Banks are devising structured products for private banking clients that are more diverse than they previously were but still have an element of protection. Michael Marray investigates.

Many structured products for high net worth individuals had a focus on emerging markets equities during 2005 and 2006, as the BRIC countries (Brazil, Russia, India, China) generated high returns.

But after fast run-ups in those markets, private banking clients are now looking beyond BRIC for new opportunities. And diversity is the new watchword in private banking circles when putting together investment portfolios.

Private equity is one area where private banking clients are using structured products to gain exposure to top fund managers and their strategies.

Similarly, structured products are providing exposure to groups of hedge funds or a hedge fund index, giving a diversification of styles and diverse exposure for investments that could be as small as €50,000. And special situation stocks, such as potential takeover targets, are also being put into structured products.

Volatility scare

Given the run up in commodity prices in 2005 and 2006 there are also many products on offer here – though the volatility has scared some investors off, as did the collapse of hedge fund Amaranth Advisors.

One advantage that structured products have to offer is capital guarantees, which allow conservative investors access to volatile markets without being fully exposed to the risks associated with them.

This contrasts with the strategies of super-rich private banking clients, who are more likely to place big bets and risk losing their principal.

“Until recently, structured products were very heavily weighted towards equities, but we are seeing growing interest from our clients in sectors such as hedge funds, private equity and commodities,” says Marc Halpern, head of structured products and derivatives at Barclays Wealth.

Providing access

“Structured products are a natural vehicle for most of these new asset classes, since they generally provide some capital protection and give clients access to strategies that otherwise would not be available to anyone making less than a multi-million dollar investment,” he adds. “In today’s market there is tremendous interest in private equity, and we are addressing this in several ways, including iShares, which are essentially exchange traded funds from Barclays Global Investors which track the listed private equity market.”

Barclays is also putting together structured notes, giving access to the best performing single private equity managers, allowing access to those markets for small amounts. An investor normally needs $10m or more to gain access to a top flagship private equity fund – and even then capacity is very limited. But Barclays can often get access to those funds, and issue notes on the back of that, allowing investors to get access for lower amounts if required.

The iShares S&P Listed Private Equity Fund is one such product, and rival banks have launched similar funds. Barclays Wealth has about $100bn under management, and currently has a recommended 5% asset allocation for private equity, where it did not feature two years ago. This move of private banking money into the private equity world is having a significant effect on the global private equity investor base.

Changing patterns

The big traditional stock markets still dominate structured products, and many investors continue to pick small baskets of stocks where they have a directional view. But here, too, investment patterns are changing, with structured products offering investors themed baskets with a clear story, as well as highly sophisticated swap and option strategies that only big trading desks can execute.

“Given the rise that we have seen on equity markets around the world, many clients feel that there might not be much room for further increases,” says Arnaud Sarfati, head of equity linked structured products at Société Générale. As a result, investors are looking for investment solutions that will leverage slightly bullish or slightly bearish equity market scenarios, but that are absolute return products.

“Over the past two to three years we have seen a huge demand for emerging market equities but, given the recent increase and some renewal of nervousness on these markets, investors are looking for emerging market exposure while seeking to manage the underlying volatility very cautiously, which can be done via volatility target mechanisms,” he says.

“Another approach is to provide high net worth individuals with a strategy based on a basket of stocks, where the strategies are market neutral, but where investors benefit from the arbitrage that can be generated not on the equities themselves but on the so-called hidden assets, such as volatility correlations, dividends and so on,” says Mr Sarfati.

“Investors are becoming more interested in themed products, and we have been structuring baskets of stocks or indices that reflect themes such as alternative energy or the water sector,” adds Peter Corner, head of structuring at Commerzbank Corporates & Markets.

“There has been a strong bull run in equity markets, so investors are starting to look at products that might give them the ability to hedge some of the gains they have already made. So we are seeing preliminary signs of interest in variance swaps where the investors will receive a pay-off if there is volatility in the market, whether it goes up or down,” he adds.

“Private equity is also getting a lot of attention, and we are structuring a growing number of products that use derivatives over underlying private equity funds,” says Mr Corner. “Investors want more diversity in their portfolios, and are looking at non-traditional investments that are not correlated with the bond or equity markets. An example of this is one of our products that is based on investments in life insurance policies.”

Takeover targets

At BNP Paribas, one structured product on offer is based on a basket of stocks that were identified as potential takeover targets, tapping into the high level of investor interest generated by the wave of mergers and acquisitions (M&A) activity that has swept Europe in recent years.

“In the equities market, last year we launched a capital protected product with an M&A theme, where our managers picked a basket of stocks screened to find opportunities in special situations,” says Jean Philippe Olivier, head of SIGMA solutions at BNP Paribas Asset Management.

The basket of stocks selected in the fund rose by 25.4% in its first 12 months, allowing the capital protected fund to give a 17.8% return in its first 12 months.

“Another product looks at stocks that will benefit from the ageing population, such as companies in the pharmaceutical, tourism and insurance industries,” he says. “In order to create better products, we have recently merged our asset allocation and structured and indexed investment management teams.”

“High net worth investors are now looking at an increasingly wide range of assets,” says Mr Olivier. “Clearly there is growing demand for structured products based on private equity, and commodities are another area of interest, in sectors such as agricultural commodities.”

Antonio Rivela, co-head of fixed income sales at UBS in London, also sees a desire for diverse portfolios from wealth management accounts. “A core affluent private banking client with upwards of $250,000 to invest generally wants 100% capital protection, and would take the fund of funds approach in order to get hedge fund or private equity fund exposure,” he says.

In contrast, key clients with more than $50m to invest would not be looking for capital protection, and would be more likely to buy certificates where they take an exposure to certain assets. These clients may also be looking to create leverage – for example, by borrowing $300 for every $100 that they invest.

“But a trend for both types of investors is that they are trying to get more diversity in their wealth management portfolios, and are setting aside allocations for equities, fixed income, commodities and hedge funds/private equity,” says Mr Rivela.

“We are also currently seeing a growing amount of activity in principal protected alternative beta strategies, such as extracting value from volatility, rather than simply taking a directional view on markets.”

Growing liquidity

Exchange traded funds are becoming more liquid, and are easier to buy and sell than was the case a few years ago. And bankers report that, aided by this liquidity, the investment horizons of many high net worth private banking clients are becoming shorter.

“Investors are taking a view on a given theme or basket of stocks, but many trades are now six months to one year, since investors like to act on an idea and then move on to the next,” says one structurer.

At present, this could mean stock markets in Bulgaria, Poland, Turkey, Mexico, Thailand and Indonesia, as investors move on from BRIC, but this could change very quickly.

In general, the market for structured products has evolved very rapidly over the past two years, moving away from simple fixed income or equity funds to offer an entire suite of products, with many clients looking to allocate between 10% and 20% of their portfolios into hedge funds/private equity, and another 5% to 10% into commodities or alternative strategies such as beta plays.

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