Safe but sorry

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By:
Helen Avery
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Burnt in recent equity market sell-offs, high-net-worth investors are clamouring for investment products that will preserve their capital. But private bank advisers are on the whole unconvinced that structured products, outside of limited use for tactical asset allocations, offer adequate returns or are sufficiently cheap and transparent to recommend to their clients. Helen Avery reports.

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".

Some market participants argue that for relatively long-term investments a strategic asset allocation is a more sensible approach to risk than a capital-guaranteed equity product. "If the asset allocator has done a good job, the investor will be operating within his risk tolerance and should not need to pay a financial premium to keep him out of the danger zone," says one observer. David Offen, a member of the relationship team at ABN Amro that works with third-party private banks, agrees. "For the mass affluent market, capital-protected products make sense," he says. "But at the upper end of the market there is little need for the products. An investor there would have a dedicated investment adviser to manage and monitor the portfolio. With a portfolio manager, capital protection almost becomes redundant."

Where capital-guaranteed products can be valuable is in tactical asset allocation.

JPMorgan Private Bank, for example, uses the products as a bridging solution for business owners who have just sold their companies. "In Europe, we're finding a fair number of our clients are cashing out of their family businesses as the M&A market picks up," says Rhian Horgan, head of structured products at JPMorgan Private Bank in EMEA. "When they sell that business they need to think about preserving that wealth. But how do you move from 100% cash to a diversified portfolio? Readjusting to the public markets takes some time, and to develop a framework takes a couple of years. But if they sit in cash, they could be missing out, so we use some of these capital-protected products to start diversifying the portfolio.

"We tend to look for opportunities to earn two times cash and believe it makes more sense to use these products tactically, keeping tenors short between one and three years. In retail it's different as people are putting money aside and planning not to touch it, but for high-net-worth clients, these products should be short-dated. Last March and April as equity markets bottomed out, we used equity structures with a one-year tenor."

There are other examples of the use of structured products in tactical asset allocation. "Sometimes after a risk profiling of a client, it can emerge that a client who has been sold a 70% equity allocation should in fact be holding just 30% in equities based on their attitude toward risk," says an adviser. "How, and how quickly, the excess 40% should be reallocated can be resolved by the implementation of structured products. The tendency would be to exit as quickly as possible, but rather we would advise the client to invest the excess in a guaranteed equity product. The investor is therefore insulated against further apparent losses but participates in the recovery. When the market does recover, the product can be closed out at a gain and the cash redistributed into a more logical asset allocation."

Some banks offer structured products to clients who wish to gain exposure to specific markets. JPMorgan Private Bank, for example, started investing in industrial metals as interest in China increased. "It can be a challenge for private investors to enter the commodities market as most funds available are equity funds and hedge the commodities exposure in which the underlying producers hedge their commodity exposure, so it's not always clear how much exposure you have. Institutional investors are able to have trade futures accounts, but it is more difficult for a private client," says Horgan.

Effective

Capital-guaranteed products can also provide access to foreign exchange market returns for private clients who wish either to hedge currency exposure or speculate on currency movement. JPMorgan has been offering one-year 98/99% capital-protected notes with a 100% participation in a basket of currencies suited to those investors who believe Asian currencies will strengthen relative to the US dollar, for example. "There are points where the dollar has been strong, but one such note matured last month earning the client 4%. If they had kept it in cash, that return would have been just 1.5%," says Horgan.

Structured products can also be effective in implementing views to meet certain client constraints such as creating liquidity, and tax efficiency. For example, Merrill Lynch recently wrapped a family of hedge funds in order to allow its clients a smaller minimum investment and greater liquidity, as well as converting what would normally have been income gains into capital gains to allow clients to benefit from taper relief on UK capital gains tax.

Yet although private bankers admit that these types of structured products offer alternative strategies to clients, once again they say they wouldn't use them by choice – only if a client wanted to take a view on an asset class. When it comes to generic discretionary portfolios, private bankers generally avoid structured products.

Citigroup's Affany explains. "They can offer value to a portfolio manager who has to put together customized solutions, in the case of concentrated positions, strategic holdings and the need for capital protection or a need for leverage," he says. "These products also come in very handy for clients who want to take specific market exposures or express precise market views such as a positive view on market volatility, for example. But in generic asset allocation, there's no need to go into the expense of a capital markets products."

Independent financial advisers similarly do not recommend excessive use of structured products. Patrick Connolly, research and investment manager at John Scott & Partners, independent financial adviser and wealth manager, says: "I would never recommend structured products to clients. We just can't find or design a product at a price worth paying. The client ends up losing about 7% of the return."

The expense of structured products appears to be a running concern among distributors to high-net-worth individuals.

"Structured products are not always easy to build, so the manufacturer tends to embed interesting levels of fees which give a low probability for the investor to make money," says Charles du Marais, director at Banque Bonhôte. "You end up needing a substantial move in the market to make money." It is not only the manufacturer who takes his cut, however. "On top of the originating investment bank, there is then the packaging company, the distributor and finally the investor," says Richard Phillipson of consultant Investit. "So a possible four parties are sharing the excess return."

That's not to say that equity structured products are not, given the right fee structure, an attractive buy at specified times.

In the present environment in Europe and the US, for example, where volatility is low, option prices are low on a historical basis, so relatively more can be bought with what is left over after the zero coupon bond is bought. Furthermore, in the UK, where the interest rate is relatively high at 4.75%, there is a greater discount on the zero coupon bond with which to buy options. "The participation rates you can get into plain vanilla equity structured products at the moment means now is a good time to be implementing certain bullish views," points out Merrill Lynch's Ryan.

Not easy

But working out what the fees are in the first instance is not always easy, given that they are embedded in the product. In the case of capital-protected products, for example, how clear is it what fee was taken before the options were bought?

"If the packager is also supplying the derivative, then they could be making a turn both ways, and you need to be sure that the underlying derivative is being bought at best price," says PwC's Wright.

This is clearly easier for institutional investors than private investors as they are able to obtain a series of quotes. "If you're a retail client you can only really compare charges through participation rates. If two products are the same except that one gives a participation rate of 100% and one 110%, then it is clear the former is charging higher fees," says Wright. But, he adds, those investing more money will be more likely to get a better participation rate simply because there is less marketing.

But how likely is it that a high-net-worth investor will find identical products to compare? According to Dresdner Bank Switzerland's structured product specialist Juerg Schlaeppi, not very. "For the individual client it is nearly impossible to compare pricing as they don't have the contacts with the investment banks," he says. "Can they find similar products to compare? And, if so, can they ensure the timing of the pricing to be the same for both?"

Schlaeppi says that Dresdner Bank Switzerland will ask at least three investment banks for a quote when creating a new structured product. "By making sure that every competitor deals with the same market conditions, it finally comes down to the differences in pricing models, risk management systems, trading books and, importantly, the amount of fees that the investment bank wants to charge for a certain product," he says.

He believes pricing is becoming more transparent among the plain vanilla products as the market matures. Schlaeppi is concerned, though, that investment banks are trying to create more complicated products where the pricing is more opaque. "For easy structures, pricing can be fairly close among competitors, but for complicated structures, perhaps where exotic options are being used, pricing can differ significantly among manufacturers," he says.

Expense is not the only reason why private bankers claim to be reluctant to make use of structured products in discretionary portfolios. "While we recognize some of the advantages of structured
products, we prefer not to put any significant amount of them into discretionary portfolios unless it had been specifically discussed with the client previously. This has less to do with value, and more about liquidity," says Tom Slocock, managing director of private-client services at Credit Suisse Private Bank. Yet he stresses that it is good business practice to mention the possibilities to a client.

In the case of capital-protected products, investors are guaranteed full return of their capital only if the products are held to maturity. Although this is an acceptable means of ensuring protection, there are concerns that clients are not put fully in the picture. "I have my suspicions that clients think that the capital is protected for the entire life of the product," says Ansbacher Wealth Management's Tim Price, whose firm tries to avoid the use of structured products where possible.

PwC's Wright agrees that liquidity should be a key question for any high-net-worth individual considering investing in structured products. "Find out whether there is a secondary market," he says. "Ask yourself the question, 'if I need to exit early how easy is that going to be?'"

But can high-net-worth individuals really be expected to know what questions to ask when investing in structured products, and do they really understand what they are buying?

In the case of capital-guaranteed products some bankers claim that they should be able to. One says: "These really are the most simple of structured products, and all high-net-worth clients are capable of understanding what they are buying here." He claims they understand how they work, but choose to invest in them anyway just because they want their capital guaranteed.

No idea

Not everyone agrees that investors are that well informed. "They may sign a term sheet maintaining they understand the products, but I very much doubt that they understand the underlying derivatives well enough to know whether they are appropriate," says a consultant. "Private bankers may claim that their clients understand the basic zero coupon plus options set up, but I've spoken to several high-net-worth individuals and they have no idea what they've bought." He adds: "It may be true that private banks are reluctant to sell them because they know they are inappropriate, but they are selling them nonetheless, and feel they can plead innocence by saying that the client understood the product. They ought to admit that their clients are not as sophisticated as the market is led to believe, and take some responsibility."

It is the intermediary, after all, who should be held responsible, points out Angela Knight, chief executive of Apcims (the UK's Association of Private Client Investment Managers and Stockbrokers). "The intermediaries are responsible for the suitability of the products, and then they must explain these products in a way the clients can understand," she says.

This will be essential as the market grows and structured product offerings become more complicated. Credit derivative products such as credit default swaps, collateralized debt obligations and credit-linked notes have already worked their way into the vocabulary of the high-net-worth individual. Anthony Morris of UBS's global credit derivatives team is confident that the market will grow. In A Wealth Manager's Guide to Structured Products published in 2004, he highlights the factors that could lead to growth of credit derivatives use in wealth management. "On a tactical level, credit derivatives products can deliver more efficient exposure to credit risk than traditional credit bonds, generating higher yields for comparable risks while also offering substantial diversification gains," he writes.

And on a strategic level, Morris describes the use of credit derivatives in the wealth management market as "transformational". He writes: "They will improve the economics of all structured notes sold to wealth management clients without fundamentally altering their risk profile. This is because almost all structured notes already have credit risk, often overpriced, even if these notes are primarily intended as exposures to equity, interest rate, or foreign exchange markets."

If clients struggle to understand the basic capital-protected product, how are they expected to make a judgment on even more complex products? It is here that some private banks are prepared to draw the line, and stand up to the investment banks that are pushing products their way. "We feel that CDOs may be beyond the comprehension of some private clients," says Andrew Popper, CIO of SG Hambros. "Only with highly financially literate clients would we consider using them." In order to monitor the products it is being sold, SG's private banking arms, for example, are served by a team of about 30 specialists in Luxembourg. This team monitors all suggested structured products for appropriate pricing, structure and suitability.

More complicated

Dresdner's Schlaeppi agrees that the growth in the market is making the client adviser's job more difficult. "My concern is that products are becoming more complicated, and the adviser is having greater difficulty in explaining the product to the end client. An adviser has a lot to do, and learning about structured products is just one part of his job. Every day there are more structures with more complex term sheets. It can be very time-consuming keeping up to date."

Dresdner runs courses on derivatives for its advisers, and provides simple fact sheets to accompany the more complicated term sheets. And its product specialists now participate more frequently in client meetings. Some private banks, such as SG Hambros, have even introduced training and spot testing of its client advisers on various structured products to ensure that they understand what they are selling as well as the products' suitability for clients.

But eventually it will be the investment banks that lose out if they do not take into account the ability of the private banker to understand the product. Oldrich Masek III, co-head of global structured credit origination/structuring at JPMorgan, argues that "investment banks need to have dedicated control infrastructure to appropriately engage the distributing private banks. A fundamental aspect of any control environment revolves around managing compliance and customer suitability."

As Nick Jones, head of marketing and sales for RBC Capital Markets, says: "If they understand it, they'll want to sell it. If they don't, they won't."