What they love is the security

Simon Hildrey explains the allure of structured products and how their designs and actual day-to-day uses vary between providers. Life could hardly be better for providers of structured products. With major stock markets 50 per cent down since 2000, European investors have been diverted into capital protected and guaranteed products to ensure they cannot lose money during the bear market. This rush into structured products has been exacerbated in continental Europe because many investors started buying equities for the first time in the late 1990s just before the technology bubble burst. According to Merrill Lynch, there was an 8 per cent increase in the issuance of retail structured products in Europe in the first six months of 2002 to €36.3bn, compared with €33.7bn in the first half of 2001. Merrill Lynch reported that the biggest growth came in Spain (165 per cent), Germany (122 per cent) and Scandinavia (114 per cent). Pioneer Investments, the cross- border funds arm of Italian bank Unicredito, raised €6bn through its structured products in Italy alone last year. Demand among private clients Gerben Jorritsma, head of discretionary portfolio management at ABN Amro in Amsterdam, says demand for structured products among private clients is growing because of the security they offer. Whether a structured product is appropriate for a client depends on their risk tolerance and the length of time they want to invest, says Mr Jorritsma. ABN Amro offers guarantees on its own funds, including hedge funds, and also provides tailor-made structured products. “If a client only wants to invest for three or four years then structured products make sense. But if they believe in equities and can invest for 10 to 15 years then they should not use structured products,” says Mr Jorritsma. Despite growth in demand, volatile markets have prompted distributors to warn investors to be aware of who is providing the guarantee, how it works and the likelihood of a positive return being delivered at the end of the product’s term. Responsible attitude Matteo Perruccio, Paris-based chief executive of Pioneer Investments, argues that while capital protected products have protected against downside returns over the past three years, providers and distributors must take a responsible attitude. “They must try to provide as much upside as possible because the stock markets are likely to recover in the near future,” believes Mr Perruccio. “Very few investors are happy to stay in a product for five years if they only get their capital back at the end of it.” Mr Perruccio says that as with any other investment, when selecting structured products, investors must study the track record of the manager of the underlying funds. Jonathan Fry, joint managing director of Premier Fund Managers, says the advantage of structured products is that they will deliver exactly what they say “on the tin”, as well as being cheaper than mutual funds. He argues that the total expense ratio of a structured product is between 6 and 7 per cent over five years, compared with 15 per cent for an offshore fund. Whether structured products meet investor expectations, however, depends on whether the investor understands the strategy of the underlying investment and what it intends to deliver. Mr Fry cites structured products that are based on average returns as an example. “A product might promise to pay 100 per cent of the average return of an index. If the index rises 10 per cent on the first day of the product and stays there until maturity, investors receive a 10 per cent return. “But if the index does nothing until the last day of the product and then rises 10 per cent, investors only receive one-365th part of 10 per cent. It is important for investors to be clear about what the product is trying to do.” He adds that if a return is based on the lowest point of an underlying investment over a set time period, such as six weeks, it is important to clarify whether this is determined by prices at the close of business each day or the lowest price during every day. Types of underlying investments The types of underlying investments used in structured products have changed over the past few years, with a widespread move towards hedge funds as providers have tried to boost returns. This increased focus on returns has been prompted by falling interest rates, which have impacted on the way capital protected products are structured, in particular by extending their term to allow notes to cover the guarantee. As Mr Perruccio says: “It is increasingly difficult to construct plain vanilla four or five-year structured products with falling interest rates.” Alam Shiblee, senior sales and structuring manager at Société Générale in Paris, cites the increasing use of fund of funds and hedge funds rather than an equity index within structured products. Société Générale has also started using mortgage- backed securities in its products. Through delivering access to these more unusual asset classes, says Mr Shiblee, structured products enable investors to diversify their portfolios. Furthermore, he adds, “using low volatility funds of hedge funds enables the provider of structured products to utilise high multipliers.” By high multiplier, Mr Shiblee is referring to what is regarded as the more dynamic form of structured products. The advent of CPPI There are two main ways a bank can structure a guarantee – using a zero coupon note or constant proportion portfolio insurance (CPPI). CPPI has been gaining in popularity among providers, partly because many prefer to use this structure with single or multi-manager hedge funds. Under the CPPI structure, assets are allocated dynamically over the term of the product. The provider can allocate 100 per cent of assets to the underlying investment from the first day and not have to buy a bond to cover the guarantee. But the provider has to ensure he has sufficient assets to buy a bond at any point during the term of the product to cover the guarantee. Take, for example, a five-year product investing in a FTSE 100 fund that would need 20 per cent in government bonds to meet the guarantee on the first day of the product. This leaves the manager with 80 per cent risk-capital utilised to try to generate returns. The fund manager has to ensure he does not lose more than 80 per cent of his assets. This is why the use of low volatility investments, such as funds of hedge funds, have grown in popularity for CPPI structured products. But the manager also needs to be aware that the bond to meet the guarantee becomes increasingly expensive as the product approaches maturity. After two and a half years of a five-year product, for example, the manager may need to use 60 per cent of his original assets to buy a bond. This means he has less room for manoeuvre unless his assets have grown in the meantime. The advantage of CPPI is its flexibility and the ability of the provider or investor to choose the level of investment risk taken. The disadvantage of CPPI, according to Bill Maldonado, global head of alternative investments at HSBC Asset Management in London, is that if the active manager suffers heavy losses in the first few months, he will have to use all his assets to buy a bond and not be able to deliver a return at maturity. Bank controls Another problem with CPPI, says Mark Chambers, associate director of Man Group, the world’s largest hedge fund company, is that the bank ultimately determines the cap on the fund manager’s exposure to the market and whether he has to withdraw from his investments to cover the guarantee. Man Group uses the other type of structured product for fund of hedge funds – the Option Based Portfolio Insurance. Under this structure, a zero coupon note is purchased at the outset to cover the guarantee of the product. The rest of the capital, usually between five and 10 per cent, is used to purchase options on the underlying investments, which are often indices. An advantage with this structure, argues Mr Chambers, is that if the options fall in value, there is no need for assets to be reallocated as the zero coupon note has covered the guarantee. Therefore, the fund manager has time to recover any losses over the term of the product, which may not be possible under CPPI. This structure tends to have a longer term than the CPPI. “With current interest rates, the zero coupon note products tend to have terms of about 11 or 12 years while the CPPI is between seven and nine years,” says Mr Chambers. A variation of these two types of structured product is gaining popularity in Europe, according to Mr Maldonado at HSBC. A protection arrangement allows any gains preserved periodically, such as quarterly, through what is known as the ratchet system. New levels of protection Under the ratchet system, if the fund has grown in value during the previous three months, this will be preserved through a new level of protection being established. Even if the fund declines for the rest of the term of the product, the investor will receive the new level of protection. Royal London Asset Management is taking the ratchet concept one stage on by offering an automatic system through its Safe Combination product. “An investor can pre-set his level of protection at five per cent or Ł5000 in gains. As soon as the value of his investment rises by Ł5000, the level of protection is ratcheted up to the higher amount,” says Neil Lovatt, director of marketing development at Royal London’s subsidiary, Scottish Life International. “Naturally, the more profits an investor locks in, the lower the level of risk he takes with his investments. The smaller the amount of profits locked in, the greater the level of risk he takes and the higher his potential returns.”

OUR PANEL’S PREFERRED PROVIDERS Advies Associates Tony Trail (left), partner at Advies, says structured products with underlying investments in with-profits funds have proved particularly popular, against a background of investors seeking comfort in capital guarantees. “Even though the with-profits concept was alien to clients in continental Europe until two years ago, they like the smoothed returns combined with the capital guarantee,” says Mr Trail. “Abbey National-owned Scottish Mutual International, for example, offers a minimum net return of 170 per cent after eight years. “Another popular structured product is where the return is determined by the performance of a basket of stocks. The problem is – what if one of the stocks is Enron or Worldcom?” Mr Trail adds that Advies prefers the less complicated structured products. “The more complicated the product, the harder it is for the client to understand it and the harder it is for advisers to sell it.” Advies Associates has 300 financial advisers with clients in Belgium, the Netherlands, Luxembourg and Germany Andrew Peat Group As well as capital protection, Tom Forman (left), operations director of Netherlands-based Andrew Peat Group, says clients are attracted to structured products because of the “different flavour of investments” they provide. Mr Forman highlights the fact investors can access multi-manager hedge funds and a variety of indices. He argues that another reason for the growing popularity of structured products is their flexibility. He cites BNP Paribas’ Rainbow structured products that allow investors to allocate weightings between three indices. They can choose, for example, to take 50 per cent of their returns from one index, 30 per cent from another index and 20 per cent from a third. While UK insurance companies, such as Clerical Medical, Scottish Mutual and Royal London have actively marketed their structured products in continental Europe, Mr Forman argues that banks such as Société Générale and BNP Paribas do not widely distribute outside their own client base. The Andrew Peat Group is part of the Prime Global Operation and has distribution agreements with agents in Austria and Germany, which have between 2500 and 3000 financial advisers Royal Skandia To enable intermediaries to diversify their clients’ portfolios, Royal Skandia put four capital-protected tranche products on to its list of endorsed funds in December 2001. The funds remained on the list for new investors. The Isle of Man-based insurer has not since repeated this. Angus Duncan (pictured), head of investment sales at Skandia, says it is difficult to offer four tranche products concurrently because asset managers do not necessarily launch them at regular intervals. The other problem is the limited time during the tranche window in which to educate intermediaries and clients about the capital-protected funds. The four capital-protected products endorsed by Royal Skandia were the Schroder Secure Growth Formula Plan, HSBC Equity Growth 4 Fund, JPMorgan Fleming Capital Protection – Global Growth and Merrill Lynch Defined Returns. Royal Skandia distributes Isle of Man-based offshore bonds throughout Europe via intermediaries