Structured products debate: The race to attract institutional investors
Structured product providers aim to be all things to all people: risk reducers, alpha generators, beta replicators – you name the risk and return profile wanted and they will match it. However, some institutional investors remain distinctly wary of what is on offer.
• Structured product providers are increasingly moving into the institutional space to provide solutions to very particular asset and liability management needs, but as yet there is no market consensus on what constitutes, and what does not constitute, a structured product
• Structured solutions can be used to manipulate and tailor the risk and return profile of an investment portfolio while also seeking to generate alpha
• The structured solutions market has traditionally suffered from a lack of transparency, and this is still a major sticking point for many institutional investors
• The hybrid nature of many structured products introduces risk factors such as correlation, which are difficult to price and manage
• The transparency issue comes down to fees and the breakdown of the underlying structure. Many institutional investors struggle to get a clear picture of these
• The complex nature of structured solutions makes it difficult for banks to be completely transparent when it comes to pricing
JF, Euromoney: Let’s start by trying to put the structured products market as it relates to institutional investors in context. How can we define this, if at all, as a market today?
EW, Calyon: I completely concur with that. It is unrealistic to think that the global family of structured products is suddenly going to become one market that will function seamlessly. One area of differentiation is the type of profile the investor has. On the interest rate side, obviously our main client segment is institutional investors. But on the equity side you find more that it is the man on the street who will be looking at these products. If you asked someone on the street what they think about the 10-year, five-year spread in euro going forward, they’d look at you blankly. If you ask them if they think the Dow Jones is going to outperform the FTSE then they might have an opinion.
KP, Legal & General: If we’re talking about the genesis of structured products for institutional investors then I think this has been led by pension schemes and insurers realizing they had to do more in terms of their liability management. A lot of them have been forced to switch into bonds, so they have had to think about how they can make those types of investments work harder in terms of returns.
TBS, Barclays Global Investors: I think it is useful to put definitions in terms of what an institutional investor actually makes of the product. If I think about pension funds, they could look at a structured product as a part and parcel of an asset allocation strategy, that is, as a component, which is where a CDO [collateralized debt obligation] or recently the popular CPDO [constant proportion debt obligation] would fit in. Or, they might look at a structured product to alter the whole asset-liability mix, which is potentially a very ambitious undertaking.
KP, Legal & General: The correlation between asset classes is important. For some institutional investors, like insurers, some of those correlation products work very well. A good example is equity-linked swaptions for some UK insurers that have had guaranteed annuity options. There’s a good reason for using the structured product there, because they can see a clear reduction in capital for holding them, but it’s very much driven by the precise liability.
WN, Prudential M&G: That’s the point. I think it’s the use that matters, and trying to link all these things together is impossible, because you’ve got a whole different set of products being applied in different ways. Right now equity derivatives professionals are looking at fixed income on the basis there are still things that can be developed in fixed income that are already in use in the equity markets. At the same time you’ve got pension funds becoming more sophisticated and insurance companies having to be more efficient with their capital, and therefore making use of things that they wouldn’t have 10 years ago. So there is an incentive for the investment banks to become involved in a sensible and reasonably aggressive way. However, structured products develop in response to where the requirements are, not in a vacuum. So I think to link them together in a nice package is almost impossible.
NH, Watson Wyatt: Quite honestly, we find the definition of structured products difficult. We have a structured products team, and if you ask that team what they believe they do, they believe they advise on the execution of products where the counterparty is a bank.
EW, Calyon: If you ask a structured products group what their mandate is then they want it to be as wide as possible. If I were asked what the definition of a structured product is, I’d say it’s providing a product that’s not readily traded on the market, where it involves combining one or the other product together and building a package, which is not readily available through markets.
WN, Prudential M&G: I think that’s fair. If there were something easily replicable in the market then you wouldn’t have a structured product for it.
JF, Euromoney: And of course when we’re talking about structured products we’re usually also talking about hybrids, which introduces issues such as correlation.
DL, Commerzbank: Hybrids to me are anything where explicit correlation between two asset classes is an actual pricing parameter and not just incidental to the product. So equity-linked swaptions, which have been mentioned, is something that I think fits very neatly in there, particularly for pension funds. Liability-driven investors have a liability benchmark and not an absolute benchmark, so really the realized level of correlation going forward is a more interesting parameter to them than equity volatility alone. The main difficulty with the market is that there are so few people actively involved that the depth is just not there at the moment, and the kind of maturities that banks are prepared to deal on don’t correspond with the liabilities that pension funds in particular are looking to hedge. So it’s certainly something that’s developing, but I would still regard it as being nascent, particularly in the equity fixed-income area until there’s a broader available pool of dealers and risk.
WN, Prudential M&G: Yes, it’s not liquid enough at the moment to be useful.
KP, Legal & General: There’s a vast range of pension schemes, particularly in the UK, looking to switch from equities to rates-type products, who might very well like to make use of a product that manages the correlation between equities and bonds but not at the prices we’ve seen.
DL, Commerzbank: My gut feeling at the moment, and I would concur with Nick, is that when you’re looking at somebody who’s driven by equity risk against a fixed-income benchmark, it’s probably still more efficient for them to trade pure equity products than it is to trade hybrid products.
EW, Calyon: The reality of markets and the liquidity of markets is one side. The other angle is the way a lot of these products are being marketed, where there is a kind of copyright on the idea, so the structurer comes up with a great combination then slaps on a large amount of margin so his traders won’t bug him about the hedging difficulties and so on and so forth. I think, coming back to what Donald was saying, it would be better if instead these were pitched more towards actually making sense in terms of cross-correlation.
DL, Commerzbank: Making the product cheaper, not more expensive?
WN, Prudential M&G: But you would still have the problem that a consultant would find it very difficult to advise a fund to go into something where there’s one person making one price. You do need to have a market that gives you some transparency.
EW, Calyon: Sure, but that’s not contradicting what I’m saying. There’s been a lot of debate about how things should be priced, and I think there’s been convergence of pricing models. Banks have an interest in having other banks see approximately the same price on the same trade, otherwise they can’t declare that as fair value. So there’s a natural tendency in the market for a certain amount of convergence, and we’ve seen this.
TBS, Barclays Global Investors: The banks are coming up with ideas and selling those to life insurance companies and pension schemes, but when it comes the other way round, the things that pension funds and insurance companies want, you probably find that these don’t suit the bank. So the banks are looking to sell things like CDOs or CPDOs and are trying to create more structures that look like they give you additional return, but they don’t really address the core risk the pension fund wants to hedge.
DL, Commerzbank: The trend seems to be very much to parcel up risks and worry about them individually, rather than looking at the whole problem. For several years that seems to have been the direction that most institutions have moved in, and most of the developments in the market seem to have been in the direction of actually hedging these risks individually rather than packaging them up and looking at a more holistic solution.
TBS, Barclays Global Investors: I think, on the ground, pension funds are really trying to embrace general changes in their approach by incorporating more use of derivatives in their overall liability risk management processes. But it’s a journey for them, given where they’re coming from, a heritage of having almost zero exposure to derivative structured instruments.
NH, Watson Wyatt: Most pension funds have been looking at their risks in an ALM context for nearly two decades now. They have been used to talking about equity risk versus interest rate risk, although they would usually have expressed their strategy in a traditional way – by selling equities and buying index-linked gilts. Nowadays the same funds might start by discussing with banks products such as swaps and equity-linked notes. In terms of trying to create hybrid structured products that cover mortality risk, we believe that market is just not there yet – primarily due to the lack of a counterparty to take the other side in a format that meets the needs of pension funds.
DL, Commerzbank: At the moment you’re limited to bank’s proprietary appetite for taking the risk, some hedge funds that they can sell it to, and maybe a few esoteric retail products that people have managed to come up with and which take the opposite side. But there’s a limited pool, and the same is true for mortality risk.
NH, Watson Wyatt: I’d say the experience is very mixed. Our experience with trustees has been that there is usually scepticism to start with, and much of that starts from the view that these people, banks, are out to make money from the fund. To a trustee it feels like a different proposition from going to the London Stock Exchange and buying an equity where you can see the price. Here the trustee is undertaking a one-to-one trade with a counterparty who almost certainly has a higher level of knowledge in the area, and who is only doing the trade because of an expectation of making money. The more the trade has a market reference point the more comfortable the trustee body will be. A good example is swaps, where we’ve seen enormous growth, at least in part because I believe trustees are getting more transparency on pricing, and can understand broadly how much money the banks are making. The more hybrid or less transparent a trade, the greater the amount of scepticism, and the lower the volumes that have occurred. That being said, we have advised many trustee boards on hybrid instruments with an aim being to let them understand what the costs and benefits are. The difficulty remains a lack of understanding about what are very complex trades, with consequent low levels of take-up.
WN, Prudential M&G: Yes, that appears to me to be a very difficult stumbling block, because transparency on some of these instruments is always going to be very difficult to get. It is not easy to get a bank to write down to the last penny exactly the returns and margins that it’s getting from the trade. You get into a terrible chicken and egg situation, with scepticism at its highest among the sort of people you need to build the market such as the pension funds who have the long-term capital.
NH, Watson Wyatt: There’s no reason why a pension fund can’t delegate to an external expert to trade if they believe the expert can determine whether the price is appropriate or fair. For higher volumes to occur, I would say this has to happen.
KP, Legal & General: There’s a difficulty here in that the banks have their structured product proprietary model, which captures exactly the risk that you want to capture but we can’t see the pricing.
I think solutions tend to be a little bit over-engineered at the moment, but pension funds seem to be just about at the point where they’re beginning to understand something like equity volatility, that it’s not something they can replicate, that it conceivably can be traded through variance swaps, for example. But a lot of the hybrid solutions that they’re being shown require a level of complexity and sophistication that goes considerably beyond that. So I think firstly investors need to understand the simple products in their entirety, and I think we’ll start seeing bespoke solutions, including correlation, when institutional investors and their advisers are entirely comfortable at pricing these things.
EW, Calyon: I think it’s one of those things where it’s new and people are getting carried away with all the applications. I’m interested to hear what other panellists might think about that.
TBS, Barclays Global Investors: We’re talking about acceptance of products. There are two points I would highlight from my experience of working with trustees. Trustee bodies tend to have much longer time horizons than other people in industry, which tempers their views of risks. Individuals would be sitting as trustees for a decade or so and be thinking in terms of that time frame. The second point is exit risk. Everyone is focused on the cost of going in, but there’s the cost to getting out. Pension schemes are always evolving and there’s always a need to exit.
NH, Watson Wyatt: And that is usually not addressed at the point of execution – there’s no guarantee what the get-out price will be.
And that is usually not addressed at the point of execution – there’s no guarantee what the get-out price will be.
WN, Prudential M&G: Going back to Nick’s question about asset managers being willing to take on the risk, as it were, of execution, we are in a better position than trustees to be able to understand the complexities in the pricing, but at the same time there are products out there that I wouldn’t feel comfortable looking at then telling a trustee board that that’s the best price they can get. You would have to be sitting inside the bank to have the right correlation model and to see exactly what the bank’s trying to do.
NH, Watson Wyatt: It is much easier if the process can involve market tension with two or three banks quoting, but the banking side doesn’t favour that.
WN, Prudential M&G: But the market could develop in the same way as the CDS [credit default swap] market. The things that we’re discussing now that are complex will seem quite easy in five years’ time.
Alpha and beta
JF, Euromoney: Let’s move on to the issue of alpha and beta generation. Are these products there just to create alpha, just beta, or a bit of both?
DL, Commerzbank: I’m not a great believer in the concept of alpha as applied to an entire industry – you can’t all beat the market. I think you can improve your risk/return profile through the use of structured products. So ultimately all they bring you is beta. There’s a limited amount of capacity in the market, as I said earlier, for people who want to effectively take the other side to a bank’s structural position, so I think you have to look at them as fundamentally risk-transforming beta-type products, not ones that are going to generate money out of thin air for an entire industry.
EW, Calyon: I tend to agree actually. I think that the main driver for people buying structured products is that it gives them access to a pay-off for a specific view. Why would you do any kind of exotic as opposed to its vanilla equivalent? Well, it’s normally because it allows you to tailor-make something that is going to be better suited to your precise view.
TA, Insight Investment: The modern approach to investment management is to hedge all unwanted risks and manage the risk-seeking assets more systematically. I think a few years ago we had this notion that a portfolio should deliver a mix of beta and alpha, and it wasn’t very clear what was in there. The return was not necessarily linked to risk either. Now we understand beta is something that we can capture quite easily and it’s not very expensive to buy. Alpha is more expensive, and there are capacity constraints as well. In capturing alpha we may want to utilize some of the derivatives structures, whether hybrid or more vanilla. That’s part of what an asset manager will be trying to do: identify sources of alpha and find the best way to take it. I think the inclusion of derivatives or structured products in a portfolio is an evolving process, and alpha is something that a lot of investors will be looking at.
WN, Prudential M&G: You have to ask: why should people be using structured products? They should be using them in order to either get a risk or return profile they couldn’t get elsewhere, or to give them access to a market, or an alpha opportunity that wouldn’t have been feasible before. There are clearly some people in the market who are using them slightly differently, as a more holistic approach to try to solve problems that they weren’t absolutely made for, which I think is where you have had some of the problems.
TBS, Barclays Global Investors: There’s another dimension that I keep coming back to in my own mind, but I don’t see many banks offering this. Pension funds today are typically selling equity at high levels and buying matching assets, so that there is this general trend towards de-risking. I think that’s accepted as fact. So it was worth thinking how this could be implemented so that a fund pension can implement this and get some option premium off it.
DL, Commerzbank: That’s a comparatively easy strategy to execute directly with the market, provided you’ve got some kind of access, and I know banks have sold complete packaged solutions for that particular problem. There are overwriting funds, for example, which go long equity and then periodically sell call options on the underlyings. But my feeling is that any institutional investor who is sophisticated enough to understand that proposition is probably sophisticated enough to be able to execute it using listed derivative instruments. You might then want to go to a bank to advise you on that, but on the other hand you would probably want to go to a consultant because, as we’ve already touched upon, when banks start straying into the consulting space it doesn’t generally act in their interests particularly.
NH, Watson Wyatt: Could you elucidate on what happens when banks move into the consulting space?
DL, Commerzbank: Well, when I said a bank that looked at a particular institutional investor’s asset-liability profile and spent a long time modelling it to come up with an ideal solution, to an extent it’s potentially wasted time, because nobody’s going to execute a particular solution without actually getting pricing from their competitors. So the bank that actually attempts to provide free consulting as a way of enticing somebody to trade with them is unlikely to get very far.
NH, Watson Wyatt: So it’s the revenue model as opposed to the ethics?
JF, Euromoney: Nick, are your clients coming and saying that they’ve just spent two weeks talking to an investment bank about an ALM strategy and asking what do you think?
KP, Legal & General: Equity volatility has tended to be low recently, so is now a good time to do this?
I’d be interested to hear Nick’s view on that. Since you are in the de-risking world, what would be your view?
WN, Prudential M&G: If you have a deficit, you can either look to take a small amount of risk across the whole portfolio, or you can look to de-risk as much as possible and then place the residual into something that gives you equity-like returns or hedge fund-type returns to try to fill in the gap. As far as I can see pension funds are leaning towards the second way at the moment. They’re very much trying to take out some duration risk and some inflation risk and leaving mortality risk, because there’s nothing they can do about it at the moment, and trying to fill in the gap by putting some reasonably aggressive positions in place, either in equities or in hedge funds.
TA, Insight Investment: Yes, the static approach would be okay if we knew exactly what we are targeting, but most of the time we don’t know – the return requirements or projected liabilities may change over time. I think the dynamic approach of managing these risks is probably what is the way forward in reality. On the side of risk-seeking assets, it is also very unlikely that the manager will have a specific view today that will remain unchanged for years. A one-off solution through a structured product is unlikely to be a realistic proposition.
TBS, Barclays Global Investors: One thing that pension schemes need to be wary of is substituting market risk – mostly equity market exposure risk – for counter-party risk and documentation risk. I think, as pension schemes move further down the route of de-risking their asset exposure there will be a greater focus on the new risk and the interplay between them. For example, the collateral received is paper issued by a bank with which the pension scheme has a derivative position.
EW, Calyon: If you do a vanilla trade then it’s replicable in the market. That means, yes, there’s transparency, but, on the other hand, there’s also less risk for the provider because it can just go and hedge it off in the market. If you put on a tailor-made or exotic transaction, then you don’t have that. Then you’re relying on your model and on warehousing risks. And this is running for maybe 20 years. So the cost of manufacturing an exotic is more than the cost of doing a vanilla transaction, where you can just intermediate with the market if you really have to. I think that’s an element of transparency that is often overlooked.
WN, Prudential M&G: I think there is an understanding that as complexity increases then there is an associated cost, but I think it’s also fair to say that margins in products tend to go down as they become more transparent, for the right reasons. If you look at something like the CDO market, the margins for banks there have clearly fallen gradually and occasionally dramatically over the last 10 years. I have no problem at all with the idea that if a bank comes up with something that is new and novel and difficult then it should be paid a reasonable amount, but one of the things that we certainly see with third-party institutions is a desire not to over-pay.
EW, Calyon: I think people find it perfectly acceptable to leave money on the table for a good structured solution that’s watertight. But everyone thinks about those times when they have heard about the excesses that banks have made, where either the solution turned out to be the wrong one or it was something that ended up costing the company much more than it had understood it would cost it.
DL, Commerzbank: Banks are expected to innovate. We work in an industry entirely without trademarks or patents, and it’s the easiest thing in the world for any one of your competitors to see your product and copy it, maybe not at the drop of a hat, but after a couple of days’ work, when it might have taken you several months to develop it. And I think banks are nervous about losing any value that they might have gained from doing the initial innovation and research when they show how products are priced and manufactured, because it is so easy for their competitors to copy it once they’ve seen it spelled out in words of one syllable.
JF, Euromoney: How are fees typically presented to clients with structured solutions?
WN, Prudential M&G: Yes, and you need to ask to go through all those things in order for that to be discussed.
DL, Commerzbank: I would say the only way that anyone will ever know is to ask up-front, frank questions: ‘How much money are you going to make out of this up front and how much are you putting in reserve? Where have you priced this parameter compared with where it’s been historically?’ But you really have to understand the products in quite some detail, and you’ve also got to understand how they’ve been priced and what the underlying models are in order to determine the answer to those questions.
NH, Watson Wyatt: So why doesn’t the bank just tell me that?
WN, Prudential M&G: But it’s fair to say if you have a watertight relationship, then the bank will tell you how much they think they are making from the trade?
DL, Commerzbank: Yes. But for complex products it’s difficult, even within a bank, to obtain a consensus on how much profit there is.
EW, Calyon: I would come back to the point that if the solution itself is understood and is clearly adding value then the whole pricing issue doesn’t come into it.