Listed products seem to meet many of the criteria for improved transparency and liquidity demanded by investors in the wake of the financial crisis, writes Michael Marray.

As the economic recovery continues in the wake of the financial crisis, providers of both structured products and exchange-traded funds (ETFs) have seen sales steadily increase throughout 2010. But providers are facing a range of regulatory changes and are busy re-engineering their delivery platforms and product ranges in anticipation of new EU rules.

Regardless of whether an investment product is structured as an exchange-traded note (ETN) exposed to the counterparty risk of the provider, or in a fund format with segregated accounts as an ETF, transparency and liquidity remain key themes for institutional, high-net-worth and mass retail investors across Europe following their experiences with the Lehman Brothers collapse and the drying up of liquidity.

Alexandre Houpert, head of exchange-traded products at Société Générale Corporate & Investment Banking (SGCIB) in London

Alexandre Houpert

Alexandre Houpert, head of exchange-traded products at Société Générale Corporate & Investment Banking (SGCIB) in London

Listing safety

Listing products on exchanges is becoming a key requirement for many investors. A listing not only gives the additional safety of the rules and regulations set by the exchange on documentation and reporting, but also has requirements for the continuous posting of tight bid/offer spreads.

In Germany, certificates are already usually listed, with several hundred thousand products on the various regional exchanges, while markets such as Switzerland and the UK are moving towards listed products.

"Structured products used for yield enhancement and capital protection have been growing again in 2010, while we are also seeing a lot of interest in ETFs from institutional investors and private banking clients. In emerging markets, for example, ETFs provide a quick and easy way to track the Bovespa [the São Paulo Brazil Stock Exchange], instead of going through the cumbersome process of setting up stock selection and research internally," says Uwe Becker, head of investor solutions for Europe at Barclays Capital in Zurich.

"The ETF market is diversifying quite heavily now, since the main equity and fixed income markets such as Euro Stoxx, Dax, S&P 500, FTSE 100, bunds or other European government bond markets are pretty much covered by most providers, which does not leave much room for differentiation," says Mr Becker.

As a result, within the ETF industry, providers are now trying to differentiate from one another by offering more exotic products, such as emerging markets. But Mr Becker suggest that investors should closely monitor tracking errors of those products, as some of the indices are not easily replicable for fund managers. The growing market for exchange-traded products will gradually offer more and more solutions to address those issues.

Funds versus notes

Many investors are attracted by some of the more stringent rules applied to listed ETFs, such as assets segregated from managers and held by third-party custodians, and oversight of the fund by trustees. They also like the fact that there is no counterparty risk linked to the issuer, as is the case with ETNs, which are obligations of the issuing bank.

However, the European passporting scheme Undertakings for Collective Investment in Transferable Securities (UCITS) has rules on diversification that do not allow a single underlying, such as gold, to be used in an ETF. As a result, some issuing banks have built up a range of ETNs referencing popular underlyings to go alongside their ETF products.

"This year we have launched 42 ETNs based on commodities and equities that also offer the investor currency protection," says Alexandre Houpert, head of exchange-traded products at Société Générale Corporate & Investment Banking (SGCIB) in London.

"It has often been the case over the past decade that when the US dollar is weakening, the price of gold is rising, and investors in Europe want the actual performance of gold without the currency movements," he says. For this reason, the ETNs are offered in dollars, euros and sterling.

"When the currency of the underlying is different to the currency of the ETN, SG is taking the currency risk out of the product, which means, for instance, investors can get exposure to gold without having to do their own currency hedging. UK investors in Japanese equities have also seen their returns hit by currency movements, so we have also launched a Japan equities ETN with currency protection," says Mr Houpert.

The UK market remains heavily skewed towards investing in the FTSE 100, although more institutions are now doing global sectoral equities allocations. Allocations to countries are being accompanied by much more detailed allocations to particular industries or sectors, and the ETF has proven a quick way for institutions to rapidly switch exposures.

In September, SGCIB's alternative investments platform, Lyxor, listed a range of sectoral Asia (excluding Japan) ETFs on the London Stock Exchange (LSE), covering areas such as consumer staples, financials, IT and infrastructure. It also launched a range of global sectoral products, including Lyxor ETF MSCI World Health Care and Lyxor ETF MSCI World Utilities. SGCIB issues its ETF range via Lyxor Asset Management, a wholly owned subsidiary.

Dan Draper

Dan Draper, global head of ETFs at Credit Suisse

Swiss market

Credit Suisse is the largest ETF provider in Switzerland, selling to both institutional and private banking clients, and its fastest-growing ETFs over the past year have been its MSCI Emerging Markets ETF and Gold ETFs.

Since Switzerland is not governed by EU UCITS rules on diversification, single underlying ETFs are allowed. Credit Suisse has had a lot of uptake from investors on its ETFs backed by physical allocated gold bullion stored in their vaults in Zurich. These ETFs are available in Swiss francs and euros as well as US dollars, so investors can choose to either keep the currency exposure in US dollars or have it stripped out of the dollar gold price. These three gold bullion products have already reached a volume of $1.7bn, despite having only being launched 11 months ago. They are listed on the Swiss Stock Exchange.

However, Credit Suisse has replicated most of its Swiss ETFs into a range of 45 UCITS-compliant funds domiciled in Ireland. All of these UCITS-compliant ETFs were admitted to trading on the LSE on September 15, and offer exposure to a wide range of benchmark indices from a variety of regions including Europe, BRIC countries (Brazil, Russia, India and China) and other emerging markets. Twelve emerging markets ETFs plus MSCI Australia were also admitted to the Borsa Italiana on the same day. There are now 11 ETF issuers listing 327 products in London and 11 issuers listing 478 products in Milan.

"Our feedback from investors, particularly sophisticated institutional investors, is that given the choice they would prefer an exposure expressed through an exchange-traded fund, rather than a note-based solution, because of corporate governance advantages of funds over notes," says Dan Draper, global head of ETFs at Credit Suisse.

There is also interest in markets such as Japan. "We have had good take-up on products such as MSCI Japan Large Cap and MSCI Japan Small Cap," says Mr Draper. "It can be difficult for some European institutional investors, especially fund of fund managers, to identify strong active fund managers in Japan. So instead of spending resources to identify successful active managers, they get their exposure to Japan via an ETF."

UBS has also been active this year setting up as an issuer of ETFs listed in London. The first 69 products were admitted back in March in what was UBS's first major issuance of ETFs in Europe outside of Switzerland.

Fund providers

ETFs are also being used as underlyings by fund providers since they offer fast and liquid access to a wide variety of underlying exposures. They are also ideal for automated strategies that dynamically re-allocate on a daily basis.

"In the private banking space there is more demand for simpler products," says Martin Weithofer, managing director at Assenagon Asset Management in Munich.

"For example, the Assenagon Trend EM 75 has a model that selects up to eight out of a pool of 18 emerging markets ETFs on a daily basis, following a momentum strategy that provides a dynamic principal protection of daily net asset value highs of 75%. For this kind of product, ETFs provide very cheap and liquid access to a variety of emerging markets equities in different regions and sectors," says Mr Weithofer.

"During 2010 we have also seen heavy demand primarily for absolute-return products. For sophisticated, mainly institutional investors, such as fund of fund managers, banks and insurance companies, we have seen strong demand for the Assenagon Credit Basis II fund, a market-neutral product that can deliver Euribor plus 350 basis point returns by trading the difference between cash bonds and credit default swaps [CDSs]," he says.

Emerging-market ETF trading volumes, London (£m)

Emerging-market ETF trading volumes, London (£m)

Retail offerings

HSBC has also been very active in the ETF market, which it entered back in August 2009 with a first range of products listed on the LSE. HSBC has since been steadily adding to the range of underlyings. Products offered to individual investors include HSBC Euro Stoxx 50 ETF, HSBCI MSCI Brazil ETF and HSBC S&P 500 ETF (USD).

Like other banks, HSBC offers a full range of both ETFs and structured products for UK investment managers. In the institutional market its structured products include a Defensive Brazil/China Autocall and a Defensive Euro Stoxx 50 Autocall.

In the retail space there is still a strong market for deposit-based structures where investors can enjoy the protection offered by the government on their account balances while using structured solutions to enhance yield.

"In a very low interest rate environment more investors are looking at structured products as a way to enhance yield, while also protecting their capital," says Chris Taylor, director of wealth management sales at HSBC in London.

"We are doing an increasing amount of deposit-based products as an efficient way to deliver into the mass retail market. Investors want simple structures they can understand. For example, we have had good take-up of a product we launched recently which will pay an 18% coupon after three and a half years, as long as the FTSE 100 is at or above its level on the date the product was launched," says Mr Taylor.

Rating the providers

Deposit structures are also used in the German market, although most mass retail investors still prefer to buy listed certificates with a pay-off. They are, however, much more aware of counterparty risk in the wake of the Lehman Brothers collapse.

Retail finance magazines regularly publish tables of bank credit ratings and CDS levels. In practice, retail investors concentrate more on a trusted brand name rather than taking too much notice of CDS spreads. But the decision makers at the distributors are acutely aware of rating and CDS trends at the providers they choose to work with.

One result of the Lehman collapse is that it has become more difficult for foreign banks in a given country to win market share, which is now more heavily dominated by traditional domestic bank names that investors feel comfortable with. A few European banks are still winning cross-border business, but the US providers are finding it particularly difficult to regain acceptance in Europe.

As a result, although the listing process does add an extra layer of compliance and transparency, which investors like, the provider brand name remains vital. And in spite of being listed on exchanges, much of the actual trading is done over the counter in trades that do not show up in secondary market volume figures.

The central strategy for most providers in today's highly competitive market is to construct a basic pay-off, but then deliver it in a number of different wrappers, according to the requirements of the client. As a result, the dividing lines between various investment products at both the retail and institutional level are becoming blurred.

The same flexible approach applies to secondary market liquidity, with banks offering their clients the trading venue or platform of their choice.

But regardless of how they are delivered, simple transparent products look set to dominate the market in the medium term, rather than the highly complex pay-off formulae that came to characterise the structured products market during the boom years of 2005-07. Product providers mostly report that they are ahead of sales targets they set themselves back in January and hope that if the tentative economic recovery keeps on track, the increase in sales volumes will run into 2011.

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