JUST HOW SOPHISTICATED are high-net-worth individuals? Smart enough, it seems, to judge that they should be investing in derivatives. In a survey of UK high-net-worth individuals carried out in November 2004 by Tulip Research, 63% of respondents said that structured products should be considered as part of a private investor's portfolio, recommending that as much as 15% of a portfolio should be invested in them. Consultants say it's a trend that is sweeping the globe. "To some extent structured products have become the next new thing in the same way that hedge funds were," says Seb Dovey, head of wealth management consultancy Scorpio Partnership.
This should be good news for private banks. In a 2004 PricewaterhouseCoopers survey of over 100 wealth managers worldwide, respondents listed derivatives and structured products as one of five areas offering "high profitability". Indeed, private banks can expect to pick up an average 1.5% margin on each product sold. For independent financial advisers the figure can be even higher.
In an environment where margins are low and competition for clients is intense, positioning oneself as a leading distributor of structured products could gather the assets that private banks so desperately need, and bring in profits.
For investment banks, the increased demand is equally welcome, particularly for those affiliated to the private banks. In the same PwC survey, wealth managers revealed 42% of their derivative and structured products as originating at the parent investment bank.
But private bankers don't seem particularly happy with the newfound interest in structured products. Although high-net-worth individuals seem to be convinced that they should be investing in them, most private bankers and advisers claim to be of the opinion that structured products are of no great value, and should be avoided if possible.
"They're nothing but a gimmick," says a relationship manager. But he is forced to admit that he sells structured products to clients if they ask for them.
If you refuse to sell your customers structured products, they might just go elsewhere, he contends. And refusing to sell high-margin products does not sit well with company executives and shareholders.
It is an uncomfortable position for the private banker to be in – especially given the scrutiny that structured products receive from regulators. Selling your clients products that you believe to be inappropriate is not too far removed from mis-selling. Just how inappropriate are these products?
Although it is difficult to judge how large the market for structured products is, estimates by Morgan Stanley and Boston Consulting Group for the European retail market alone in 2002 were more than $400 billion, with a projected annual growth rate of 8%.
The most popular forms of structured products among high-net-worth individuals and retail customers are capital-guaranteed or capital-protected products. With investors having seen the value of the FTSE 100 fall 53% between April 2000 and March 2003, it is no mystery that these products are receiving attention.
These are the most basic of the structured product family, and generally consist of a bond or note whose pay-out at maturity is linked to the performance of a stock market index, single stock, basket of indices, interest rates or commodities. For example, an ultra-high-net-worth individual could invest £10 million in a five-year note with a guaranteed return of 100% of the initial capital at the end of five years plus 90% of the increase in the FTSE 100.
Capital-guaranteed products might well be popular with high-net-worth individuals but many private bankers and advisers make no bones about the lack of value these products add to a portfolio. "These are rubbish," says an adviser. "High-net-worth individuals are leaping on anything that they think is going to reduce their risk but might give them equity-type returns."
Indeed, high-net-worth individuals seem to view the product, no thanks to its being marketed as "a guaranteed equity product", as an alternative to investing directly in equities. Yet a look at the underlying reveals that with the investor's £10 million, for example, the bank isn't taking over some of the equity risk. Rather, the investor simply has less allocated to equities.
For example, the bank takes your money and buys zero-coupon bonds that, in the current market, cost £8 million. These are redeemable in five years' time at £10 million, guaranteeing that your initial capital is returned. With the remaining £2 million, the bank pays itself a fee and buys a call option on the FTSE 100.
The percentage of growth that the bank decides the investor could receive (in this case 90%) is largely dependent on how volatile that index is when the bank buys the option (which will decide its price) and then on the size of the fee that it charges.
If the index is lower after five years (which the investor believes might be the case – the reason for purchasing a guaranteed product), the investor will lose all of the option money but the bank will lose nothing. And having had their money invested in equity options rather than the underlying, investors have also been ineligible for dividends, despite having had a £2 million exposure to equities.
"If the UK market returns you 8% per annum, 3.5% of that would be income. It needs to be taken into account," says Adam Ryan, who is responsible for the use of structured products within private clients' discretionary portfolios at Merrill Lynch.
Mistaken
Similarly, while 80% of an investor's money has been exposed to bonds, no annual coupon is received. "If people think they are an efficient way of investing in equities, then they are mistaken," says Neil Wright, director of financial planning at PricewaterhouseCoopers. "You miss out on a dividend, your money is tied up over the term of the product, you're not guarded against inflation, and the costs are high."
Furthermore, equities as an asset class tend to require a time horizon of more than five years.
As Ryan points out: "If you really don't think equities are going to produce positive returns over a period of more than five years, then you shouldn't be investing in anything linked with them in the first place." And if you think the equity market is going to embark on a meaningful and prolonged bull run, says Youssef Affany, head of investment analysis and advice for Europe at Citigroup Private Bank, "keep away from these things and just buy the market".