Structured products are not just things that you buy in M&S, says Caroline Allen
‘Structured products’ are not just things that you buy in M&S, says Caroline Allen
It’s not exactly the sort of investment you can boast about at dinner parties. While conversations about equity markets, fine art, bloodstock, and even hedge funds have some interest for those concerned with wealth preservation or accumulation, structured products just don’t have the same social allure.
How can you get friends excited about an option that essentially gives you a little sacrifice a bit of the upside? Who is interested in the precise banded layers of risk and reward according to how the FTSE, or other more obscure underlying indices, move in the two to twelve years?
Yet, you won’t get far into a conversation with an investment banker these days before structured products are mentioned. Indeed, in a very short time, structured products have become a lucrative part of the banking business. According to BNP Asset Management’s latest quarterly results, structured products brought in some €8.2 billion during the first nine months of 2005, and overall, alternative and structured products accounted for €27.6 billion.
However, regulators and starting to voice concerns. ‘Investment banks have played a leading role in the design of structured products, both to achieve risk transfer and to meet demand for extra yield that has built up during this period of low interest rates,’ notes the 2006 Risk Outlook from the UK’s Financial Services Authority (FSA).
‘While product innovation can both benefit investors and reduce risk concentration, it also raises a wide range of concerns – for example relating to legal and operational risk or the risk of mis-selling (including when the product is sold via a third party).’ Other parts of the document mention valuations and credit ratings of issuers.
So where does the risk lie, for investors? Structured products date back to the 1980s, when derivatives were first used by portfolio managers to leverage gains. An array of products now serves anyone from retail to institutional investors, with a range of returns and protection. But the essence of the product is a derivative of some sort, usually with a fixed term, which gives some protection against potential losses, while leveraging potential gains.
In the 1990s, the leverage side of the equation was most prominent. Clever financial modelling squeezed even higher returns from quite modest portfolios. The protection element was just window dressing: nobody believed an index could drop 30 per cent. In 2000, several did just that. Many investors were actually leveraged on the downside, losing their capital as well.
Structured products were also loosely associated with the mis-selling of precipice bonds. But for some, they did indeed provide the protection promised. Proponents say the fallout from the collapse of the hedge fund Long Term Capital Management would have been far more serious had many investors not had the safety net offered by structured products.
Post-2000, product providers turned the marketing proposition around, emphasising protection and capital guarantees as well as outperformance. Modelling is now far more conservative, with shorter terms, varying risk profiles and wrappers.
Products are available for most major equity indices, in addition to property, commodities, and hedge funds. The credit ratings of issuers are scrutinised more carefully, and investors can secure ‘kickouts’ (early exits) and other guarantees.
But sceptics have other reservations. One is an old favourite: fees. In this sector, they are determined largely by the volatility of the underlying market, the credit quality of the issuer – the more blue chip, the higher the charge, since you are mitigating default risk – an of course, the market spread, including other distribution charges that need to be covered. ‘Fees are still too high, too complex, too opaque,’ complains the head of a family office in London. ‘They can never seem to explain exactly how they work.’
Privately, bankers say complaints about fee levels are ever-present. In fact, it would be a naïve client who didn’t query fees. They feel they have a high level of expertise, although there is an element of charging what the market can bear. ‘If they are prepared to pay unproven hedge fund managers 200 basis points-plus, 100-160 basis points for high conviction ideas is a fair price,’ said one director.
But the FSA has already fired a warning shot. ‘Uncertainty about the valuation of illiquid assets may also increase the risk of conflicts of interest – or even fraud – to the detriment of the investor and of market confidence more generally,’ says the 2006 Risk Outlook Report.
It points out, too, that a significant proportion of revenue comes from fees, and since these are relayed to asset valuation, there may be an incentive to overvalue assets. ‘A number of incidences of false and fraudulent valuations have been identified around the globe and we expect an increase in such developments.’
Tim Mortimer of Future Value Consultants, which sells independent reports on the value of structured products to institutional investors, says the problem is that there are no explicit fees, as there are with funds. ‘It is all built into the deal, with the different terms and details. There are varying degrees of closure.’
Far more serious, and difficult to rebut, are suspicious of a fundamental conflict of interest, that clients who but structured products are somehow the patsy in the market. Investment banks are designing products sold by their own units, instead of taking a ‘best of breed’ approach in the true interests of the client. The bank’s defence is robust.
Firstly, there are plenty of regulatory risks in flogging inappropriate in-house products, and the cost to reputation of a judgment of mis-selling is high, and rising. Secondly, mis-selling is no way to retain your client long term. And all banks insist the long term interest, and relationship, is paramount.
This is a familiar dilemma from the retail financial service sector. If you go to, say, Noble Group for a structured product, don’t be surprised to be offered a Noble Group solution. In fact, as one intermediary pointed out, until ‘open architecture’ became a buzzword, you would have been surprised not to have been offered a house project.
Rhian Horgan, head of structured products at JP Morgan in New York, says investors are ‘sold’ products as such. ‘Many investors are quite nervous at the moment. They want a solid name, and ‘stabilisers’ [side-wheels on a bicycle] for their investments. They have a risk budget; we help them decide how to allocate it.’
She adds that structured products are good investment in themselves and also prove useful for transitioning portfolios. ‘As clients get more comfortable, the protections can be removed, but it is better, to begin with, to offer more modest returns and a high probability of achieving them.’
Thomas Fekete, head of structured products at UBS Wealth Management in London, says open architecture allows advisors to secure the best product for clients. ‘We deal, but they are certainly one of our regular providers. We work with perhaps five to ten banks overall, and three to five banks on each product. The choice depends on the price, liquidity, know-how, and after-sales service. Working with several banks also diversifies risk.’
Another concern, especially amongst smaller investors, is that they might actually be facing the bank as a counter-party in the market, through the bank’s own proprietary trading desk. Once more, regulatory scrutiny is raised as a rebuttal. So why are clients still concerned?
‘It may be a misunderstanding of the responsibilities,’ suggests Fekete. ‘Investment banks’ proprietary desks are simply not involved. The trade goes through the agency traders who go in the market to get the best price they can.’
Japan is frequently cited as a market where structured products did well for investors last year. However, accounts of losses elsewhere persist. All parties tend to point the finger.
The second tier players blame the big banks – especially the Americans – for commoditising structured products and selling them like insurance, without the personal service assured at smaller firms. The big banks point to the depth of their expertise and to their balance sheets, adamant they have no need to stoop to conquer.
All products providers, meanwhile, are busy working out where the ‘sweet spot’ is in this fast-growing market, ranging from the ‘mass affluent’ to the big hitters among the institutional funds. ‘Look at where the banks are selling fastest – the mass affluent,’ comments one private investor. ‘Why? Because it is easier for them. They are not challenged by those clients.’
It may surprise them, but high net worth individuals and family offices are not necessarily preferred clients. ‘Dedicated financial engineering is costly,’ notes Franck du Plessix, head of structured products at Société Générale Asset Management Alternative Investments.
‘We are selling a lot of bespoke products to the very top end of the market, where there is growing demand. Family Offices want to be institutional investors but they have a high level of expectation in terms of reporting and services, and are quite time consuming. We need to consider opportunity cost and win-win outcome for each deal.’
He claims the only way to build a sustainable business in this product area is to start with the risk-return profile of each client, then identify an underlying market on which to structure a suitable product. That kind of bespoke solution doesn’t come cheap, but it clearly yields handsomely.
SG Asset Management generated net inflows of €27.4 billion during the year, mainly as a result of a strong sales focus on structured products, which generated €12.7 billion of net inflows, or 46 per cent of the total. At the end of the year SGAM managed a total of €326.7 billion, up from €266.8 billion, a year earlier.
So, will there be the sort of gold rush into structured products witness with hedge funds and other products before them? ‘There is no doubt that the business has grown a lot, but it is still a relatively small proportion of overall bank revenue,’ says JP Morgan’s Horgan.
‘It is not a separate asset class.’ Nick Perryman, a senior client advisor at UBS Wealth Management, offers a cautious welcome: ‘I would always be worried if any product or asset class started to become a major concentration in a client’s portfolio. But clients are becoming increasingly interested in a product that allows them to quantify their potential loss, while offering them leverage on potential gains.’