What are the most popular structured products among private banking clients?
In Hong Kong and Singapore 85-90% of business is comprised of three flow structures. First, there are equity-linked notes, from the simplest version, with a single put, to a worst-of put or a put with a knockout. Second, there is the auto-callable daily range accrual, which can be on single stocks or multiple stocks. These are still hugely popular though weÆre starting to see some variations of the basic structure.
The third family of flow products, probably the most popular of all, is the accumulators. More than 90% of accumulators are transacted in over-the-counter (OTC) form, and most would be geared on the downside, which means that investors risk more if the market goes against them, but their risk is further out of the money, which is to say a larger fall is required if the market goes against them, because more premium is earned by selling two puts, so the puts can be further out. Recently variations with guaranteed accumulation were introduced and have become widely accepted, since in a bull market the typical 105% knock-out level can get breached very quickly.
What role should structured products play in an investorÆs portfolio?
Every clientÆs portfolio should have some structured products, though how they allocate within the portfolio is entirely up to them û either as a separate asset class or specific asset classes split into vanilla and structured portions. To me, the beauty of structured products is that they are like Lego blocks û you can create any kind of risk/reward profile you want, which is something you cannot do with the vanilla underlying itself. You can trade any view at any time, with total flexibility. The financial engineering technology these days, with all the exotics that are being developed, means you can literally express any view or combination of views in a single structure.
Do private bank clients still need to buy equities directly or can structured products completely take their place?
These days there are equity financing structures that are able to pass through the dividends and associated taxation credits, and even the votes û arguably, these are most important to substantial shareholders.
Once you are able to provide such entitlements to investors, combined with the ability to completely tailor an investment to their views, why wouldnÆt investors replace a vanilla equity, that basically only lets them go long, with a structured product?
Private banking clients donÆt seem to have much interest in principal-protected products. Why is that?
They just have a different risk/reward view. They are more sophisticated and have a higher tolerance for risk û many of these clients will be dealing in OTC form, which in itself gives them leverage as they are not putting up any principal.
Even for notes, most investors will be margin-lent to by the private banks û so they might be buying a million dollars of notional but only have to put up $300,000 of principal and any coupons they receive are thus leveraged.
But investment banks are nevertheless keen to try to sell principal protection to them?
When investment banks sell any of the three flow structures, and thatÆs most of their business, they are buying volatility. Selling principal-protected structures allows them to sell volatility. There are typically three or four ways to sell volatility: the first is to hedge funds, the second is via warrants, and the third is through structured products. (The fourth is just banks selling to each other.) While private bank clients do buy some protected structures, they would account for less than 10% on the equity side.
Are there any other structures you donÆt like?
On the retail side there are some structures that seduce investors with a very high initial coupon, but the actual probability of receiving returns subsequent to that large first-year coupon for the balance of the life of the product, which can be five years, is very low indeed.
There are also structures that are overly complex and almost impossible for a retail investor to understand.
I like two-minute products: where it takes two minutes to explain it to the distributor, it takes the distributor two minutes to explain it to their front-line sales staff, and it takes them two minutes to explain it to the customer û and then two minutes for the customer to make up their mind to buy it!
Investment banks complain that the way private bankers are incentivised makes them too focused on shorter-dated products. Do you think thatÆs fair?
Absolutely fair. Relationship managers at private banks get paid according to assets under management and a cut of whatever fees they can take out of the structured products they sell: so if they have a choice to sell a product where the money is locked away for three-to-five years and earn say 2%, or earn 30bps for selling a one-month ELN û you go and do the sums.
So would there be appetite for longer dated products if private bankers pushed them? Or are there reasons why the clients donÆt buy them?
ItÆs not just the private bankers pushing their clients with the short-dated structures to suit their own needs.
Short-dated products are actually more popular in Asia because Asian investors have a shorter-term outlook than European investors, but a lot of it is definitely the incentivisation structure of how relationship managers get paid.
Would something similar to a fund managerÆs management fee, a so-called trailer fee, help to re-balance those incentives?
The problem is that with the exception of US dollar and Aussie dollar rates, which are at reasonable levels, most of these longer dated structures tend to be 100% principal-protected and itÆs tough to pay a trailer fee if youÆre trying to do something in Hong Kong dollars, euro, Singapore dollar, and ringgit, because there is little money to buy the option with meaningful participation in the first place.
It sounds great in theory, but I am not sure how possible it will be given where rates are at the moment.
If the level of protection is less than 100%, thatÆs another story.
This article first appeared in FinanceAsia magazine, July 2007.