Structured products: Keeping it simple

STRUCTURED NOTE SELLERS have good reason to reconsider the types of payoffs they offer investors. The credit crisis has lifted the lid on the can of worms that was the structured credit business. It has also had the knock-on effect of making investors wary of anything bearing the tag "structured", including complex equity-linked notes, which are far removed from the world of securitization.

Investors have also noted the underperformance of some of the more difficult to understand products, such as those that gave access to equity market correlation. Dealers say investors are signalling that they no longer want to sit through a lecture where every second word is "rho", "gamma" or "vega", but would rather hear an interesting but simple investment story that they can understand.

This has raised demand for less quantitative-driven and more transparent payoffs, say dealers, and has partly led to a shift away from highly complex products. Instead, banks are pushing a new generation of payoffs, some of which try to present, in note format, the type of alternative strategy usually only associated with hedge fund investing. Since the start of the year, several banks have issued notes based on equity long/short strategies for example. The structured note offerings, however, tend to be constructed on a managed rather than a discretionary basis, offering investors the transparency they demand. As one banker puts it, it’s a "glass box rather than a black box" way to make an alternative investment.

This can also be seen as an attempt by the investment banks to gain a foothold in alternative investments, given the amount of investor cash that has flowed into hedge funds since the start of the decade. Structured note versions of hedge fund-type strategies also charge much lower fees than hedge funds – some just 1% a year. With more investors starting to view the hedge fund fee structure as purely serving the needs of the manager – because failure is rewarded as well as success – while the ability of hedge funds to actually generate alpha is also being questioned, structured note issuers are slowly making their way into alternatives.

Another approach increasingly being used is to construct automatic trading strategies, which again are presented in note format. Some of these use the recommendations of in-house analysts to come up with automatic stock-picking strategies. For example, an algorithm can be constructed that picks the top performers from a universe of several hundred stocks based on some fundamental criteria, such as dividend yield, and re-balances the portfolio at set intervals to maintain an optimal exposure.

The aim with these types of products is to convince investors that they are placing their money on a relatively simple but still smart trading strategy, rather than a highly complex and technically impenetrable payoff. "Structured product makers always used to battle to be the most innovative house and to come out with the most complex solutions, which was why we started seeing products that gave exposure to volatility smile, to forward smile and this kind of thing. The problem was that even the more sophisticated investors were not able to understand what was driving the behaviour of these assets. That meant that if a strategy ended up not being successful then it was difficult to explain why," says Pierre Bes, head of private banking coverage for Europe at Barclays Capital in London, adding that investors are now looking for "simple and intelligent" ways of selecting underlyings. "Investors want simplicity and transparency," he says.

Strategies

All the big structured note issuers are working on new automatic strategies that can be wrapped in note format and sold to retail and institutional investors. A number have already hit the market. At the end of February, Barclays Capital launched the Commodities Out-Performance Roll Adjusted Liquid Strategy Index (Corals Index), which aims, through analysis of fundamentals, to capture alpha from the commodity markets. The index invests in 12 liquid commodities that the bank’s analysts predict will, as a portfolio, perform well on a risk-adjusted basis.

"The price appreciation that the commodity markets has seen is based on strong fundamental factors such as rapid growth in emerging economies and sustained demand from developed countries versus the numerous constraints that continue to hamper supply growth. Consequently, commodity prices will continue to face upward pressure," says Kevin Norrish, London-based director of commodities research at the bank.

"Even the more sophisticated investors were not able to understand what was driving the behaviour of these assets" Pierre Bes, Barclays Capital

The rationale is that quality companies, which have earnings that are better than expected, don’t often display an immediate move in price because the market should already have factored in any potential surprises. Any new upside will emerge afterwards, once the strategy has taken a long position in the stock. The Q-Bes strategy is then used as the basis of structured notes where the earnings surprise algorithm is overlaid with a long/short strategy, going long the earnings surprise strategy and short a broad equity market benchmark – the S&P 500. Investors can then take exposure in principal-protected or other structured note formats.

JPMorgan is also selling structured notes linked to the performance of an index that tries to extract alpha from the commodity markets. The bank describes its Commodity Igar Long-Only index as a momentum-based algorithm that seeks to maximize the performance of investments in a selection of commodity sub-indices. It uses derivatives to take exposure to up to 12 different commodity sub-indices, covering agriculturals, metals, and oil and gas. The bank offers exposure as a capital-protected note, in synthetic portfolio insurance form, in total-return swap format, and as a delta-one note.