New questions, new answers

Eighteen months ago, banks were offering bespoke, proprietary products, and investors were receptive to them, recalls Adrian Valenzuela, global head of investor sales for equity derivatives at JPMorgan. Now, however, investors are looking for standardised, tradeable and easily priceable products, he says. But, as he explains, this does not mean they are necessarily simpler. “These may be just as sophisticated as earlier products – or even more so – but the bespoke and proprietary elements have been replaced by standardisation.”

According to Christophe Baurand, head of sales at Société Générale’s (SG) structured and alternative asset management arm, Lyxor: “The focus is now on diversification, transparency and liquidity, with a marked increase in interest in non-directional products such as our Absolute products.”

Timing solution

Absolute is one of SG’s answers to the timing issue that often dogs investors’ re-entry into the equity market: timing the turn in the market is crucial but impossible to gauge with any precision. The Absolute strategy, which gives exposure to the Dow Jones EURO STOXX index, enables investors to re-enter the market at any given point because the product performance remains independent of their choice of timing.

Laurent Besnainou, head of equity derivatives sales at SG, says: “Absolute has been one of our great successes because the pay-off continues to deliver strong returns whatever the market conditions, thanks to an exposure to the absolute performance of the DJ EURO STOXX 50. Many investors haven’t had any strong directional opinion but still seek a certain level of performance, even in difficult market conditions. It has been proving particularly relevant, as shown by the large interest it has raised among our clients so far.”

Several of the other voguish new products have been based on proprietary indices and in-house research. Rich Carson, global head of equity derivatives at Deutsche Bank, says: “On the structured product side, research-based products, relative value and other market- neutral strategies have gained a significant following. The flow side has meanwhile been extremely active, driven by the high levels of market volatility.”

In terms of research-based products, Mr Carson says that uptake of the bank’s Croci range has seen good recently. Croci, which stands for Cash Return On Capital Invested, is a proprietary equity product built on Deutsche Bank’s own research.

Means of attraction

Other products that are attracting interest are based on thematic and story-driven investment themes, as well as exposure to underlying emerging markets, says Shaun Wainstein, head of equities and derivatives in London at BNP Paribas (BNPP).

Products with look-back features have also gained traction recently, according to Jean-Eric Pacini, BNPP’s head of structured products. Such products have an option strike at the lowest point over a given period, giving investors upside exposure to a market rebound. “However, because the products strike at the lowest point over a wide time horizon and give exposure to the market at maturity, they remove the onus onto the investor of getting the market timing correct – investors do not need to determine the point at which the markets will start to rebound,” he explains.

Simon Yates, head of global equity derivatives at Credit Suisse, says that products offering exposure to hidden risks, such as skew (the uneven volatility implied from put and call options) and correlation, have gained a strong following. “Hedge funds have long been active here, but we have recently been showing the strategies to the larger and more sophisticated pension funds that are keen to gain exposure to hedge fund-type strategies but with greater liquidity and transparency than hedge fund investments offer – and without the management costs.”

Structuring for alpha

Hassan Houari, head of equities derivatives structuring at Barclays Capital (BarCap), says that alpha-generating products and strategies that are both easily tradable and fully transparent are the ones that have been attracting most interest. Among these are the UK bank’s market-neutral strategy Q-BES (Barclays Earning Surprise Strategy) together with Voltaire, which is a long/short volatility carry strategy, and VAAM, which is a volatility-based asset allocation strategy.

Q-BES is an approach to long/short investing that is designed to exploit market reaction to earnings surprises. Its particular objective is to react to earnings surprises before they are fully priced in by the market. Voltaire is a proprietary index that BarCap has developed that gives exposure to volatility as an asset class. It aims to exploit market inefficiencies in the over­estimation of implied volatilities.

And VAAM is a multi-asset strategy that switches among a selection of asset allocation profiles, based on a measure of the observed risk in the equity markets. Each month the portfolio allocation is determined according to either the movement or the level of realised volatility in the MSCI World Index. During periods of high volatility, for example, VAAM will move to an allocation with a lower risk profile, and in periods of lower volatility it will move to an allocation with a higher risk profile.

Revolver (Realised Volatility Variable Equity Return Option) is another BarCap strategy that aims to control volatility while increasing returns. It evaluates the risk in the markets every day, giving varying exposure to the market, depending on the risk. It can be used as a standalone long-only strategy or as the underlying investment for an options-based strategy, such as a capital-protected note.

Hedging products

Having incorporated hedging strategies into their core portfolios, but seen the cost of hedging increase in line with the rise in volatility, investors have recently begun to look at ways of reducing the cost of ­hedging. To cater for this demand, BarCap created VALID, a variance-based technique that it claims can reduce the cost of protection by up to 50%.

The VALID strategy was developed to counter the fact that buying equity prot­ection in volatile market environments is relatively expensive. Elevated implied volatilities and a steepening of the skew cause the price of vanilla put options to rise, particularly the price of lower strike put options.

By making the participation of the option inversely proportionate to the realised volatility of the underlying asset, VALID allows investors to hedge out their equity risks at a lower cost. If the high volatility prediction is not realised, the full put payout is achieved at lower cost than a plain vanilla alternative and participation in the put can even be greater than 100%. Conversely, if there were higher realised volatility, the investor’s participation on the put would fall below 100% and it would underperform the plain vanilla alternative. BarCap’s research showed that the variance-linked put product would have outperformed the vanilla put in 62.2% of cases in the period from January 1987 to January 2008.

Flagship index

Along similar lines to BarCap’s Voltaire, the SGI Vol Premium is SG’s flagship index in the Alpha range of the SGI index family. This is an investible index that exploits the volatility risk premium – the spread between the implied and realised volatility. The premium can be captured by short positions in variance swaps, but only more sophisticated investors can execute the strategy in its original form. SG developed the investible index to deliver the same returns in a transparent, easily tradeable form to investors who are unable to undertake the more complex strategy themselves.

The Vol Premium index is calculated and published by Standard & Poor’s. It is based on a systematic strategy under which the index sells implied volatility and delivers realised volatility, hence capturing the risk premium contained in implied volatility. It gives investors the same sort of positive exposure to the spread between implied variance and the realised variance that they would obtain by undertaking the strategy themselves.