Appetites return but tastes have changed

While at the start of the year, demand for structured investments was concentrated in those products underpinned by strong liquidity and credit quality, in the last few months risk appetite has returned and investors are building up their exposure to equities, and adding asset classes such as emerging markets and commodities that they think offer attractive opportunities for growth.

“Following positive stock market performance, investors’ risk appetite has risen,” says Georg von Wattenwyl, global head of financial products, advisory & distribution, at Zurich’s Bank Vontobel. “We see interest in equity derivatives products with coupons, since interest rates are still very low, and also strong interest in alternative asset classes such as commodities – investors include them increasingly in their portfolios for diversification purposes.”

For the first half of the year the focus in structured products was on fixed interest of short duration and high quality, driven by clients looking for yield enhancement, but since then risk appetite has returned and clients are looking at equities, believes Gavin Rankin, head of investment advisory at UBS Wealth Management in London.

“Many are looking to build the equity component and structured products are therefore an important tool for the risk averse,” says Mr Rankin.

“Alongside that core will be satellite investments, which may entail structured product exposure, for example to achieve an attractive yield or play a theme,” he adds. Plays on infrastructure in Asia and on natural gas have also been gaining traction.

“Many clients are overweight a thematic story such as emerging markets in the belief they will offer better growth over the long-term, and given the high levels of volatility traditionally associated with emerging markets, many would prefer to use structured products for their exposure,” says Mr Rankin.

“Commodity exposure is also picking up again as a play on emerging market growth or commodity shortages.”

In terms of product structure, investor appetite is for simple, vanilla arrangements, not as a backlash against lack of transparency, but rather because current pay-off profiles do not offer sufficiently better returns for those wishing to take on additional complications. “If a client can get a good return without a complex structure, then why would he want to put a complicated structure in place,” says Mr Rankin.

Shift to transparency

“There has been a shift to transparency and simplicity with greater emphasis on understanding the pay-offs and performance scenarios,” says Rasik Ahuja, head of structured products at EFG Private Bank. “There was some emphasis on thematic plays a couple of years ago, but in this environment clients are looking for direct equity exposure either through ETFs or structured products on market indices.”

The hunger for clarity is an interesting development in an industry often criticised for pushing products and product design to the detriment of an holistic investment perspective. Arguably, the typical structured product provider is culturally a distributor, with products pitched on headline rates, which means sometimes scant regard is paid to the macro-economic angle, asset allocation and portfolio planning.

Private bankers say they are shocked at the portfolios they inherit from other institutions as they are often stuffed with structured products which do not sit well together and lack a cohesive rationale. “What we have found is that a lot of the private banks haven’t really practiced open architecture,” explains Mr Ahuja. “We see a large number of portfolios full of products issued by the same bank, with limited application of a macroeconomic framework in the context of the overall portfolio.”

The issue is sometimes talked up, however. “You know how it is!” Mr Rankin jokes. “Every portfolio you inherit from another company is bad.” Nevertheless he suggests that investors should check they are well diversified both by guarantor and by instrument.

“A lot of people get confused about structured products and think of them as a separate asset class, like hedge funds,” adds Mr Ahuja. “We look at them as more of a tool to provide exposure to various underlying assets with a high degree of flexibility and often they will be used for providing capital protection, yield enhancement, leverage and access to an underlying, where there is no investible index or fund.”

In terms of portfolio strategy, the most important step is to agree the strategic asset allocation and to assess the client’s tolerance to risk. “The monitoring should start before the investment decision is made with an assessment of the investor’s risk-return profile, his investment horizon, his view on the market and specifically on the underlying assets, and then after the decision is made the monitoring should continue since the risk-return profile of his investment might change according to market conditions,” says Mr von Wattenwyl at Bank Vontobel.

Backing up

An important distinction between best practice in investment consultancy and sales-led strategies is that the former is characterised by research-backed thinking, so strategy is built out from a compelling investment opportunity rather than a provider identifying cheap derivatives to wrap into a product, with a snappy but often flawed sales pitch.

“A lot of our conversation with clients is research-led, and for us China has been a key call year to date but the solution might be either a long-only mutual fund or a structured product sitting in their satellite portfolio,” says Mr Rankin at UBS.

“Some investors have been disappointed by the performance of structured products relative to equity benchmarks. These products offer a high level of protection on the way down, but are not so good to hold onto on the way up. It is therefore important to review instruments frequently. Clients tend to forget that the capital guarantee is at maturity, and so should focus more on returns in the immediate future.”

Liquidity has never been more desirable, and this demand has been met by a raft of structured Ucits III funds that offer the daily pricing and inherent risk control of the traditional Ucits regime as well as harnessing the newer and widening powers to trade derivatives and other funds. For example, Jean-Philippe Olivier, head of Sigma Solutions, says the Parvest Step 90 Euro fund market is well regarded for its “strong competitive edge in the use of specific options strategies embedded in our funds, offering participation in the equity markets as well as permanent capital protection features, and capitalising on the transparency of daily NAV and liquidity of the funds wrapper”.

The fund, which has a 10-year track record, has a ratchet mechanism to consolidate gains in rising market and made 10 per cent from December 07 to 15 September 09, compared with a loss of 35 per cent for the market. This has been achieved by use of flexible options strategies, such as timer options when the manager wants to be long but volatility is strong, as these are much more efficient than standard call options. Pricing for timer options is dependent on volatility in the market and can cost 30 per cent less than vanilla options, depending on the characteristics dealt.

Sigma has also developed the Parworld Emerging Step 80 fund which trades options on emerging market exchange traded funds (ETFs), and is dynamically allocated to cash, exceeding 50 per cent participation in bullish markets and decreasing significantly in bearish markets.

Product providers remain keen to push out the boundaries. Gareth Parker, director index research and design Standard & Poors, says there is an unstinting desire among the big investment banks to develop more advanced concepts. “ETFs have grown massively over the last few years and while for some time people have been saying that the ETF market is too heavy, new ideas are still coming through,” he says. Indices structured as 130/30 funds have caused a particular stir as “a US concept pulling its way slowly around the world”.

Trading currency

Many providers have been structuring FX baskets on Asian/emerging currencies. “Currency arbitrage has only recently been thought of as an asset class and does appear to be a solid source of beta,” says Mr Parker.

“Most asset classes have been closely correlated in the current cycle, so risk control has come to the fore, and it’s quite usual to control volatility and risk or to manipulate a multi-asset portfolio in some way,” says Mr Parker. Major market indices are frequently manipulated to reduce expected volatility and produce a steadier return using optimisers such as the Northfield Portfolio, which creates a portfolio that delivers more return for each level of risk, adjusted to reflect differing investment viewpoints.

Products incorporating exposure to volatility have not been widely embraced, despite their potential application in recent market conditions, because volatility is difficult to forecast and to wrap into an investment product. Volatility trading or variance swaps are arguably too complicated for all but the most sophisticated clients.

“The Vix index has always been difficult to track,” adds Mr Parker. “With State Street, we developed a way of mimicking holding the underlying futures in the Vix, and rolling them, and so on. This has been a very popular and fast-growing ETF. Volatility does have a place, generating a consistent return over time, but it is less about looking for diversification of returns and more about the search for new assets.”