Rebuilding trust in equity markets: Entering a new world

'Damned if we do, damned if we don't,' perhaps best sums up the situation faced by investment managers today. To earn their keep, they have to do more than simply park their clients' assets in cash deposits - particularly now that rates are narrowing in on zero - but the alternatives are still looking pretty dicey. Every day new analysis emerges, pointing alternatively to an imminent economic upturn or a sustained downturn. By staying out of the market they risk missing the upturn, but by plunging headlong back in, they are putting valuable capital at risk.

The market conditions are hardly ideal for anyone - but they do play to the strengths of equity derivatives structurers who have an array of capital-protected and market timing-based products to showcase to anxious investors. According to Hassan Houari, managing director at Barclays Capital, both of these products are back in force: "Investors of all shapes and sizes aren't so much looking for the bottom, as looking to re-enter the market with maximum reassurance."

Thomas Salter, executive director for equity structured products at JPMorgan, adds: "Institutional investors are currently focused on engineering a risk-managed re-entry into equities. Additionally, investors in northern Europe and the UK are focused on limiting their downside exposures and minimising the capital at risk."

A need for capital protection and 100% upside participation might normally be answered with a simple call option, but in this economic environment of low interest rates and high volatility, these are prohibitively expensive. Equity derivatives structurers have instead had to work harder to devise suitable products - although the bulk are fairly simple, short-term, broad-based products.

Shaun Wainstein, head of equity derivatives at BNP Paribas in London, says that, for instance, most investors are considering one, two and three-year products, not the 10-year products they were seeking before, and on broad-based exposures. As a result, most of the recent products have been based on indices, not single stocks or tailor-made baskets of stocks. He adds: "It is now mostly about finding simple ways to get equity upside, with limited downside."

Mr Salter agrees: "People are focusing as much as they can on very simple products and indices rather than single names. They are not trying to be too clever or to make very sophisticated choices until there is more normality." Another feature singled out by Mr Salter is that the increased focus on counterparty risk has increased the popularity of UCITS (undertakings for collective investments in transferable securities) fund-based products. "This is particularly the case among larger institutional clients doing trades of €100m or more," he says.

Hassan Houari, managing director at Barclays Capital

The proposals 

Many of the product structures being touted are reinventions of long-standing products, re-engineered to suit market conditions. Mr Houari says that BarCap's longstanding Revolver strategy has gained a new following recently. Revolver increases equity participation as volatility falls, and underexposes investors to equities as volatility rises. The strategy evaluates the risk in the markets every day and then gives varying exposure to the markets dependent on the risk. When the markets exhibit more risk, it gives less exposure and when the markets exhibit less risk, it gives more exposure with up to two times leverage.

The product, which was developed two years ago as a means of affording investors controlled access to less liquid emerging markets, has become applicable to all markets because of the high-volatility regime.

Similarly, BarCap's Quantitative Investment Strategy (QIS) products, which were rolled out a few years ago, have found a new appeal, particularly with pension funds that have been buying into the QIS range of Alpha strategies as alternatives to direct hedge fund, or hedge fund-linked investments.

Mr Houari adds: "Other products that have been shown to have increasing appeal are fast-recovery products, and we have seen strong interest in our Barclays switchable notes which potentially transform equity market upside performances into high fixed income with full capital protection."

Over at JPMorgan, the equity structured products team has instead been proposing products that employ the longstanding constant proportion portfolio insurance (CPPI) techniques - giving investors full equity upside exposure with capital protection, therefore minimising any increase in regulatory capital. One controlled re-entry route, in which JPMorgan has seen quite a lot of interest, is based on risk control options. These are not entirely dissimilar in effect to CPPI overlays and they aim to control the level of risk (volatility) of returns by varying exposure to a given portfolio.

The way they work is as follows: if an investor has, for instance, a risk appetite for a 15% volatility, but equities are at 30% volatility, he would really just want 50% exposure to equities. He could buy that targeted exposure through a risk control call option as a relatively cheap means of gaining protected upside exposure without requiring a huge upfront premium, while reducing volatility. On the way up, the investor would miss a little of the gains, but once volatility calmed down, his exposure to equities would increase in line with his target volatility.

Emmanuel Naim, head of equity structured products for corporate and investment banking, Société Générale

Indices launched 

Standard & Poor's launched a family of risk control indices last year, on which the US bank has written the bulk of its options as a means of helping investors get back into broad equity market exposure in a controlled way.

Bankers at Société Générale have meanwhile looked to the fixed-income world for inspiration, devising a way to adapt a concept widely used there for the equity universe. With 100% capital guaranteed at maturity, the bank's Tenor strategy aims to provide investors with full exposure to the upside performance of a given index or to secure a substantial predefined coupon. This can be achieved through an early redemption mechanism, which can be triggered at SocGen's initiative. If the product is not called, the investor receives 100% of his capital at maturity plus 100% exposure to the performance of the index. If SocGen calls it during the investment period, the investor will get 100% of his capital back, plus his target return, multiplied by the number of years elapsed since the product's issuance.

Emmanuel Naim, head of equity structured products for corporate and investment banking at SocGen, says there has been a lot of interest in the product recently from institutional investors - particularly from insurance companies and pension funds who have been seeking to get back into the market.

Investors seeking to benefit from a potential further decrease in the equity markets before taking long positions have meanwhile turned to SocGen's Compass product. Again, this product was first developed to address a different need - in this case to navigate downside market-timing risk. With a short exposure maturing at the bottom of the market and a call option also striking at the bottom, it now allows investors to benefit from a possible further decrease in the market, while leaving them exposed to the market rebound when it occurs. The product has a semi-annual look-back construction, which means that the payout at maturity is indexed to the lowest level reached by the index during the investment period.

Finally, for those investors with asset-liability mismatches and strict regulatory constraints, SocGen has developed a suite of hybrid solutions that hedge all of their exposures on a combined basis. By hedging a group of exposures - for instance, equity and interest rate, or inflation risk - collectively, the bank estimates that it can achieve savings of as much as 30% to 40% as compared with separate hedges of their funding ratios or balance sheets.

Shaun Wainstein, head of equity derivatives at BNP Paribas in London

Combined concept 

Towards the end of last year, SocGen started adapting the combined hedging concept - which is, in essence, a play on correlation or de-correlation between asset classes - for investors concerned about the probability of a deep recession. "The investors were looking to hedge their oil, interest rate and equity market exposures, but instead we proposed a combined solution - the economic downturn perform - which proved very effective and a much cheaper alternative to individually hedging the three asset classes," says Mr Naim.

If all the banks put a lot of focus on developing products to suit different markets and advising clients as to what to do and when, Mr Naim believes SocGen stands out by having historically done this with good results. "We now have a strong track record as well as a large toolbox of products to play with."

Bold claims perhaps, but an increasing number of clients seem to believe them, having asked the bank to allocate their cash across its structured product range itself. SocGen has responded to this demand by creating a tailor-made, actively managed structured product, dubbed Crossroads and, more recently, two flagship Crossroads funds which will be used to showcase the bank's added value in terms of active structured products management.

Funds of actively managed structured products have a large number of critics - many of whom argue that the process adds another layer of fees to the investment process without substantially improving the substance of the client's portfolio. Mr Naim refutes this criticism, saying that the products are very well suited to investors who want to benefit from the bank's management and structuring expertise, who are not familiar with structured products, and who therefore want to shift gently into the structured product universe.

The evidence so far suggests that SocGen may be defying the critics and that a significant number of investors believe Mr Naim's claims - SocGen has €2bn already invested in its dedicated Crossroads mandates.