The art of product design

While sales of traditional mutual funds are drying up, structured products are increasingly in demand. If you haven’t done so already, it’s time to add structured investments to your range of services or face banishment to the sidelines while other wealth managers cash in.

But creating the perfect structured product investment takes work. You may need to create a different structure for each new product. It may be necessary to set up several relationships with fund providers and investment banks. And perhaps most testingly, you might need to change your whole product creation philosophy.

In Europe, a few different factors are fuelling the rise of structured products, ensuring that they are impossible for wealth managers to ignore. Belgium, France and Spain are major product sales hot spots, according to Feri Fund Market Information, which has looked at regulated guaranteed funds, one of the segments of the structured product market that is easier to track (see table on page 31).

Over the past three years these countries have seen massive increases in sales of listed guaranteed funds: Belgium has seen a 46 per cent increase, France 41 per cent and Spain 69 per cent.

European drivers

Sales of structured products more generally are strongest in Germany, Italy, Spain and Switzerland, according to Alex Fletcher, European managing director at Goldman Sachs Asset Management.

“Different things drive the sales of structured products in different countries. It could be a regulatory issue. In Germany, for example, financial institutions are beginning to sell fund of hedge funds to the public directly, but until recently we could only do that legally through a structured product,” says Mr Fletcher.

“A guarantee also appeals in parts of Europe that have experienced a particularly pronounced bear market. The Neuer Markt fell 90 per cent from its high to its low. This was especially tough on German investors because they were new to the equity markets.”

There are also elements of structured products that have universal appeal. Ashok Shah, chief investment officer at London & Capital, a boutique fund manager for private clients and institutions, says: “The main reason for structured products becoming more popular is that they cover the downside. They take that negative side off your return stream. This is especially important for those that don’t have a high pain threshold.”

As the demands of investors have grown and evolved, so have structured products. Mr Shah says that a few years ago structured products were being used on the edge of the portfolio to gain protected exposure to the odd market segment but now “we are seeing structured products used differently, they are taking their place in the core of the portfolio to manage volatility”.

Twelve months ago many structured products were based on the equity markets, such as the S&P500 Index. This was because equities had performed badly and as a result they were cheap, so people wanted to get into the market but not without protection, explains Mr Shah.

Six months ago the story changed: “Emerging markets bonds and high yield bonds were doing well, off the back of strong economic growth, which was driving credit upgrades. People wanted to participate, but since this is a higher risk area, again, not without downside protection.”

“In the last three months the global economic growth rate has shown no signs of stopping, therefore there is a huge increase in demand for commodities. But they are very volatile and can move up or down by 20 per cent in just a week, so structured products are an ideal way of gaining access to these markets.”

So how should wealth managers go about creating the products to meet this demand? The London & Capital approach is to partner with at least four different investment banks – Barclays Capital, JPMorgan, Société Générale and Credit Suisse First Boston – which provide the structure or guarantee. It then bases each product on carefully chosen external funds exclusively.

“There are products out there that are downright nasty, so you have to be careful who you work with”, says Mr Shah. “The quality of the counterparties we use is key for us. We only use high quality, blue chip players and we have enough size to be able to go the investment banks and ask them for a specific solution. They will tell us exactly what it will cost – it’s totally transparent. We are well aware of the kinds of restrictions that can damage investors.”

But he admits that some structures are more complicated and bespoke than others: “It depends what basket we want to link to. If the underlying is the S&P500 you can easily synthesise a product to you requirements, but it’s a different matter if you want to link to six commodities.”

Tailored products

On the other hand, he warns against off-the-shelf-style solutions. “If you wanted an easy life you could imitate other products but you don’t get a bespoke solution that way. The investment banks will often say they have designed something for a customer and they can do something similar for you.

“But we generally don’t like to go for these. We’ll have a certain idea of what we are looking for and we’ll want something more personal.”

When thrashing out the deal with the investment bank, it is important to be clear on the product’s duration, be it five, 10 or 20 years. Equally, the exact nature of an underlying must be agreed upon. “You have to start with what you are looking for in terms of risk and reward,” says Mr Shah. “As the economic cycle changes you may be interested in different things, so you might want to build in the opportunity to use leverage further down the line, as long as the downside is protected.”

Olivier Nolland, head of sales of structured products for SG Asset Management, recommends a slightly different approach to creating structured investments. He argues that it is essential for a provider of structured products to have an in-house investment banking arm, admittedly a luxury not everyone has.

“We’ve never had to use an external guarantor,” says Mr Nolland. “The capital guarantee is provided in-house within the SG group. Our competitors in the structured asset management business who have to buy the guarantee outside their group are forced to outsource the gap risk and hence add a sizeable cost to their offer. Having access to a guarantor in-house allows us to provide a far more competitive product than the competition.”

In-house management

While creating a product, the structured product department has daily contact with the private banking arm, whose risk team vets everything. SG also bases many of its structured products on in-house funds. The alternative investments department is split into four sections: structured investments, funds of hedge funds, private equity and real estate. “We work closely with the other departments to create bespoke products”, says Mr Nolland.

The advantage of using in-house funds is that, theoretically, you have full confidence in the quality of the underlying. Mr Nolland says his department has created several products structured on funds of hedge funds recently. All were structured on in-house funds created on a solid base of research by an SG due diligence team in New York.

Products are created in response to client demands, which fit into two broad categories: “Retail networks looking for innovation come to us for new ideas on underlyings that will perform and our abilities to offer innovative pay-offs and optimised structures.

“Other retail networks could have much more precise needs. They come to us with a detailed product specification and use our structuring and commercial abilites to meet their specific needs. In both cases, we offer expertise on all types of underlying – fixed income, stocks, credit, inflation, commodities, hedge funds – and under different types of wrappers, such as notes, funds or swaps, and we can also deliver different types of pay-offs, such as coupons or ratchets at maturity.”

One example of the latter is a Akoya, a French guaranteed investment recently launched by SGAM, which is to be sold through the group’s private bank. The six-year product aims to capitalise on the two main equity investment strategies, value and growth, by combining them into a single efficient model.

It amounts to a diversified basket of funds optimised over its lifetime. The capacity of value funds to cushion the investor from market slumps is combined with the potential to participate in market rebounds through growth funds, while securing 100 per cent of the initial net capital at maturity. The current allocation comprises eleven funds chosen for their performance potential and risk/return characteristics.

The final element in creating structured products is less tangible, according to Alex Fletcher at GSAM: “You need to make sure you are not in a straightjacket. We must think of ourselves as a provider of uncorrelated investment solutions and must not get hung up on how these products are delivered.

“We are a manager of different investment solutions and it shouldn’t bother us whether we do it through a fund or a structured product. It’s not the end of the road for funds, we should just provide both options and use as many different vehicles as required.”

He concludes that product providers must remain “agnostic” on the question of what the product is.