Paul Burgin says growing numbers of advisers and wealth managers are building their own bespoke structured products
Retail structured products offer access to capital guarantees and index-linked upside. In auto-callable format, they allow investors to take profit and switch to other vehicles as market conditions change. They also have their disadvantages.
Firstly, retail products are built to attract the maximum number of investors. In the UK market, that means simple structures, typically 100% capital guarantee and usually only one index – usually the FTSE 100. Access to other indices or asset classes is often limited.
The marketing apparatus surrounding retail issues is also costly. Brochures, prospectuses, advertising and mailings all eat into the available pot of investment cash, reducing protection or payoff, or increasing counterparty risk. Adviser commission diminishes the pot further.
Market conditions
Changing market conditions can limit any single tranche’s appeal. Offer periods last a month or more, requiring hedging to protect offer terms and conditions. But the cost of hedging eats into those initial product features. If volatility increases, products with better features may come to market during the offer period.
Retail structured products are also a ‘buy and hold’ investment. They have limited appeal to discretionary managers who need flexibility and the availability of a liquid secondary market.
The solution is to opt for bespoke structured products that fit particular client or portfolio needs, thinks John Husselbee of multi-manager North Investment Partners, an early adopter.
He says: “Our first experience was with off-the-shelf institutional products. The next stage was bespoking, which unlike having a tailored suit made, is even cheaper.”
The key to a successful structured product is knowing exactly what you want it to do, thinks Husselbee. “You have to see an anomaly in the market, then speak to the investment banks to see if it really exists. Then you work out the best way to play it,” he says.
The effect of Lehman
Since the collapse of Lehman Brothers, investment banks have improved the transparency of their structured product services. Husselbee says: “There are more people willing to talk and help build bespoke products. They have set up these platforms so it is not about rebuilding terms and conditions each time. It is becoming a boilerplate operation.”
Having had to make the first approach, Husselbee is now regularly contacted by investment banks with ideas. He receives many calls during each month but takes up very few offers.
Case study
Wealth adviser Intelligent Capital has around £100m in assets under management. It has already offered two bespoke income products to its clients. Both were well received and the company plans to launch another in a few weeks.
The firm last sold a retail offer in 2003. When it wanted back in, managing director Graeme
Forbes thought the company could get better terms on the primary market for a pool of clients.
He says the company’s ability to obtain client subscriptions quickly was also a great advantage.
“We can put together a product and gather money in a number of weeks. Hedging in the offer period eats into the coupon so we keep it to a minimum.”
Intelligent Capital’s first issue was agreed with Barclays Wealth – whose retail products it had previously sold – on ‘minimum terms’. Clients were told about the capital protection, the counterparty and the potential return. They were also told they may get better upside once the product struck, but that this could not be guaranteed.
“In the end we could not beat the initial 8% income return. But it was still a no cost exercise for clients,” says Forbes.
The two products already issued have been annual kick-out plans. One of them recently terminated and earned investors 13.5% over the year. Not surprisingly, Forbes says those clients are receptive to repeating the experiment. Future issues may be more exotic.
No matter how complex the underlying, due diligence is an important part of the process. Intelligent Finance employed external consultants to add to its own in-house research on providers and counterparties.
Shop around for the best deal
Stuart Fox of City Asset Management thinks wealth managers must shop around to find the best deal. He says: “You have to rely on the investment banks, so you have to ask several of them to price them up and then compare.”
He says option elements are fairly standard, so a few calls will establish whether the upside element looks fair value or not.
The credit element that provides the protection is more difficult to judge, although CDS spreads and durations should indicate a rough range. “You need to understand volatility, the time left on the product and other basics, but leave the actual workings of the product to the investment banks,” advises Fox.
The company currently has 15 structured products on its buy list. Investments equate to around £25m of the firm’s total £350m under management.
Its first product was the result of City Asset Management’s extremely bearish outlook in 2008. Morgan Stanley helped formulate an accrual strategy that added to the pot every day the FTSE 100 remained under a certain level. The maximum index level for the digital options was set high – 50% over the level of the FTSE at strike date – to ensure it paid out regularly.
Subsequent products included synthetic zeroes, recently swapped for a ‘best entry’ tracker. Fox says he has been careful to spread credit risk between Morgan Stanley, Goldman Sachs and Citigroup. The company uses Société Générale and BNP Paribas for more complex and commodity based products.
Concentrate on credit
Stephen Ford at Brewin Dolphin is a veteran structured product investor, playing them since 2000. He says due diligence has to concentrate on the credit side as that is where most of investors’ money goes.
His first product was linked to a basket of equities that included Worldcom – not an auspicious start for upside returns. Thankfully, the product behaved unexpectedly on the secondary market and Ford was able to get out and move on. It proved a valuable lesson. Ford says: “I obsess with the credit. I can get better terms by taking slightly dodgier products, but why would I want to?”
He limits his counterparties to banks that are systemically important. When he held Merrill Lynch credit, knowing it was linked to Northern Rock, Alliance & Leicester and Bradford & Bingley meant a British government rescue was more likely, as proved the case. Likewise, Ford only bought his first Goldman Sachs-backed product last year after it became a commercial lender with exposure to the Fed window.
Ford believes there is more to consider than just credit ratings. Jurisdiction, ring-fencing and winding up rules in different domiciles need consideration.
Ford avoids independent structured product packagers, with the exception of Catley Lakeman which is helpful on pricing and less accessible bank asset classes. He says: “What can the other independent players really add? They certainly do not pay enough attention to the credit risk.”
Concentration risk
Chris Taylor from independent packager Blue Sky Asset Management disagrees. He admits neither direct nor independent providers have a monopoly on product ideas or capabilities. But independents have advantages when it comes to counterparty selection, diversification and cost.
Taylor says: “Banks restricted to offering product based solely upon their own internal treasury team inevitably bring ‘concentration risk’ to client’s portfolios, over time.” Independents can dilute risk further by accessing counterparties with no presence or direct offering in UK retail.
In the same vein, independents offer an unfettered choice of investment strategies. He adds: “No bank can profess to be industry leading across all markets and asset classes, at all times.”
Taylor refutes the argument packagers add an unnecessary layer of costs to bespoke products. He says: “It is a misconception independent providers are an extra mouth at the table.”
Without their competitive leverage, overall product terms would likely become less competitive, thinks Taylor. Gross fees for independents are often lower than big bank competitors, particularly where indirect bank products marketed by retail divisions are concerned.
Discretionary managers
Marc Chamberlain of Morgan Stanley’s structured product division says investment banks are keen to hear from new clients. He says: “We have discretionary managers, for the smallest to the largest nationals. And we are offering bespoke products to larger IFA firms. We get referrals from other clients, but we are being proactive too, looking for managers we have not had contact with before.”
Investment minimums have fallen in recent years as an element of commoditisation has taken place in the structured market. Chamberlain says £1m is the normal entry point, but it is not set in stone. He says: “A small size will usually grow. The differentiating factor is the secondary market. Discretionary managers can make decisions quickly. So we may issue a smaller size first as a lead order.”
Market makers such as Morgan Stanley can sell lower initial volumes from its own inventory knowing the product can be sold on to other interested parties, or that the particular structure within a fund may subsequently attract more monies from inflows.
