Index-based structured products have grown in popularity since the financial crisis, as investors have sought flexible and bespoke ways to gain exposure to certain assets. And while the threat of tougher regulation looms, bankers are confident it will not slow down the market. 

Investment strategies based on indices have been around for decades, but in the past 10 years their popularity has risen significantly. There has been a proliferation of indices developed by banks and other financial services firms for investors wanting a performance target for their portfolios and, as a consequence, a rise in the number of index-linked securities offered by those institutions.

Many indices and products related to them, such as those designed by UK firm Markit, are for the use of a wide array of investors. Others are more bespoke and are sometimes even devised for a single client.

Seeking growth

A few investment banks, particularly those with expertise in structured products and derivatives, have made a big push to grow their index services since the start of the global financial crisis. They are often quick to create products that give investors access to certain assets when they spot rising demand.

Some banks target retail investors wanting exposure close to home. In mid-June this year, Dutch bank ING began offering clients ‘sprinters’ – leveraged investments with underlying assets – based on the NL20 Index, which reflects the performance of the 20 biggest companies originally listed in the Netherlands. ING’s marketing emphasises that the index represents “true Dutch entrepreneurship”. Arjen de Blécourt, head of ING’s sprinter desk, says: “The launch of the NL20 Index is clearly one of those new products that is of interest to retail investors as the index represents the true Dutch investment universe and is a total return index where dividends are reinvested to show the real performance of the index.”

Other banks have moved in response to growing interest in nascent asset classes. Barclays recently launched an index tracking contingent convertible bonds. Known as CoCos, these instruments can be written down or converted to equity at specific trigger points. They are typically issued by banks trying to bolster their capital bases in response to increased capital requirements following the crisis. CoCos are not eligible for broad-based bond indices, but Barclays thought there would be demand for investors who hold such securities, the supply of which analysts predict will grow substantially in Europe in the next few years, for a new index to benchmark their holdings against.

Niche market

The market for structured products based on indices is a niche one. Some banks, ING being an example, have large businesses focused on their home markets. Others are strong in particular assets classes, such as Deutsche Bank, whose commodity products have long been popular with institutional investors.

Few banks, however, are able to offer their clients index-based products for a wide variety of assets and markets. Among them are Barclays and Société Générale, which both have market-leading indices platforms that they have built up in the past five years.

Société Générale launched its index business, called Société Générale Index (SGI), in 2005. Initially, the bank focused on equities, given its traditional strength in equity derivatives. Over time, the indices evolved to most other asset classes, including interest rates, credit, commodities and foreign exchange.

To date, Société Générale has launched about 750 indices and has more than $16bn of products under management. Some of them are 'flagship indices' that are sold widely. The bespoke ones, customised to fit the needs of a small group of investors and sometimes even designed for just a single client, are the most popular. “We launch two or three indices each week,” says Marc El-Asmar, global head of sales in Société Générale’s cross-asset solutions team, which SGI comes under. “Most of them are bespoke. They are going to institutional clients who have designed them for their hedging or investment strategies, or to wealth and asset managers.”

Bankers doubt demand for these structured products will wane any time soon. Some point out that market conditions are creating plenty of opportunities for their institutions to create new indices. Société Générale recently launched one for investors wanting exposure to what they believe will be a pick-up in mergers and acquisitions activity. “We are seeing interest from a variety of investors, including small asset managers and private banks. There’s a lot of momentum,” says Hubert le Liepvre, global head of engineering in Société Générale’s cross-asset solutions arm. “We recently launched an index focused on merger arbitrage. That’s an example of how the product range is developing according to the evolution of the market.”

Flexibility counts

One of the big advantages of index products is their flexibility, with investors able to define their asset class and time horizon. Certain parameters, such as the leverage, can be recalibrated regularly. For investors wanting to hedge, there are plenty of indices, usually based on options, that can help them reduce the volatility of their portfolios to potential drawdowns. And they can provide exposure to assets that might not be so easy through other investment routes.

“They offer exposure to an array of indices via a relatively simple pay-off which can be tailored to meet any customer's needs,” says Claude Amar, chief executive of Sunrise Brokers, a large equity derivatives brokerage. “For example, they can provide investors coupon-type structures which give them, firstly, exposure to the equity market and, secondly, a relatively secure income with a limited downside risk.”

Furthermore, they tend to be less costly to access than many managed funds. “Index products are usually cheaper than the alternatives,” says Marc Pantic, head of SGI. “You don’t have to pay for a manager. You just trade a swap to access the algorithm. The fact that you trade a swap makes it cheaper in terms of cash. You don’t have to invest cash.

“You will never be able to replace the alpha of a good manager. But you will probably be able to capture most of the performance of the average manager at a cheaper cost through index products.”

Index products are coming under scrutiny from regulators, forcing the market to adapt. Regulators particularly want to see less opacity regarding the fees and rules related to indices and index-linked products. “If there’s one word I would select to describe the push of new regulation, it’s ‘transparency’,” says Mr le Liepvre.

One way banks have evolved is to use independent calculation agents. Société Générale feels they are necessary, despite each index having clearly laid out rules at its launch, to avoid any accusations of manipulation. “We decided from the beginning to have indices that are independently calculated,” says Mr El-Asmar. “The strategies are defined and there are index rules. But we use external calculation agents so that we can’t be said to influence an index once it is launched.” 

Benchmark rules bite

One fear of structured houses is that their flagship, and possibly even bespoke, indices will be targeted by the same rules that will eventually govern major global benchmark indices such as Libor, which regulators want to reform because of the way some banks manipulated them during the financial crisis. Watchdogs such as the International Organisation of Securities Commissions (Iosco) and the European Commission (EC) are yet to finalise rules or definitions for ‘benchmark indices’. But their guidelines so far suggest they will cast their net wide, which could cause problems for investors in structured products.

“Iosco’s principles for financial benchmarks had a very wide definition of a ‘benchmark’,” says Andrew Sulston, a lawyer at Allen & Overy specialising in derivatives. “The EC’s proposals last year for benchmark regulation were more focused, but its definition was still pretty broad.

“We can’t have a situation where regulated institutions have to dump their holdings of any index products or floating-rate instruments. There will be significant unintended consequences if they don’t get it right.”

A worst-case scenario for banks would be if they were forced to transform their index businesses into separate legal entities to satisfy transparency requirements and regulators’ insistence that there are no conflicts of interests with, for example, traders being able to front-run client orders. But bankers believe their actions so far – including the use of external calculation agents, making sure new products are run past compliance officers and creating Chinese Walls – will ensure that does not happen.

Market participants are optimistic about the future of index-based investing, saying that the flexibility and relatively low cost of index products will ensure that their popularity continues to grow. And most doubt that new regulations will cause long-term problems. “It is hard to say but I believe these regulations have been anticipated for a long time, and should not have a huge impact in slowing down the activity,” says Mr Amar.


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