Spoilt for choice

The barricades have gone up across Europe, and are being manned by two rival armies, clutching their strategy blueprints. Their targets are the retail and high net worth investors looking for direction amid uncertain markets.

On one side are the investment banks, able to rely on a battery of capital markets weapons such as options and warrants in order to structure guarantees and certificates on exotic investments, including hedge funds. These institutions, such as BNP Paribas, Merrill Lynch and Commerzbank, have large marketing budgets, a trading mentality and due to a lack of regulation, can put structured products on their shelves within days of a short-term investment opportunity presenting itself.

On the other side of the fence are the asset managers, often fund houses directly owned by the same investment banks, but harbouring different agendas. They are looking for long-term investors in pooled fund products, and their pan-European distribution strategies need to be finely honed in the new competitive climate.

The question is who will triumph in the battle for the hearts and minds of investors, who make the final choice on whether to operate a funds portfolio, based on asset allocation, or a collection of structured product investments based on short-term market calls.

“All the investment banks are pursuing a similar strategy, which is that the margin for structured products is much more attractive, not just from the banks’ view point but also from the distributors’ view point,” says Roger Portnoy, leader of the Wholesale Initiative at Merrill Lynch.

This is a group initiative to place products, originated within Merrill’s Global Markets group, with external private banks on a white labelled basis in an open architecture environment.

“If you are a private bank you have to think how you can make more money in terms of servicing your affluent clients,” believes Mr Portnoy.

“The distribution fee on structured products is up to 100 or 150 basis points, and even more for CDOs (collateralised debt obligations]. So it is more attractive to you as an intermediary to promote this kind of product,” adds Mr Portnoy.

He believes that certain investment banking-style products, particularly equity-linked offerings, are easier to market to retail investors than others. Credit and debt-related offerings, are more favoured by institutional clients and sophisticated private individuals.

“Retail clients don’t get involved in debt,” says Mr Portnoy. “The equity products can often be publicly listed as opposed to over-the-counter (OTC) sales.”

This means the banks must develop different structures for separate distribution channels.

“The demand for structured products comes from all sectors in financial services, not just retail banks and insurance companies, but also private banks,” says Christian Kwek, global head of structured products at BNP Paribas.

“Private banks are users of not just capital guaranteed products but also of what we call income products,” he says. He explains that unlike capital protected products, where the return is protected, these income products, which are linked to indices, typically produce a high yield, although there is a risk of the capital not being returned.

For instance, with a three-year product, investors would receive a coupon for every year that the stock market for those indices did not go up. “If the market fell, you would have protection up to a certain point and beyond that you would begin to loose your capital,” he explains. This particular type of product has been very successful among Swiss and Spanish private banks. “We also did the hedges for quite a substantial proportion of the products that are being sold by firms such as Credit Suisse and UBS,” says Mr Kwek.

European interest

Mr Kwek sees the demand for structured products as being high all across Europe. “Italy is probably the most active market, but the vast majority of that is linked to mutual funds,” he says. “In Spain there has been a tremendous market for the likes of Santander Central Hispano and BBVA, which have placed a substantial amount of equity-linked structured products not only in the form of notes but also in the form of funds.” The UK, France and Belgium are other markets where BNP Paribas identifies significant demand for these products.

Because investment banks and fund managers are trying to attract the same distribution networks, competition is inevitable. Although some see it purely as a question of investor choice.

‘Hybrids are an area we are looking at closely, particularly as we see the price of oil go up and how this is affecting the world’s economy’

Christian Kwek, BNP Paribas

‘For private clients there is a wide range of tax-optimised structured and money market funds with capital guaranteed’

Günther Graw, DWS

“There is a certain degree of competition between the structured notes market and the structured fund market,” admits Mr Kwek. He believes some small asset management firms could be feeling they are losing some of the assets that would normally go into mutual funds. “The interesting thing is that the Italians, for example, have reacted rather positively because of their ‘if you can’t beat them, join them’ mentality. A lot of fund managers are asking banks like us to help them put together products on their mutual funds. We work closely with very large asset management companies, which have investment banking arms and which also have structured products, to come up with products for them because clearly one of their objectives is to continue to increase their assets under management.”

For Mr Portnoy at Merrill Lynch, there are two different ways of looking at the investment bank versus fund manager issue.

“The fund manager can do his job, which is to manage money to make a return, and the investment bank can manufacture a wrap. It is a win-win situation because the money gets raised on a fund that the fund manager is collecting fees on and the investment bank wins by charging money on the structure side. It is like a partnership.”

However, he adds that the conflict is more likely to be found on the equity side. “On the debt side you don’t find this, because we are the structurer of the note.

“It gets more complicated when we have an alternative asset scenario where we create a product that is based on an underlying alternative asset,” Mr Portnoy explains. “And of course, a fund manager who has alternative assets within his portfolio may also want to give access to retail customers by repackaging them into a fund of funds. Does it need the bank to do that? Well, it depends on the distribution requirements.”

In general, Mr Portnoy believes that when it comes to investment banks and fund managers there is more synergy than competition, “although there are some overlapping skills.”

But what do the fund managers think? Günter Graw, head of guaranteed fund products at German cross-border giant DWS, comments: “On the one hand it’s competition, because you can structure a similar product as a fund, an insurance policy or a certificate. So for reaching the same target you have a lot of different possibilities

“But I also know that depending on the legislation in some countries it’s a question of deciding what kind of structure is the best one.”

Mr Graw says that the demand for structured products also differs from country to country. “Germany is not the country where we see the strongest demand. The situation here is a bit different compared with other countries regarding the total market share of guaranteed structured funds. Here it’s much lower.” DWS manages over 30 per cent of the structured funds present in the market in Germany.

“If we talk about private wealth management, for instance, in our company we have a broader definition of structured fund products. For private clients there is a wide range of tax-optimised structured and money market funds with capital guaranteed. In our company these products have a larger volume than equity-linked structures.”

Swift to market

One of the advantages that the investment banks have over fund managers is that the process to get a fund up and running is usually much longer and more complicated than, for instance, putting together a structured note.

“This is largely to do with the degree of regulatory paperwork involved in creating a new fund,” says Mr Kwek. “For notes and insurance policies the regulatory environment is much more flexible. You can issue a note in the London or Dublin stock exchange virtually in two weeks time, whereas a fund with identical investment characteristics may take six weeks to reach the market.” Rudolf Siebel, director of the German fund managers’ association BVI, has decided to fight the battle on behalf of retail investors, he feels are getting side-tracked into inappropriate product solutions by investment bankers.

“In Germany, structured products can be launched off-the-shelf, sometimes in just one day, which gives much flexibility to investment banks. But they have led to a loss of inflows to the funds industry,” believes Mr Siebel.

“Since Autumn last year, investors have been frustrated and disconcerted with markets, particularly equity, as they have not seen an acceptable path of return. The funds industry has responded with absolute and total return, bond-orientated strategies predicting performance. But this has not been sufficient for investors who want protection against falling markets, which has led to the rise of certificates.

“But most of these products are not suitable for retail investors, as only short-term market expectations are catered for. Often, they need to sit on these products for 13 months or longer, due to the tax situation and the nature of instruments.”

Mr Siebel says many investors buy new products every four weeks, so can easily end up with a portfolio reflecting 12 different investment decisions for the year.

“This is a hotch-potch portfolio of counter-productive influences,” believes Mr Siebel. “It does not permit you to achieve what you wanted in the first place.”

He points to Deutsche Bank research, detailing issuance of 46,000 structured products, ranging from index-replication certificates to highly complicated knock-out options. Investment banks have also been pre-empting marketing campaigns from hedge fund managers, by launching certificates linked to alternative investments.

“The theme we have seen in 2003 was a lot of interest in the alternative assets class with capital guaranteed,” says Mr Portnoy. “Depending on which country you go to, that could still be the theme, and investment bankers are still pushing those products to the market at the retail level.”

However, Mr Portnoy adds that in his opinion the alternative asset play is already out of date, especially if the fact that the last six months haven’t been very good for alternative investments is taken into account.

“We think the theme this year is about leverage. If a very wealthy person has $10m (e8m) of liquidity, and wants to have between 10 to 15 per cent of his portfolio highly geared, he doesn’t want to make 7 per cent. He doesn’t want to make 12 per cent either. He wants to make 30 per cent.”

Mr Portnoy explains that such an investor is looking for products that can give significant gearing to his portfolio, and he is prepared to take the risk. “The only products that can do that are structured products. You can’t buy anything, not even a public-listed product, which can give you that kind of opportunity and there is an appetite for that when you get to that level of customers.”

BNP Paribas predicts that hybrids, such as equity/fixed income or equity/commodities, will provide the greatest interest in the near future. “Hybrids are an area that we are looking at very closely, particularly as we see the price of oil go up and how this is affecting the world’s economy,” says Mr Kwek.

“Many investors think that equity investments are very closely linked to the price of oil, and they are making investment decisions based on that, so we are trying to create hybrid products to distribute,” he adds.

‘Most [certificate] products are not suitable for retail investors, as only short-term market expectations are catered for’

Rudolf Siebel, BVI

‘The fund manager can manage money to make a return, and the investment bank can create a wrap. It’s a win-win partnership’

Roger Portnoy, Merrill Lynch

The muslim vote

Another trend in the market, particularly related to the wealth management side, is the increasing interest in Islamic finance, and the demand for Islamic compliant investment products.

“The Middle East is a very important market. Before, investments were very much concentrated in hedge funds, but now investors in Saudi Arabia,for instance, are trying to reassess the amount of assets they have invested in non-Islamic funds,” says Mr Kwek.

He explains that Switzerland is one of the European countries where Islamic-structured products are in great demand, coming from Middle Eastern investors.

BNP Paribas organises seminars and presentations across Europe to educate distributors and partners about these types of products.

“Our job is to come up with new products for people to package and sell,” says Mr Kwek. “It is an institutional commitment to be transparent and upfront in the way we sell our products.”

BNP Paribas is currently working very closely with Dow Jones on a new hedge fund index, explaining in seminars across Europe the way the index work and the type of structured products which can be constructed around it. “We take market information very seriously,” says Mr Kwek.

But at the end of the day, it is the distributor’s role, not the manufacturer’s, to channel investors towards the most suitable products. “There is still an education gap and we educate our own private bankers about these products,” says Merrill’s Mr Portnoy “However, the private banker, through whatever mechanism he is using, is the one that determines the products he sells.”

Additional reporting from Yuri Bender