13 Nov 2012, Richard Jory, Structured Products
In a year when most banks shied away from trumpeting innovation, Société Générale (SG) continued its crusade to further tweak the financial technology that forms the basis of the structured products market. The result was an enhanced collar, which was designed to lower the cost of hedging associated with traditional collars.
“The idea for the product emerged from discussions with pension funds and insurance firms about limiting their downside without giving away too much of the upside,” says Marc El Asmar, global head of sales at SG in London. That objective had previously been achieved by using collar strategies such as the zero-cost collar, whereby investors buy a put option that is financed by selling an out-of-the-money call option.
“With the market environment being what it is, if you want decent downside protection – such as 10% over one year – the cap is pretty low, which means you cap your upside almost completely and you end up just hedging yourself,” says El Asmar.
“One of the ideas was, rather than buying long-dated put options, to shorten them, but it wasn’t effective,” says El Asmar. “So we tried a systematic strategy in which selling the upside would bring in a higher return to enable the purchase of the downside protection. We tested selling call options quarterly and progressively bringing the time down and the sweet spot that we arrived at in terms of pricing, liquidity and the efficiency of the market was selling two-week call options.”
This is optimisation and it is appreciated by the bank’s clients, says Hubert Le Liepvre, global head of engineering at SG in London. “We can do various products with a view on an index,” says Le Liepvre. “If, instead of taking the real index, you take the enhanced collar index – that is, an index that is optimised in terms of volatility – you have much better results and it is much more stable.”
The innovation lies not only in the idea, but also in crunching the delta to get to that optimal two-week figure, says El Asmar. “We are talking about thousands and thousands of historical data – not only on the performance side but also on implied and actual volatility – and using simulations to find the exact sweet spot where you can extract the best value between the difference in implied and realised volatility.” The development took around four months, and other banks have already sought to replicate a structure that SG had been marketing discreetly.
One asset manager that invested principally in actively managed funds and preferred to use the S&P 500 index was looking for a fund with a low expense ratio that was consistently in the upper quartile after its quant filter while offering yield. “We were bullish on the US market a year ago and also looking for income, so we naturally thought about writing some kind of covered call strategy. Defensive equity income has attractions for us, given our focus on preservation and growth of capital,” says Duncan Blyth, senior investment manager at Turcan Connell in Edinburgh.
“We spend a lot of time ensuring the right amount of risk is in client portfolios and try to ensure you don’t get large drawdowns,” says Blyth.
“We are not able to efficiently write two-week call options on a portfolio, so it was something an investment bank would have to do for us. SG was probably one of two banks that could do this in a cost-efficient manner.”
While performance in the first six months has not been particularly good, Blyth has no doubts that this is the right product for his needs.
“We remain positive on equities, and this is a good, solid, defensive, equity income-type return. You also have the knowledge that if some kind of tail event happens, you have that put protection in there.”
Volatility is lower and the returns are usually similar or slightly lower while the Sharpe ratio is better, says El Asmar. You can do any kind of product on top of it, he says, citing as an example a Ucits fund on the Euro Stoxx 50.
The bank has also used the enhanced collar to target most of the constant proportion portfolio insurance (CPPI)-based products sold in an insurance-wrapped format or directly to investors. “We have taken the risky assets and proposed to insurance companies and asset managers that they replaced them with an enhanced collar.”
This was the case with Swiss insurance company La Vaudoise, which back in 2009 launched an open-ended CPPI fund based on the Euro Stoxx 50, S&P 500 and Swiss Market Index that included a permanent protection feature. Disappointing equity market performance in 2011 was compounded by the mechanics of the CPPI, which rebalances to cash if risky assets lose value. The fund then had virtually no exposure to a rebound in equities, which made it remarkably unattractive.
However, providing the enhanced collar as an overlay to the risk asset portfolio revitalised the strategy while avoiding any increase in the cost of the guarantee. A restructuring was avoided, asset exposure was increased by 100% and the open fund was again attractive to new investors. SG is using the enhanced collar to systematically revitalise and give a fresh start to products in the CPPI bucket across Europe, says Le Liepvre.
There are certain constraints, however. “You can only do this if the retail or individuals holding these policies have an asset manager with the capacity to underwrite the change of the underlying without the consent of the individual,” says El Asmar.
The bank has successfully introduced the technique in the UK, France, Benelux, Switzerland and Italy and has done €2 billion of notional business on it in the past 12 months. It has also been successful in restructuring CPPI deals outside of the enhanced collar, including one for an Austrian insurance company. The company had signed up for a CPPI strategy from SG, but was pleased with the bank’s desire and ability to restructure the investment into something that would prove more fruitful. “The original product had turned to cash and there was some longer duration,” says the head of investments at the insurance company.
The restructuring was aimed at achieving an equity pick-up similar to the one achieved a year earlier for the same company. Both restructurings coincided with rising equity markets, and Tollay notes that the timing of the deals were fortuitous. But he was even more pleased with the option that SG provided to lock in the 8% and 6% returns that were provided for accounts that had mainly turned to cash. “There were some administration issues at the beginning as we all got used to the new product, but now it works quite well and is fine for us,” he says.
Further steps that the bank took to cope with volatility included the development of a Vix index suite, which included the design of the Lyxor ETF S&P Vix Futures Enhanced Roll (LVol). The LVol was created with a future roll mechanism complemented with the liquidity that exchange-traded fund (ETF) provider Lyxor is committed to providing in support of its products. This summer, Lyxor completed the product range with two new volatility ETFs: the LVol 2 and SVol.
The LVol 2 is a new, long-only volatility ETF offering up to 100% leverage in an investment that can be 100% in cash or 100% in the LVol 2. The leverage and deleverage mechanisms aim to avoid a long volatility exposure when not required, for instance when rolling costs are high, and are based on a simple indicator comprising both a rolling cost/gain and a momentum component.
When buying volatility, optimising the cost of carry might be inpossible when volatility is increasing, says El Asmar. Deleveraging is then the best option, he suggests. “The principle is to make an index that does that in a rational way. When the cost of carry is optimised and the volatility is low, you are invested in LVol 1. But when volatility increases and you would rather sit on cash, then deleverage or reduce your exposure.” Ultimately, everyone wants active management, but no one wants to pay for it, he says.
The new short volatility ETF allows investors to take advantage of the rolling gain when shorting Vix future contracts when the Vix traditional term structure is in contango.
“There are a lot of volatility products out there but the good thing about this product is the transparency. It’s based on Vix and the weightings in each of the contracts are provided daily so we can replicate the NAV calculation.” says Turcan Connell’s Blyth. “Volatility is a tactical decision, but a lot of banks are trying to monetise it by creating strategies to buy and hold. You have to be mindful of your timing, more so than for any other strategies.”
The enhanced collar is much more differentiating [on volatility than offerings from other providers, notes Le Liepvre. “It is not only a reflection of the trend or fashion for [volatility products]. Clients are concerned about potential losses, so you start from there and build around managing their portfolio within a more stable or secure framework.”
El Asmar compares the effect of the new technique within SG to when the bank first pushed its Mountain Range and target volatility products. “It’s almost always a hit with clients. They like it and want to invest in it, and once they invest in it, they are happy with it. It performs how it was forecast to and they usually increase their investment.”
Aside from volatility, SG is most proud of the research brains that have led to the creation of the Quality Income Index, whereby the bank’s analysts have isolated the future forecasts of which companies will be paying dividends. The strategy led to the creation of an index in May that was returning 5.5% in its first six months.
The bank has also provided “outstanding sales service, and provides a very short reaction time and good, aggressive pricing,” says one Switzerland-based wealth management company, which has been a frequent customer of the French bank this year.
The wealth manager was particularly complimentary about the bank’s SGIS collateralised issuance programme, which was designed earlier this year to offer a new approach to structured products issuance and allows any type of note to be collateralised. “We checked a couple of potential issuers and chose SG,” says the wealth manager.
“It was easy to find a common language with them, and in comparison to the other issuers, their product seemed most understandable, not only to us, but also to the clients we offered the product to. They did it fast and in an understandable manner… when it came to the pricing, they were also the best.”
Bank of New York Mellon was brought in as collateral monitoring agent and potential liquidation monitoring agent to add an extra layer of comfort for investors. There is strict segregation between the issuer and the custodian. “We have used the programme three or four times, and we have only used government bonds as collateral,” adds the wealth manager.
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