Delegate biographies: Learn more about the panelists
| Executive summary
• The structured products market has become much more of a mass-market business, attracting ever greater amounts of retail interest
• Structured products have also become more commoditized and transparent
• Sophisticated investors understand that structured notes are very different to asset-backed securities
• Issuer credit risk is becoming a much bigger topic
• Structured notes that involve the investor selling volatility are popular. However, pure volatility, correlation and dispersion plays are still the purview of highly sophisticated, specialist investors
• There is a lot of interest in wrapping systematic trading strategies |
JF, Euromoney: This is a particularly challenging and interesting time for providers of structured notes. But before covering the most recent market upheavals, let’s talk in general about how the market has evolved over the past few years. Albert, what changes have you seen?
APl, Citi: Within the structured products business over the last two or three years we’ve seen a massive expansion in two ways. First, market reach has become much broader, so it has become much more of a mass retail type of market. This in itself produces some challenges in terms of how we present products. But second, we’re also seeing that private clients, through the private banking networks, are now starting to integrate derivative strategies and structured products into the core parts of their portfolios. Private investors and private banks are no longer viewing structured products as a satellite allocation, or something to be slotted into the portfolio as part of the alternative allocation, along with an equity component and a fixed-income component, and so on. Instead, we’re seeing structured products being used to overlay entire portfolios as the core part of the asset allocation. High-net-worth investors have become much more conscious of what structured products can achieve.
GC, Credit Suisse: We use structured products as an element of portfolios to help dampen down volatility within those portfolios. We also use them to give exposure to areas that are risky. So we might use a structured product where there is a fat tail risk effect but where we want to gain the exposure because the returns could be attractive. The structured product lets us recognize the fact that there’s a risk there that can emerge from time to time. An example of that might be, say, an equity position on the Taiwan market, where occasionally there are frictions with China and you can get sudden movements in that market. So we tend to integrate structured products as part of the core investment, and use them to diversify risk, or add a little bit of risk skew into the portfolios.
ZM, RBS: The structured products market has become a lot more commoditized and far more transparent and, as such, a lot more competitive as well. Also, I think we have a far more educated client base in terms of the intermediaries who are sourcing products for their clients. It does seem as if structured products are moving more into the mainstream, but I think it’s a very slow journey. Our experience is that a lot of the newer fund managers are now more open to new ways of delivering alpha, and are far more familiar with structured products. Rather than putting nought to 5% of their portfolio in structured products, some fund managers are now prepared to go up to 10% to 20% of their portfolio.
APo, SG Hambros: From my perspective, I would say that the private banking clients that represent the upper end of the market are rather sophisticated and very receptive to structured products. Also, as has been alluded to, the relationship managers that we get today in the private bank are a very different breed to what they used to be. So not only are the clients becoming more sophisticated but the relationship managers also now have a much better understanding of what they are selling. Last, but no means least, the technology has evolved in terms of constructing products. The structured products themselves are becoming more sophisticated and more flexible in giving clients the opportunity to play a significantly wide variety of investment themes. Also the technology for ensuring the capital guarantee has become far more sophisticated. So, overall, I think we are still in the midst of quite a significant expansion of the market for structured products in terms of the quantity of the structured products we are selling but also in terms of the quality of the products and in terms of the degree of sophistication of the clients.
APl, Citi: One of the developments of note that has taken place over the last three or four years is how the product set has grown up from the point of view of the range of services that are built around it. Liquidity is the obvious first point. People should now be in a position to view structured products as being as liquid, or almost as liquid, as any other type of investment – the investor can expect a daily secondary market, and a guaranteed bid-offer spread on most products. With that, I think the industry is starting to get better at addressing issues around the quality of marketing material. At the end of the day, a structured product is only as good as the description of the concept on paper. I think we’ve got better at that over the years. But this cuts across the whole range of services, from educating the workforce to expressing how products work and giving people interactive tools to be able to understand the life within a life that a structured product has. We’re even recording educational videos that we show on our website.
JF, Euromoney: Let’s move on to talk about the credit crisis and the effects, if any, this is having on the structured note market. Are investors making the distinction between asset-backed structured credit exposures and what we would refer to as structured notes, or structured products generically, which of course are traditionally originated out of equity derivatives desks, even though today almost any exposure can be taken synthetically? Is the "structured" tag having a negative impact on all derivatives-based investments?
APl, Citi: I think people who are more actively engaged on a day-to-day basis in the marketplace understand the difference. It could have a greater impact on the confidence of people at the retail level.
ZM, RBS: In the UK, at least, while we in the industry refer to these things as structured products, this isn’t necessarily the case in the public domain, where they might simply be referred to as a deposit, for example. As a result, I don’t think retail individuals specifically view us as "structured product providers" per se; ultimately this is a term we use internally.
Having said this, I do think that perhaps an upcoming issue will be the creditworthiness of some of the providers that are offering these structured products. That is potentially looming on the horizon, and it’s something that we should all be very conscious of. There are a lot of issuers out there with varying levels of credit rating. Do we believe it’s very clear and precise to clients what risks they’re taking when it comes to credit risk?
APl, Citi: No, I don’t. To go back to the original question, I don’t think structured products are suffering too much today because of the association with the CDOs and other structures that have taken a hit. There are other issues that concern investors, such as the general market volatility. I do, however, think we have seen some retrenchment but then structured products obviously present investors with some very clear advantages in the current market, because they let them play the market with a certain amount of protection. So from that point of view there could be a big comeback. Also, I do agree with Zak that sensitivity to the credit quality of the issuer dominates the market today.
APo, SG Hambros: What is important from the point of view of the client is whether they go for a product with the better price, or the one with the better credit. Sophisticated clients are beginning to think in terms of diversification, so even if they were willing to take an EMTN from a particular issuer because it’s a good price, then they will not take them all from the same issuer. So they’re trying to diversify their portfolios in terms of credit issuing.
GC, Credit Suisse: The only impact we’ve seen from a client perspective is a focus on what the underlying of the product is. As long as the underlying does not fall within one of these areas that have had problems, then clients are not worried too much. And one of the things we have noted is that pricing is still quite aggressive across all the banks that we approach.
JF, Euromoney: Let’s now look at how investors can use structured products in the current environment. What products should investors be considering in an environment of sustained higher implied volatility?
GC, Credit Suisse: Well, clearly the structured products that involve selling volatility are to the fore at the moment. Generally speaking, it’s the yield enhancement notes that are doing quite well. So investors are looking to get good yield coupons on indices. Less sophisticated clients will probably be interested in an index-type structured note. More sophisticated clients might do a similar kind of note but with a focus on sectors that have fallen substantially in value.
ZM, RBS: There are structured products that can be used in any type of environment, and, of course, in times of high volatility there are a number of different styles of products that can be used to generate higher yields and create the kind of alpha that people are looking for. One of the key factors is market confidence. If everyone feels that the market is going to fall, then no matter how wonderful your product, you’re going to have problems selling it. In terms of the types of products that you can do, as George mentioned, it’s really about selling volatility. So you could look at range accruals, reverse convertibles, auto-callables.
APl, Citi: Looking at it from a retail private client’s perspective, I think people are still more interested in the underlying story. So we are seeing more and more interest in, for example, access to research-based products. We will take a piece of research, look at whether it has worked in the past, whether it still has legs, and if can we structure it into an interesting product. It’s also worth noting that we talk of a high-volatility environment, but actually it’s probably more of a normalized volatility environment. Over the last three or four years we’ve had particularly low volatility. A lot of that is probably due to the large amount of overwriting strategies put in play, which is depressing individual single-stock volatilities. So there have certainly been a lot more sellers of volatility, but the pressure of what’s happening in the marketplace has now pushed through that natural supply. But that means volatility is actually back to more like its 1970 to 2004 levels. I do believe, though, that we shouldn’t be driven by the market parameters. We need to design products to suit these particular market conditions; we need to look at the underlying fundamental story and at what types of pay-offs make sense given those market conditions.
Successful strategies
JF, Euromoney: I’ve heard there is a lot of interest at the moment in structuring products that essentially wrap some sort of systematic trading strategy into a note. So there seems to be a lot of interest in creating structured notes linked to a systematic equity long/short strategy or systematic FX carry trade, for example.
ZM, RBS: Long/short strategies are clearly very successful at the moment, so people are definitely looking to take such exposure. With these products, investors are obviously moving into the hedge fund-style, absolute-return environment, and that clearly is happening more and more. I think people like the greater transparency of a note, so the money’s coming in as a result of it.
APo, SG Hambros: Going back to what was discussed before, I completely agree that the fundamental story is a very important one and that the product should not be driven entirely by a play on volatility, because I think it’s quite clear that the current market environment, where we have falling interest rates and higher volatility, is a difficult one for structured products. Investors are seriously tempted to do yield enhancement products where they’re selling a put option on a certain underlying, and there is certainly some merit in doing reverse convertibles and so on. But these products could also be a trap. Take reverse convertibles on financials. I assume the people who did that trade are not terribly happy, because it’s quite possible that they now own the underlying stock. The client has to be kept aware of the fact that there are two categories of products, ones that have been designed for clients with a low-to-medium risk appetite, and then ones, like the reverse convertibles, that are designed for clients with a high appetite for risk.
GC, Credit Suisse: Indeed, I think the client has to be happy with the underlying, without a doubt.
APl, Citi: Getting back to the appetite for new underlyings that are more active, I think people have got used to static, index-type underlyings, and now, given the convergence between the structured products industry and the traditional investment management industry, investors are looking for a bit more activity from the underlying investment themes we might choose. That could be as simple as saying we rebalance based on our research. Going forward, I think many more structured products will have to be tied back to something that is more active than a passive index. Also, I think the market has matured somewhat in that you can’t really differentiate yourself any more on pay-off. Three or four years ago a lot of energy would have been spent coming up with a new, clever pay-off. Nowadays, basically any investment bank can price any arbitrary pay-off in about 20 seconds, so product providers can’t differentiate themselves on pay-off.
JF, Euromoney: So is there anything that could potentially look innovative at the moment on the retail side? What about supposedly latest generation products such as dispersion notes?
APl, Citi: You can wake up in the morning and find that assumptions on correlation or volatility that were valid yesterday have suddenly changed overnight. And I don’t think there are many investors that have internalized that to the same extent they’ve internalized a view on the stock market interest rates, or even foreign exchange. As a personal view, I don’t think there is currently a place for selling pure volatility or dispersion or correlation to retail investors.
GC, Credit Suisse: I agree with Albert completely. I don’t think there’s any demand for some of these things, like the dispersion notes. Clients, even sophisticated private clients, like to feel that they know what sort of outcomes they’re going to get or where their profit’s going to be made.
Not zero-sum games
JF, Euromoney: Is there also a danger with these types of products that investors will be wary of banks looking to sell them certain types of risks simply to balance their own trading books?
APl, Citi: These are not zero-sum games. It’s not that if one side makes money then the other side must lose money. People have opposing views on markets. Demand from hedge funds, for example, is often the opposite of the demand among retail, so you can structure products that will suit both types of investors, and essentially try to offset some of your risks that way. I think we can strip out the various elements of risk that people are comfortable with managing, and feel comfortable having a view on. Then we can isolate those from the other risks, and find where the best appetite for those risks are in the marketplace. So you can have the situation where both sides will essentially be able to make money from taking opposite sides of the same trade – whether it’s hedging a position on a trading book, a retail investor protecting their capital, and the hedge fund providing some supply on the volatility side. The point is that pure volatility, dispersion and correlation don’t necessarily belong in the retail and private client space. There are better parts of the marketplace that can manage, understand and absorb that type of risk.
ZM, RBS: On the point of having a fundamental view and then using structuring to take that view, there’s a debate there about how much value added that fundamental view provides. How good are people at calling the market correctly? If one finds a mathematical formula that works, then it should perform, irrespective of an individual’s qualitative view.
APo, SG Hambros: Zak, you may be right, because I realize that no one has a crystal ball, and some of the views that the strategists take are wrong. But you would still have to have a good story. So I agree in the spirit of the dialogue that you suggested, but if you find a good algorithm, a good mathematical formula, even though it may be more productive than taking the view of the market, you still have to articulate that story and be able to explain it to a client. The client will not accept a black box-type of explanation that says: "Trust me, I know what I am doing."
JF, Euromoney: Shall we talk about principal protection and CPPI [constant proportion portfolio insurance]? What type of principal protection makes sense at the moment?
APl, Citi: CPPIs in general don’t like volatility. They tend to over-trade in more volatile markets and are designed to perform at their best in a single-direction market moving firmly upwards. By contrast, take the standard cash-plus-call type of product. Even if the market drops 20% then recovers 20%, the investor is back to where they started. With a CPPI, if the market goes up and down 20% then you’re not back to where you started, you’re back with a lower allocation. So CPPI tends not to like volatility. But there are very few CPPI products that actually cash-lock. The investment can end up crawling with not much hope of recovery, and so may never turn back into an equity-like investment, whereas something where the investor bought volatility will essentially turn back into that type of investment again.
JF, Euromoney: So if you were putting together a structured note just now, with full principal protection, would you be going for a zero-coupon bond?
APl, Citi: I think what works again has to depend on the fundamental view you take on the marketplace. I’m reluctant to use the word expensive, because expensive for options is relative to what the underlying price will actually turn out to be. But relative to recent years, yes, volatility is expensive. If you wanted access to the market at this point in time and you believe markets are in a position to recover – so you’re buying a growth-type of product with protection – then you’ll probably want in some ways to maximize your potential participation in the recovery. But it’s probably a better time just now to look at 95%, or 90% protection, rather than 100% protection, which is quite expensive. You could think of a product that is 100% protected just now being like a product in a higher interest rate environment that is 105% protected. Do you really need that 5% protection on top in a low interest rate environment, or are you willing to give up some for share capital?
GC, Credit Suisse: I’ll give an example here. We were looking at a note six months ago that would give 100% protection with 100% participation in the Nikkei index. Now, just the other day, we were trying to structure a similar note but were only getting 45% participation with full capital protection. So yes, participation has really suffered. Fundamentally, it feels like you can take a bit of risk with the protection; you can lower the barrier a bit to get some money to buy more upside participation to play a recovery.
Expensive protection
ZM, RBS: At a high level you would naturally say that in an uncertain market why wouldn’t you want to be locking in your gains and looking at 100% protection? It appears an obvious call. But I agree with my colleagues here – in a falling rate environment the cost of that protection is just too high, and the clever money is looking at the leverage plays, at the opportunities that you see for growth, and at accepting more risk. And I think that at-the-money quotes are not necessarily where you want to be either, but rather soft protection, the down-and-in put-type structures, are more attractive because the markets are so depressed.
APo, SG Hambros: Absolutely. In an environment in which you need protection, protection will be more expensive. Obviously the cost of protection is higher today because of lower rates and higher volatility but protection is still needed. I think the answer is to find a lot of techniques that allow you to get the protection but which mitigate the cost of volatility, and you do that, as everybody here round the table has indicated, by lowering the level of the guarantee, by choosing options such as Asian options, or by introducing caps and barriers. That makes a lot of sense in the current environment. So the need for protection is very clear, while the fact that the protection is more expensive to buy is also very clear.
JF, Euromoney: Let’s finish by talking about real fundamentals. How are investors to position themselves, given rates and inflation outlooks for the future?
APl, Citi: I don’t see a huge amount of appetite for taking a pure inflation view. If an investor is putting money away on a 10- or 15-year basis then I think it is becoming increasingly interesting for them to look at some form of inflation protection. But for three- or five-year investors, even those that have traditionally looked at capital protection or a minimum return and who see that if inflation does turn out to be an issue then that hurts real performance, I don’t think they’re overly concerned about inflation per se. In saying that, from a trading perspective it’s relatively easy for the marketplace to provide solutions today, and it’s usually a hybrid desk that will look at something that has an element of inflation. It can work well in terms of diversification as part of a cross-asset product. The other thing we’ve seen is inflation being used as a trigger for an asset allocation strategy. So under certain inflation situations the product will automatically have an exposure to commodities, while under other inflation scenarios it will have an exposure linked to equities and so on. That’s more of an automatic type of trading strategy, and not necessarily inflation protection, but we certainly are seeing more recognition, let’s say, of inflation.
APo, SG Hambros: I personally fear inflation. I think that we are moving into a more inflationary environment – all the ingredients are there. I think what people have a tendency to consider as temporary elements have actually become structural. Headline inflation figures may exclude energy and food. But the problem is that not only are energy and food important, but the increase in the price of energy and food is not a seasonal development, I think it’s a structural development. There are significant reasons to believe that, with the China and Asia story and so on, and the obvious increase in demand for commodities, which is worldwide. So what do you do in the current environment? Obviously you can do products that play directly on inflation, but I think it is more interesting to look at commodities, such as oil and gold, which usually serve as hedges against inflation, and to try to develop structured products based on the underlyings that would react by going up in price in an inflationary environment.
GC, Credit Suisse: I agree with those comments. But I think one has to be careful of some of the commodity indices that products can be attached to, given things like negative roll yield, which has meant on some indices you couldn’t make any money on them because the futures were so expensive. We’ve been looking at things like getting a more active underlying index; such an index has rebalancing moments, for example, in using fixed weightings across a range of commodities. If you look at a run on corn for example, you know corn is doing extremely well, and this will draw farmers into planting more corn, which will eventually lead to corn going down in price, and then some other commodity will go up. So you have to have a look at the slightly smarter indices that can play these cycles within the long-term trend of what you’re trying to do with a commodity in terms of hedging against inflation.
Inflation hedges
ZM, RBS: Clearly, as we’ve heard, we can deliver products that are aimed at performing well or protecting against rising inflation. The unfortunate thing is that hedging for inflation is expensive, which means that optically you get products that don’t look so great. The result is that you get products that don’t look that great in terms of pricing against a subject matter that clients don’t understand that much and are not that worried about. So you can get the situation, certainly in the retail space, where it’s too expensive to deliver something that has limited value to the client, and therefore you don’t see a great amount of it.
APo, SG Hambros: One thing to remember is that from our point of view in the private banking world, inflation for the wealthy is significantly higher than for retail.
GC, Credit Suisse: It’s about probably around 7%.
APo, SG Hambros: It’s much higher than the CPI [consumer price index]. So to the extent that you can come up with good products that actually hedge against inflation, you can find a rather receptive audience among high-net-worth individuals. Ironically, they feel inflation more than others.
ZM, RBS: Certainly, in the retail space in the UK, people are more concerned about house prices than inflation.
