Education can bring an end to market’s cyclic shifts

To understand why Asian structured products are as they are, you have to go right back to the start. This is the mantra offered by all of the market participants contacted by PWM Asia. From its birth more than a decade ago, the structured products arena in the region has been shaped by the unique demands and risk appetites of its investors and inconsistencies in regulation. These factors have driven product development through cycles of confidence to the current tenuous balance of customer protection and reward. The market could still tip back towards another extreme, but many hope that this reflects another step forward in investors’ education and an end to the dramatic cyclic shifts that previously characterised the market. The demand for reverse convertibles in Asia evolved around the time of the Asian financial crisis, borne out of a requirement amongst investment banks in the region to source put options for hedging purposes, says Henry Pang, head of equities and derivatives in Asia for BNP Paribas. Reverse convertibles, or equity linked notes, comprise a zero component deposit and an option component, whereby the investor is essentially short a put option on the underlying security. “The idea is that if someone is selling a put option, then essentially the premium coming from the put option can actually be seen as an additional income to supplement the interest on the zero component deposit,” Mr Pang says. “Investors who are going into these kind of structures tend to take the view that they won’t mind taking some risk on the downside, unless the underlying actually drops and therefore the put option has to be exercised, but in return they know they are going to enhance yield on that deposit,” he adds. This principle, Mr Pang believes, is a keystone to all that followed. “What we have discovered over the years is that investors in Asia like trading stocks. A substantial proportion of investors are equity investors, and so the idea of taking downside risk on certain names is absolutely acceptable to most of them,” he explains. “At the same time, investors are benefiting from the fact that the two key centres in Asia, Hong Kong and Singapore, are generally relaxed regimes for tax purposes,” says Mr Pang. Yield enhancement products are now the mainstay of the structured product market in the region. These, and accumulators, or range accrual products, have been particularly popular in Asia’s episodic bull markets. Accumulators Accumulators were developed from existing foreign exchange products, and have similar characteristics to FX break forwards. Under such a contract, the investor accumulates a given number of forwards on the underlying stock at the elapse of each trading day, given that the stock does not trade above a given range. If it touches the upper bound, the contract is terminated. For the past two or three years these have been gaining popularity, although at times they have not been considered suitably exciting, and BNP Paribas has been providing modified versions that allow additional return for a greater downside risk. “The variation will involve investors taking more risk if the stock price is moving downwards, to the extent that typically we have this additional condition in that if the stock is above the strike price but below the upper barrier price, on that day the investor will be accumulating one times the daily number of forwards,” Mr Pang says. “However, if the stock price has gone down below the strike price, the investor will be taking two times the forward, ie if this is going against the investor then the investor will be doubling the loss,” he explains. BNP Paribas also offers variations on the accumulator that mitigate against high volatility causing the stock to breach the barrier price, by offering guaranteed delivery of an agreed number of forwards. And the evolution of the structured product market in Asia is not limited to modifying existing flow products. According to Mr Pang, last year marked a milestone in their usage as well, buoyed by rising markets. “Because of the euphoria related to the rally in the China market, and the realisation by global investors that the opportunities in these emerging markets, China, India, in particular, are so great, and obviously because of the hot money going into the Hong Kong market, the Chinese market, the strong rally also has resulted in increased investor interest in structured products,” he says. “Most of it was for yield enhancement purposes. But what also made last year a unique year was that investors not only went into structured products for yield enhancement purposes, but they also went into structured products for leverage exposure,” says Mr Pang. The downturn And then the credit crunch hit. Asian investors have experienced downturns before: in the aftermath of the dotcom boom, they migrated wholesale to capital guaranteed products, according to Nicolas Reille, head of sales and marketing for structured products in Asia for Société Générale. “It is a market that goes from one extreme to another extreme,” he says. In bear markets, investors use structured products exclusively for risk management. In bull markets, they switch to flow products. With the equity markets as jittery as they were in late 2007, market participants seemed geared up for another slide into conservatism. However, while there was indeed a shift, it has been by no means as emphatic as in previous cycles. The market appears to be trapped in its inflexion point. Mixed sentiments – the credit crunch tempered by a Chinese rally – have left the Asian markets hung, and, Mr Reille says, this is a healthy balance. “I think that the middle ground offers adequate return and sufficient protection for investors, and I believe that’s where the structured product is, and we haven’t really been in this area before,” he says. Whether the market slides again will be a function of how well the market can be educated, and how well the misconceptions that have built up around it can be overcome, Mr Reille believes. Foremost among those misconceptions is the issue of maturity, he says. “Investors are concerned about the maturity of the product. They are always looking at as short a maturity as possible… We know that too short a maturity impacts on the performance of the product. So it’s better to expand a bit the maturity of the product to give more power to perform and investors, instead of waiting for the [contract to mature], can capture the performance by trading the product on the secondary market.” No back testing This reluctance to use longer-dated products is partly symptomatic of a regulatory peculiarity in Hong Kong and Singapore. Neither jurisdiction allows back testing, which allows investment banks to use historic data to demonstrate how the product would have reacted in historic market conditions. Back testing is common in Europe and in some markets, such as France, it is compulsory. “The fact that we can’t use back testing means that investors, in a bull market, tend to compensate for this lack of visibility with very vanilla products that have a short term maturity. And they will use more structured products with high return guarantee only as a risk management tool and as an alternative to deposit where the deposit rates are really low,” Mr Reille explains. There is some suggestion that the rules will be reassessed, and if they are, the current tenuous balance can be reinforced. “If tomorrow we are able to demonstrate and show some back testing analytics, I am sure that would help to show investors that the capital guarantees are not only a risk management tool, but they can also generate return,” Mr Reille says. There are other signs that investors have matured, according to Ian Sosso, head of Commerzbank Corporates and Markets in Asia-Pacific. In the past, Mr Sosso says, complexity of returns was of paramount importance. “Banks were competing by designing very fancy payoffs, and the products became very complicated,” he says. “So as a structuring house you’d be trying to find a very fancy payoff, and then you’d be putting global stocks into this product. The market got smarter with time, and I think over the last two years we’ve moved away from having products that were specifically payoff-driven, to investors looking more at stories,” says Mr Sosso. Thematic investing has reached Asia, both in the form of traditional equity funds and structured products, focusing on growth stories such as renewable energy, water or luxury goods. “The trend actually has been to get more simple products,” he says. “So instead of competing by trying to find the most unusual payoff, now the trend is much more about finding the story that really makes sense for the investor, then creating a product around it, which is a sign of greater maturity, I would say,” he adds. The banks are taking this to its next logical step, Commerzbank’s Mr Sosso says, which is to create products on a dynamic underlying strategy, rather than on a static basket. “So the lines between fund management and investment banking in that respect, and even hedge funds, are getting a bit more blurred,” he says. “What investment banks are doing is creating strategies that are systematic. I mean, we don’t do discretionary management, but what we can do is create an index that has a predetermined strategy that works according to a formula,” explains Mr Sosso. “All the banks have come up with different strategies. Sometimes it is in equity markets, sometimes it could be the commodity markets, sometimes it could be the FX market. So banks are spending more time trying to create a strategy that they can use as an underlying,” he adds. Commodities That the banks and their customers are looking outside of equities is another important development. There was a fairly significant rates market in the early part of the century, just after the dotcom bubble burst, but that subsided as the equity markets recovered. Now, as prices continue to rise, the commodities story is looking like a compelling one for investors. As well as providing a lucrative haven from equity markets, it is a theme that is well understood by Asian investors, Mr Sosso says. “A lot of the growth story for commodities originates from Asia. If you look at the China and the India stories, for example. I think that investors are aware of the growth story being Asia-driven.” The market is only six or so months into its balanced revolution, and it is by no means certain that it will persist. What looks like diversification could simply be investors taking strong views on other asset classes, and what looks like balance could still turn out to be indecision.

‘A substantial

proportion of Asian

investors are equity

investors, and so

the idea of taking downside risk on

certain names is absolutely acceptable to most

of them’

Henry Pang, BNP Paribas