With inflation eroding real returns, investors are ready to take on greater equity market risk. But only if other risks can be excluded from the mix.

Investors want to take risks. But not every type of risk. This is the challenge facing the structuring teams for investor solutions at leading investment banks. Major central banks are increasingly behind the inflation curve, as fears over bank and sovereign balance sheet stress weaken the desire to hike interest rates. As a result, low-risk investments often yield below-inflation returns. This is frustrating for private investors, and potentially disastrous for institutional investors such as pension and insurance funds, if their yields are too low to match the growth of their liabilities.

The natural response to this for investors is to take on equity and commodity risk as a macroeconomic inflation hedge. As Michael Marray reports in this supplement, that trend is in evidence, especially in Asia, and also in Germany, which is Europe’s largest structured products market.

But visibility on future trends in the equity and commodity markets is poor. Investors are still unconvinced that peripheral eurozone sovereigns can avoid restructuring sovereign debt, which could trigger a flight to safety. To that risk must be added the continued violence in the Middle East and north Africa and resultant higher oil prices, which are dimming the economic prospects for major oil importers.

Moreover, emerging market equities, very much in favour over the past year, are in some cases reaching valuations that make investors uneasy. One structured product provider is already looking to enable investors to arbitrage between the valuations of emerging market equities and those of western European companies that have substantial emerging market exposure in their core activities but seem to be trading at a discount relative to stocks listed directly on emerging market exchanges.

Old risks, new risks

If valuations look excessive and geopolitical risks are rising, then it seems likely that market volatility will increase. In emerging markets especially, liquidity tends to be lower and volatility can soar in times of stress. Of course, options market participants are already wise to this, and option premiums are high enough to deter many investors from making use of plain-vanilla volatility swaps.

Increasingly, investment banks are looking to provide alternative methods to hedge against volatility, and dynamic research-driven or algorithmic products are growing in popularity. These can respond to market signals to reallocate exposures automatically as volatility rises. In many cases, these are packaged into the exchange-traded fund (ETF) format.

This also helps avoid other risks that investors are no longer willing to bear since the financial crisis. Specifically, it alleviates the risk of counterparty default that has haunted investors since those who held structured products issued by Lehman Brothers found themselves embroiled in the bank’s administration proceedings. In addition, ETFs can provide daily pricing and liquidity, allowing investors to exit quickly and change their market position without incurring heavy discounts on selling the product.

But the Basel-based Financial Stability Board (FSB) of global regulators issued a report in April 2011 suggesting that the rise of ETFs may be generating a new set of risks. In particular, the report focused on the growth of so-called “synthetic” ETFs (see chart), which use derivatives to replicate the returns of a customised index, rather than investing in cash assets.

According to the report: “The increased popularity of ‘synthetic’ ETFs as well as the more intensive recourse to securities lending by providers of plain-vanilla ETFs raises new challenges in terms of counterparty and collateral risks. In addition, the expectation of on-demand liquidity may create the conditions for acute redemption pressures on certain types of ETFs in situations of market stress, which could in turn affect the liquidity of the large asset managers and banks active in this market.”

Global exchange-traded fund assets, European exchange-traded fund asset composition

Safety first

In response to the FSB report, the top providers have sought to play down concerns about how ETFs would function in times of market stress. Nizam Hamid, head of ETF strategy at Société Générale’s funds platform Lyxor, points out that Lyxor limits the exposure to over-the-counter (OTC) swaps in its ETFs to 10% of total assets under management. He remains confident that ETFs would find sufficient liquidity in market stress conditions, in both the underlying cash and futures markets they invest in, because ETFs are still a relatively small part of the total derivatives usage.

“The focus on the OTC swaps used within ETFs is perhaps an unfair reflection of the size of the market and indeed overly dramatic. At the end of June 2010, according to the Bank for International Settlements, total forwards and swaps in equity-linked derivatives was $1754bn. The total size of assets under management in swap-based ETFs in Europe was only $124bn,” says Mr Hamid.

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