Hybrid debate participants
JF, chair I think we’ve probably picked one of the most interesting areas of the financial markets, in terms of development, to talk about today. The hybrid structured products market seems to have finally really taken off. Why has this happened now?
CR, Goldman Sachs From my perspective, one of the most obvious aspects is that the traditional asset classes - fixed income and equities - simply started to offer less interesting returns than investors were habitually used to, and as a result there were fewer opportunities available. At the same time, some of the less familiar asset classes, for example commodities, and some of the emerging markets, started to produce very interesting returns. One example is our commodity index, which has had returns of 20% to 25% in the last couple of years It was natural for investors to start thinking about what these other asset classes might return. In addition, from a structuring point of view, amalgamating asset classes can make sense. An example would be to take three different asset classes and look at the difference in cost between buying individual calls on each of the underliers, or buying an arithmetic basket of the three underliers. Buying the basket starts to improve the type of participation you can achieve in your chosen markets. If you take it a step further and leverage the structure by creating, for example, a worst of pay-off, again based on the original basket of underliers that you are bullish on, you find participations going to four times the original participation for the more traditional approach of buying calls on the individual asset classes. Concepts like that, which are relatively simple, clearly outline the opportunities that accumulating packages of asset classes can provide.
AZ, Commerzbank We’re certainly seeing the combination of the use of various different asset classes for risk purposes. I would add that from our perspective there was a kind of saturation with the development of pay-off provisions. All the structured product houses now have huge groups of people providing different pay-offs, where they are coming out with formula after formula after formula, and suddenly we found that we seemed to reach a saturation point in the market, so that what people became more interested in was underlyings rather than pay-offs. That’s a general trend we’re seeing now.
CR, Goldman Sachs The concept of diversification has also become a hot topic. This was originally sparked by the asset-liability debate surrounding the undiversified nature of some of the very large pools of investments backing hybrid liabilities. At the same time, the concept of diversification and the ability to play across asset classes and potentially make your returns more efficient were, I think, key pointers towards some of the more structured products that started to accumulate asset classes and provide investors with diversified returns.
SW, BNP Paribas There’s been a lot of talk on diversification but it is just one of four factors driving the growing interest in hybrids. A second factor driving demand is yield enhancement achieved through the use of asset class combinations. The third element is the investors’ market view showing increasing levels of sophistication. Rather than just looking to go long equity or to buy bonds, investors are looking at the interaction between different markets and different combinations of factors. For instance, investors may wonder about the impact of the price of oil reaching a barrier over equity-linked payoff. This is a good selling point for hybrids because they offer precisely the opportunity to express strong market views. The last element driving the demand is the use of hybrids as a protection tool. Institutional clients are buying them as a way to combine principal protection with two different exposures in a single package, thereby reducing the overall cost of buying protection.
SS, Citigroup I would add to the diversification point that commodities and inflation have in the past been significantly neglected areas with very little direct exposures. We have witnessed an increased level of interest in taking exposure on these underlying as part of a hybrid exposure. Of course, in the last year or two we’ve subsequently seen interest in gaining exposures on a standalone basis, especially around commodities.
AP, SG Hambros I certainly agree with the people who preceded me, but I would highlight a slight difference from Charlotte in the sense of where we have seen the demand for hybrid portfolios originate. In her view, it seems to be a demand that emanates primarily from disappointment with traditional asset classes. In our experience, it’s not so much the disappointment with the absolute performance of the traditional asset classes but more with the volatility of the traditional asset classes, so that’s where I have a slight difference. After all, the results in equities have not been bad in the last few years, so one cannot be disappointed with what’s happening there, even if one would have made more in speculating on commodities. But I think there is a significant concern among private clients about the volatility of the traditional asset classes. The early 2000s were very traumatic, and that has not been completely forgotten by our clients. They have been traumatized by what happened and they have not recovered from that trauma. So I think that the demand for hybrid portfolios is probably more related to the desire of the clients to have their portfolio managed in a risk-controlled environment, rather than disappointment at the absolute level of returns. I think we are simultaneously seeing demand for three things, which have to converge into one single product that we need to deliver to our clients. First, as pointed out, there is demand for diversification and the need to introduce asset classes that were not customarily introduced in a diversified portfolio, like commodities and so on. The second need is to reduce the volatility, or to ensure some form of capital protection for the portfolio. The third, which is extremely important, is, to the extent that you can create a diversified portfolio and then attach to that portfolio a certain form of capital protection, you have to be able to manage the underlying basket in a dynamic fashion. No one today will accept a diversified portfolio, capital protection, but then an underlying basket that remains fixed for a long period of time. So what we are seeing coming together here is: one, demand for diversified portfolios; second, demand for some form of capital protection or controlled risk; and third, whatever you do in terms of creating the diversified portfolio and whatever you do in terms of capital protection, you have to have the ability to manage the underlying basket in a dynamic fashion.
