The maturing of structured products

Scandal and regulation have been predominant factors in the UK structured product market. The industry has much maturing to do, writes Paul Burgin

The British structured product market is different from its European cousins. Products tend to be simpler, regulation heavier and distribution more fragmented. IFAs control less than one quarter of the structured market but have a lot of clout in defining public opinion. The precipice bond scandal and collapse of Eurolife, Arc, DRL, Keydata and NDF still loom large.

Chris Taylor of Blue Sky Asset Management says events and regulation forced change, but not every provider has learned lessons from the past.

“There is still a polarised and clear distinction between best in breed and also-rans. Proprietary distribution, tied salesforces and shareholder pressure still motivate some to use opaque higher-margin structures,” he says.

Growth

Despite the setbacks, the industry has grown from just 20 providers a decade ago to over 100 today, issuing around 1,000 products per year.

The UK Structured Products Association says: “The retail market, which is still dwarfed by institutional use of structures, has over £42bn invested and is still growing.”

It continues: “Structured products are examined more closely than any other type of retail investment and are still popular since investors like buying investments where the parameters for gain and risk are clearly defined.”

The collapse of Lehman Brothers put risk and transparency in sharp relief. Even though British investors escaped relatively lightly compared with those in Asia, the fallout was widespread. Advisers and investors were quick to demand more detail on products and counterparties.

Communication

“In the immediate aftermath of Lehman, marketing and communication was key. We provided supplementary material on how products work and details on counterparties,” says Sophie Barnett at Morgan Stanley.

New products were devised to calm investor fears of further defaults. For a while, gilt-backed vehicles were popular even if they came with a heavy cost to payoffs. Structured deposits remain big sellers thanks to their inbuilt FSCS protection.

Barnett says the industry is still developing credit-risk options to protect investor capital. She thinks the next big push could be structured funds.

Using the Ucits wrapper for structured products seems a no-brainer. Funds are highly regulated, custodial powers segregated and vehicles must be liquid. They also have the additional advantage of being familiar and more easily accessible.

But the Ucits solution comes with its own issues. Setting up a fund takes time and money. Inflows must be gathered quickly to avoid additional complication and hedging costs. The format works well on the Continent where banks can be certain to attract millions if not billions into new fixed-term funds.

Hope

Fondos garantizados offer a glimmer of hope in the Spanish fund market which continues to lose investors and assets. Structured funds already account for almost 30% of AUM and will gain this year as 278 issues worth e16bn reach maturity. Spanish banks must provide additional underlying guarantees funds will pay back capital if they default. As Spain’s sovereign and savings bank credit ratings slide, many distributors cannot underwrite guarantees themselves on new funds designed to retain maturing client money.

Ucits funds do at least offer an element of liquidity. Continental funds provide set exit windows or impose penalties if investors leave at other times.

Sophie Barnett admits the British structured product market could do more to develop a secondary market for ordinary investors. “Although providers now offer daily or weekly pricing, the information is not completely transparent. You can see the underlying asset rise or fall, but there are lots of other factors like interest rates, credit rating and volatility that affect the actual structured product price,” she says.

Judgement

Discretionary managers already have ‘look through’. Barnett says: “They can judge when is the optimum time to come out of a product. When many products were pricing below par, they also used buying opportunities for capital-protected products.”

Technology is not a barrier to developing a retail secondary market as administrators can already provide pricing. “But the UK is not like the liquid German market. Products are different and so are investors. It is about education, learning about when to lock in returns and about rebasing,” Barnett adds.

The RDR may be the impetus for such development. Advisers retaining their independent status will have to consider structured products and other alternative investments such as ETFs from 1 January 2013.

Platforms

Wrap platforms are already adding in structured products to their ranges. Fund platforms will likely follow after the FSA’s platform review. In the meantime, the FSA’s recent review of structured products is causing difficulties, thinks Gary Dale of Investec.

“Unfortunately, the FSA guidelines are now being read as law. Lots of networks have taken them literally,” he says.

Clients with no capacity for losses are being offered mutual funds, not structured products. Standardised risk profiling by larger IFA networks is lumping all SPs as high risk, not looking at each underlying index and associated counterparty risk.

When it comes to diversification, the regulator’s example of an adviser setting limits of 10% portfolio exposure to a single product or 25% exposure to multiple products is also being taken verbatim, Dale says.

More adviser education is needed, he says. The development of standardised soft information on indices, counterparties and spreads should help advisers in the future, providing it is independent and inclusion is not dependent on product providers paying a fee.

Love/hate

Until the RDR goes live, structured products remain very much a ‘Marmite’ product for advisers – some love them, some hate them. Colin Jackson of Baronworth is a convert to the cause.

He thinks transparency has helped, but the low interest rate environment has had a bigger impact on demand from income seekers. “With rates so appalling on the high street, investors accept they have to take some risk to capital. They used to go for guaranteed bonds, but not any more,” he says.

Those low rates are pulling down payoffs. Providers are experimenting with new formats, indices, ‘best entry’ or ‘tracker plus’ issues. Jackson warns them not to risk their reputations for the sake of headline rates.

“Some are far too clever for their own good. We stick to things clients like. We prefer only one index and something that is easy to understand,” he adds.