shares," says Mr Houpert.

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Alexandre Houpert, head of listed products for northern Europe at Société Générale in London

Synthetic zeroes

In the UK, Société Générale offers investors a wide array of listed products with FTSE 100 underlyings, including 'synthetic zeros', which are quoted on the London Stock Exchange. Intraday liquidity is guaranteed by Société Générale.

Synthetic zeros are used in portfolio allocations as a yield-enhancement product, and could replace some bond allocations, especially at a time when interest rates are very low. In the UK market they are available on a range of FTSE 100 stocks. The investor will receive a pre-determined amount per product, known as the synthetic level, provided that on the exercise date, the price of the underlying equity does not close below a predefined protection barrier level.

Temporary breaches during the life of the product do not affect the exercise payment. But if the protection barrier has been breached on the exercise date, the investor will receive the underlying equity value - its price on the exercise date.

The attraction is generating a return even if equities underperform, perhaps falling as much as 40% over two years, depending on where the barriers are set.

One recent synthetic zero had Barclays plc as an underlying. It was issued with Barclays trading at £2.87 ($4.44), with a protection barrier at £2 and a synthetic level of £4. This was set to generate a return of 39.18% on the exercise date, provided Barclays shares had not fallen more than 30.31% during its lifespan.

Portfolio diversification

Institutional investors are also looking to diversify their portfolios, but are still wary of highly illiquid asset classes such as private equity, and many are also worried about black-box investments such as hedge fund portfolios, although having a mixture of strategies via funds of funds remains acceptable to some.

The search for transparency and liquidity in structured products has led to an emphasis upon highly liquid underlyings, and during 2009 and 2010, more pension funds and asset managers have been making portfolio allocations to FX-related structured products.

"During the financial crisis, institutional investors increased their allocations to FX and even as markets have recovered, demand for FX structured products has remained strong," says James Davison, head of FX structuring for Europe at BNP Paribas in London.

"Algorithmic carry indices have come back into favour in 2010 with the revival of the carry trade and we are seeing more asset managers and pension funds buying these products," he says. "We have also been actively marketing our hybrid capabilities, for example, dual digital options on equity and FX, and this has generated interest among hedge funds looking to cheapen equity plays by linking them to FX," he adds.

One BNP Paribas hybrid product allows investors to express a bearish view on the euro versus the dollar combined with a bullish view on the S&P 500 stock index. The client gets a digital pay-off, for example 12% after one year, if at that point the S&P 500 has not fallen below a given barrier and the euro has not pushed above a set barrier versus the dollar.

In another strategy, the BNP Paribas Cosmos Index tries to capture the relationship between FX and other asset classes, represented in the three sub-indices of interest rates, commodities and equities. It is based on the observation that FX responds to other markets in a predictable and delayed way and involves responding to buy/sell signals using standard moving average techniques and volatility filters.

Yield generation

In the pure FX space, algorithmic carry-trade strategies are a popular way of generating yield. For example, the UBS V10 Strategy offers investors access to carry trade strategies involving pairs of G-10 currencies, with daily monitoring of volatilities which may reverse a given carry trade if necessary.

In the alternatives space, in spite of the lock-ups on hedge fund redemptions during the financial crisis, some asset managers and pension funds still feel that potentially high hedge fund returns are hard to ignore and continue to want to make some allocation to hedge fund exposure.

Therefore, hedge fund replication products are still being sold, although with a high level of overall monitoring from an investment bank via managed accounts.

Replication products are also being used by hedge funds themselves, because in today's market they need to keep more sizeable cash holdings to cover sudden redemptions. Returns on highly liquid short-term fixed-income investments are so low that they can significantly drag down the overall return of a portfolio. A hedge fund replication product can replicate average hedge fund returns, but offer daily liquidity if needed.

With interest rates so low, all types of institutional investors are under pressure to generate extra yield and keep their portfolio return targets on track. Structured products are tapping into this need and giving them access to more complex trading strategies such as daily covered calls with volatility filters, or FX carry trades that typical asset managers focused on equity markets would find hard to execute themselves.

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