Structured products sway retail banks

Structured products – packaged investments using derivatives to replicate market performance, sometimes linked to a money-back guarantee – have often been painted as evil incarnate by providers of traditional mutual funds.

Pan-European houses relying on retail and private banks to distribute their funds are becoming increasingly uncomfortable with the reality, which is a favourable climate for structured products. Currently, in continental Europe, it is still an uphill struggle to persuade retail banking networks to sell funds. There are three reasons for this:

• Investors who have suffered from the bursting of the technology bubble and subsequent bear market are reluctant to get their fingers burned once more.

• Funds take so long to launch that it can be six months after a ‘hot’ theme has been identified, before it can be adapted for mass consumption in a retail mutual fund. This is often too late to net big profits.

• There is a plethora of simple structured products available through most banks in Europe, which compete with mutual funds, and offer investors quick access to market upside, along with some protection.

Distributors clearly want to sell these products, and they are popular among investors. Research conducted by PWM for Credit Suisse Asset Management, with analysis by consultancy Feri FMI, shows that more than 60 of Europe’s top 130 distributors of investment products, responsible for ?70bn of annual fund flows, will be placing their clients’ investments into structured products this year.

In Germany, where mutual fund players are up in arms about the increasingly dominant position of the investment banks, distributors see structured products as equally important to mutual funds, according to our research.

Enthusiastic investment banks

The investment banks who dream up the concepts, and persuade the distributors to buy them are bristling with confidence. Société Générale has been so successful in engineering structured products for sale across various European markets, with distribution partners including ING, Crédit Agricole and Caisse d’Epargne, that some of its top talent was recently poached by up-and-coming French rival, Calyon.

The prevalence of such poaching sorties between rival investment banks is testament to the increasingly competitive nature of the business, and the premiums innovative financial engineers and salesmen can command.

One of the strategies which these mavericks are pushing to a still twitchy public of European retail investors is multi-asset class products. Successful distributors can combine allocations, allowing clients diversification, through choosing from a variety of performing assets.

Barclays Capital, which employs a team of 40 financial engineers in its headquarters overlooking London’s Docklands is particularly keen on this concept. “Hybrid products are gaining popularity as they are able to blend different asset classes, like equities, bonds, commodities, inflation, currencies and hedge funds into a single wrap,” explains Hassan Houari, head of equity derivatives structuring at Barclays Capital. “For instance, we would structure an investment that offers 100 per cent capital protection plus an exposure to the best performer within a basket of several assets.”

Barclays is also pioneering the inclusion of new types of underlying stocks, not previously used in structured products. “With general country benchmarks taking a back stage, we have successfully introduced a new breed of products offering an enhanced value proposition to the end client with instruments linked to ‘ethical’ baskets for example, or to commodity and property-linked stocks,” continues Mr Houari. “These strategies can be either static, as was generally the case, or dynamic, i.e. changing during the life of the product to adapt to market conditions, but constantly wrapped by a capital protection with a CPPI [constant proportion portfolio insurance] mechanism, for instance.”

Conservative solutions

Another trend is the construction of equity-linked products that can turn into a high yielding, fixed income investment, based on market conditions. “Many European investors are conservative,” says Bernard Desforges, global head of sales and structuring equity derivatives at Société Générale in Paris. “They are happy to take some equity risk for a while, but as soon as they have secured some profits, they are keen to lock into a safer investment. This is very different from Asia, where investors are much bigger risk takers.”

Société Generale’s ‘Click Oblig’ concept is a syndicated product launched on this basis for retail investors. “Due to decreasing Euro interest rates, it is very difficult to offer 100 per cent protection or a capital guarantee, in addition to the performance,” observes Mr Desforges, pointing out the increasing price of options needed to purchase a guarantee, leaves a lesser principal for investment, which is also further diminished by distribution fees.

“We need to find some kind of balance between a guarantee embedded in a product and potential return. So we are selling more and more product that is not 100 per cent guaranteed, with some equity risk, but also with some protection afterwards.” The risk profile of such products rests midway on the equity-fixed income continuum.

Société Générale is also increasingly using hedge funds, selected and monitored by its Lyxor subsidiary, as underlying investments for structured products, in this case usually linked with a money-back guarantee.

“We are working closely with colleagues in Santander on specification and construction of structured products”

James Bevan, abbey

“What we do on equities, we can also do on a basket of hedge funds or managed accounts,” explains Mr Desforges. “We know it’s a non-regulated industry, but having a specialist in place makes a huge difference, making sure hedge fund managers comply to all the required ratios. We do believe we can extract alpha from arbitrage strategies, but it’s difficult and we need a focused effort to make sure the hedge funds stick to their guidelines.”

A force to be reckoned with

Spain, Italy and Belgium have all been fertile hunting grounds for European investment banks, which have partnered with retail facing institutions including KBC and Fortis in Benelux, and Spain’s BBVA and Santander Central Hispano.

The sales forces of these institutions are successful because they introduce a simple concept, and then continue to modify it slightly with every new tranche of product. This is simply not possible with selling mutual funds, which would require re-training a sales force to master each new investment concept or asset class. “The problem for distributors is that they can train a sales force to sell one core product,” observes Mr Desforges. “But they cannot retrain their sales force every time there is a new product. So it’s important to have one product which can change allocations over time.”

London calling

But the one market currently being eyed up by all the big players is the UK. “The London market could really take off for structured products,” believes Mr Desforges. “There is room on both the life insurance and the banking side. Lloyds TSB and other banks are launching products for retail distribution. Abbey has a new shareholder, Santander, which is the biggest distributor of structured products in Europe. They will progressively share their philosophy with Abbey.”

James Bevan, Abbey’s chief investment officer, has no doubts that his high street banking group has already dived deep into a process of transformation, since being acquired by its new Spanish masters. “Santander has a rich and deep record of incorporating customer centric investment solutions with a profound competence in structured products and a strong sales culture,” says Mr Bevan. “We are working closely with colleagues in Santander on specification and construction of structured products, and we would hope that we can demonstrate an attractive combination, using some of the best retail banking and asset management skills from Santander, with outstanding investment banking competence in Abbey.”

Combined approach

This new approach of matching asset management with investment banking is certainly gaining credence in the UK, where Abbey hopes to package a safe investment based on cash or derivatives such as swaps, together with low-risk institutional asset management strategies including tactical asset allocation, foreign exchange and trading credit debt. The target, as ever, is equity-like returns, with much-reduced risk for investors.

In many groups, the use of derivatives, pioneered by investment banks, but now increasingly permissible under European Ucits legislation, is taking root in traditional asset management, in concepts such as target or total return funds. These are, in effect, structured products delivering a defined return, but handled by active investment teams.

The fact that the divide between the banks and the fund houses is no longer a unbridgeable gulf is acknowledged by Bob Parker, deputy chairman at Credit Suisse Asset Management. He insists that fund houses must offer a combined approach going forward, particularly as registration of funds in European markets can take anything from 60 days to four months. Structured products can be launched immediately.

“Structured products and mutual funds will be equally important going forward,” says Mr Parker. “To be successful in markets, you have to have a range of structured products. If you say to your distribution partner, ‘it will be ready in two months’, frankly, you’re dead. If you say it will be ready in a week, you will have the chance of success.”

Direct competition

In Germany, however, where structured products enjoy their deepest penetration, with up to 60,000 capital market style certificates listed on the Frankfurt and Stuttgart exchanges, fund managers are not in such a benevolent mood. Rudolf Siebel, head of the BVI, the country’s powerful mutual funds lobby, acknowledges that derivatives can be efficiently used by experienced portfolio managers, but is sceptical about the efficiency of a portfolio of structured products measured against a portfolio of mutual funds. The BVI is currently awaiting academic research on this issue. “We hope that some of this research will prove you are only making short-term decisions,” grimaces Mr Siebel.

He believes structured products have an unfair advantage because they are lightly regulated, quickly launched and have no requirements to publish costs. In addition, they often avoid tax on income, and are unfairly favoured by a German government keen to promote Europe’s largest derivatives market.

At Société Générale, Mr Desforges is unfazed by this hostility, saying that the German campaign is aimed simply at unburdening the excessive regulation of mutual funds, rather than frightening customers away from structured products.

“It takes two months to get regulatory approval for funds in Germany, but a matter of weeks for certificates. This obviously creates a discrepancy. My feeling is that Bafin [the German regulator] should decrease the approval period for mutual funds, in order to ease the entry barrier for them.”

Investment banks and fund houses are now in direct competition for retail customers believes Mr Desforges. This sentiment is echoed by David Stuff, head of UK retail structured products at Barclays Capital.

“Defined return products offer a clarity and certainty that active management cannot,” says Mr Stuff. “Additionally, defined return products can offer the asymmetric returns that appeal to private investors.”

“European investors are happy to take some equity risk, but only for a while” - Bernard Desforges, Société générale