Changing landscape

The Irish structured product landscape is changing as volatile financial markets push investors to seek alternative assets, capital protection and shorter-term products. In a week of financial turmoil and failing banks, issuers' credit ratings were a concern, while the subject of fee disclosure fuelled debate. By Emma Dunkley

The inaugural Structured Products Ireland conference, held at the Radisson SAS Royal hotel in Dublin on Wednesday September 17, opened with a pertinent keynote speech about regulation in Ireland's structured products market. Anne Troy, head of Investment Service Providers Supervision at the Irish Financial Services Regulatory Authority highlighted that compliance with regulatory requirements is vital in the volatile economic environment. Originators of structured products need to be careful who they are selling to, while investors need the relevant skills to properly evaluate what they are buying, especially with the reputations of banks at stake. "We ensure consumers are treated fairly and provided with the correct information to make informed choices," said Troy. In a week where bankruptcy ravaged the financial markets, the importance of these fundamental regulatory requirements was particularly relevant.

As global markets are in decline, structured products provide a viable alternative to direct investments, said David Neary, head of structuring at Bank of Ireland Global Markets (BOI). While the advantages of direct investments include access to mark to markets, the performance of assets in current market conditions can go up or down and structured products provide the ability to manage risk-adjusted exposure tailored around an investment view or payout profile. "We see two primary knock-on effects of the difficult investment environment: there is increased demand for capital protection and investors are less keen to lock their cash away in longer-term products," said Cliona Coakley, equity derivatives specialist at BOI.

The types of underlying assets that complement short-term structured products include equities, forex, commodities, interest-rate curve plays, inflation and hybrids. "Interest-rate curve plays, while traditionally more an institutional play, are creeping into the high-net-worth space," said Coakley. "Also, with Irish inflation above 4% at present, we expect index-linked structured products to be increasingly popular," she said. Structures which suit short-tenor products include capped calls, as a cap increases participation in the underlying, strangles for investors with a non-directional view and forex wedding cakes, with returns linked to the exchange rate falling within a certain range. "Reverse convertibles are suitable for investors who require a higher return than vanilla deposit rates and are willing to put their capital at risk," said Coakley.

In volatile markets where the performance of asset classes can change dramatically from one day to the next, innovative indexes that avoid the mainstream provide an alternative. Alpha indexes are designed to outperform traditional reference indexes, while beta indexes seek to replicate the high potential investment universe, although access to these underlyings is difficult compared with traditional indexes. "For example, emerging markets outperform, but they are hard to access when volatility is high," said Cem Bilgi, structured products specialist at Societe Generale (SG CIB). "This provides cheap and effective access to emerging markets, as the long/short structure has lower volatility and is efficient in gaining participation," said Bilgi. Emerging markets have outperformed developed markets by 157.4% since the start of the stock market rally in March 2003, according to Bloomberg.

Rather than a beta index reflecting emerging markets, SG offers the SGI SLS Emerging Index that goes long emerging markets and short the Dow Jones (DJ) Global Titans 50 TR index. The emerging market exposure is long, based on a synthetic index approximately matching the sectorial composition of the of the DJ Global Titans index, which is shorted. The SGI SLS has a volatility cap risk-monitoring mechanism, which allocates into the outperformance, so that if the volatility of the outperformance exceeds a predetermined level of 15%, this allocation is reduced. If realised volatility is less than 15% then up to 150% is invested in outperformance. SG designed a three-year product linked to the index, providing 100% of the initial investment plus 100% of the performance of the index, as observed at maturity.

The use of structured products within long-term savings and retirement planning was presented by Al Plattner, managing director and head of European structured product sales at Citi Markets and Banking. "Variable annuity products benefit from maintaining the potential upside of equity markets through retirement while offering guaranteed retirement income," said Plattner. Variable annuities comprise an accumulation phase and a withdrawal phase. In the accumulation phase, the investment accumulates returns through exposure to a risky asset, typically a balanced portfolio of equity and bond indexes or mutual funds. In the withdrawal phase, the investment is being consumed, which starts at a set age for a certain period. Alternatively, the investment can remain in the risky asset and the investor may switch during the life of the product.

"In variable annuities, investors can invest a lump sum upfront followed by irregular investments over time. Structured products can handle this on account of their flexibility, and offer quant capabilities to manage the market and actuarial risks," said Plattner. There are three types of approaches that allow investors access to underlying portfolios with protection, he said. The delta hedging strategy uses short futures, adjusted periodically to synthetically replicate puts, to hedge delta. The three-Greek dynamic hedging consists of short futures, three 15-year puts to hedge vega, and swaps or swaptions to hedge interest-rate exposure. The advanced dynamic hedging uses the three-Greek dynamic hedging with exotic options, such as a basket of options, lookbacks, or equity-rate hybrids, for example.

Citi has designed Citi Flex, a platform for variable annuity products. "The investor's money is placed with fund managers, and Citi provides the protection," said Plattner. "For example Citi makes up the value of the portfolio or the income if the product doesn't perform or the investor outlives their investment." The investment is a portfolio of mutual funds, and any accumulation is 100% re-invested. There are three different risk-return portfolios, comprising defensive, balanced and aggressive approaches, which investors can switch between to adapt their exposure to fixed income and equities. "Structured products increase the transparency and certainty of what investors are buying," he said.

The benefits of accessing managed futures via structured products were highlighted by Tony Gannon, chief executive of Abbey Capital. "In today's environment, we're seeing so many people who can't mark to market exposure. The beauty of managed futures is that all of the trades are independently valued every day on regulated exchanges, so it's very easy to price," said Gannon.

Derivatives can also enhance portfolio value through portable alpha and the creation of synthetic asset classes to boost potential absolute returns. Targeting low correlation across many strategies is the key to risk efficiency, said Hugh Prendergast, head of international products at Pioneer Investments. But how difficult is it to find uncorrelated strategies? One solution is to create a new asset class, comprising the portfolio manager's skill to provide alpha, which is uncorrelated with the underlying benchmark. "By removing market exposure from that strategy, the new source of return is uncorrelated to the underlying asset class," said Prendergast.

The champagne roundtable addressed audience concerns over the importance of institutions' credit ratings and fee disclosure. The latter sparked some lively debate between the panel and delegates, who demanded to know why distributors must disclose their fees in compliance with the Consumer Protection Code when issuers do not have to meet this obligation. The reason issuers or banks do not disclose their fees is because they are not required to and, in many cases, do not know what their fees are from the outset, said Alan Wolfe, senior consultant at IIB Bank. Unless an issuer fully pre-hedges its position, fees are unknown at the start of the product, he said.