JPMorgan builds derivatives know-how for private clients

The emergence of a new division at JP Morgan Private Bank, which will be built as a joint venture operation with its investment banking parent, is a clear signal of a new trend in the industry. Corporate finance, derivatives know-how and other high end institutional services are increasingly being shared by investment banks with their wealth management colleagues, in a bid to leverage group contacts and techniques to further boost profits. However, with derivatives-based structured products now such an earner for both divisions, the two sides of the business are playing down their co-operation in this lucrative arena, and the private bank claims to create structured products in total independence from the group’s investment bankers, on a best of breed approach. There is an indication here that these products are no longer being used in an opportunistic fashion, but have evolved into a separate asset class, with its own allocation in a private client portfolio. Structured products provide a creative way for diversifying sources of return, while those with downside capital protection also dampen volatility impact, claims the bank. These properties are particularly relevant in the ultra-high-net-worth banking world, where individuals have strong concentrated sources of wealth, said Tim Harris, chief investment strategist EMEA at JPMorgan private bank. “We are in a wealth preservation game, and structured products therefore can play a useful role in helping to maintain our clients’ wealth in the long term.” The two sources of return, beta and alpha, do not offer a rosy scenario. Mr Harris estimated that, going forward, beta from equity markets will be in the range of 7-10 per cent, but volatility has to be taken in the equation. Moreover, most long-only managers have been finding it increasingly difficult to generate alpha in recent years. In 2006, investors paying fees for active management have a 70 per cent probability to pick a manager who will not beat the benchmark. JPMorgan has been implementing structured products strategies for its private clients for the last three years. “We use structured products in a portfolio context, as a source of alternative alpha, not in an opportunistic way,” said Hannes Hofmann, head of equity structured products Emea, at JPMorgan private bank. “Being able to create structures that maximise returns in a single digit return market is very important.” This is because investors’ sacrifice is less likely to occur on the upside, while they can gain moderate downside protection or leverage returns up to a cap, this way managing volatility. There is clear trade-off between the level of downside protection and the level of upside participation. “We recommend to our clients to go for limited zones of protection, rather than full protection, which is relatively expensive,” he added. Factors determining the way a product is structured are investors’ views on the markets, the level of capital protection they need and the time they are prepared to lock up their capital in one investment market view. “We tend to keep our structure as short as possible, as it is hard to predict with precision what the market will look like in five years.” The reason why in the retail market there are longer horizon structured products is because a lot of them have full protection, which becomes more manageable in a long-term approach. Mr Hofman warned against the temptation to employ structured products as an easy and quick remedy. “Structured products are not a panacea,” he said. “The expectations from this asset class are probably talked up too much in certain parts of the financial market, especially in the retail sector, compared to what it can deliver.”

Strategic vs tactical allocation Distributors face the challenge of having to decide the optimal allocation to structured products for their clients, if indeed there is such a thing. “By definition, 100 per cent of what we do in structured products, from the portfolio construction point of view, is tactical not strategic. If you try to model structured products on the long run, you have got expected returns which mirror those of the underlying asset class, because we are just redistributing expected returns priced, within the equity market,” said Mr Harris. “It will be unusual for us to have more than 10 per cent of a client portfolio in equity or fixed income structured products. We have found an equilibrium level in the 5 to 10 per cent range.” The ability of private banks to educate their customers to structured products plays a key role in favouring the growth in usage of these instruments. “Many customers are just happy sitting in liquidity. That is always a challenge in private banking, make people’s money work harder,” he said.

Hofman: they are not a panacea