Equity derivatives house of the year – UBS Warburg

If you thought institutional investors and fund managers were remorseless in their desire to shave the last basis point of trading cost, think again. Some of the largest are keen to reward derivatives dealers for their ideas as well.

Take Deutscher Investment Trust (DIT), the e46 billion fund management arm of the Allianz Group, for example. It has been an active user of derivatives overlay strategies for 10 years, and is one of the most sophisticated buy-side users of derivatives in Europe. DIT is a bottom-up stock picker, and so has a strong bias to using single-stock options to generate absolute returns over relatively short terms, typically three months, says Eric Böss, the firm’s Frankfurt-based head of equity and derivatives trading. Typically, that means writing call options. In the last quarter of the year, with European markets recovering from their lows, DIT made money from selling put options on shares such as France telecom and Munich Re, and straddles on pharmaceutical stocks. “This was the first year in the six years I’ve been at DIT that we really went out and sold volatility,” says Böss.

While price is important to Böss in choosing his derivatives dealers, he is most impressed by UBS Warburg’s derivatives research, singling out analyst Alex Ineichen’s work on single-stock options for praise. “They understand our set-up and how it works,” he says.

Effectively treating volatility as a tradable asset, DIT is far ahead of most other European fund managers. But there’s no doubt that use of derivatives by other buy-side firms is spreading fast. Although Handelsbanken Asset Management, part of the Svenska Handelsbanken, only does a small volume of derivatives dealing at present, it is expecting to do significantly more over coming months in an effort to leverage better returns from its portfolios, says Richard Nilsonn, head of equity trading at the Stockholm-based investor.

Again, the quality of research is more important than the price of the trade, because Nilsonn is looking for information about a range of trading opportunities. He singles out UBS Warburg’s research on stock volatilities for praise. “If I have a single-stock option trade in volume, my first call would be to UBS,” he says.

UBS Warburg’s reputation for solid, reliable, advice in equity derivatives dealing has been hard won. In 1997 the bank was almost bust. Belying its image as a conservative pillar of the Swiss financial establishment, its global equity derivatives business, run by Ramy Goldstein, had taken large, mispriced and un-hedgeable bets writing long-term options.

UBS was forced to write off Sfr650 million in 1997 and SBC, which bought UBS in 1998, was forced to write off another Sfr760 million. These losses, coupled with losses sustained on a giant call option sold to the Long-Term Capital Management hedge fund in 1997, forced UBS into the hands of its rival, SBC, and turned UBS into a textbook study of how to mis-manage risk.

Over the past five years, the equity business has been rebuilt on more solid foundations. Wolfgang Stolz, UBS Warburg’s European head of equity derivatives, was working as a marketer for the firm in 1997. “The first lesson we learned was the need for diversification. Seventy percent of our business had been in five or 10-year guaranteed products. Today, none of our fifteen or so equity derivatives lines account for more than maybe 10% or 12% of revenues.”

Although UBS Warburg’s European equity derivatives business has seen total revenues fall over the past 12 months – about 15% or so from a record in 2001 – that diversity has been a key strength in a difficult market. Corporate finance related business was worst hit. Structuring and distributing hedge fund products to investors large and small was the healthiest single line.

Among European pension fund and insurance companies, the most important trend has been the move to large-scale hedging and portfolio insurance products, a business in which UBS Warburg has been in a good position to exploit because of its weighty share of the cash markets. In 2001 a typical European pension fund trade might have been a $50m notional cliquet options purchase; in 2003 that often became a one billion euro notional deal involving put spreads or collars, says Stolz.

The Continental European retail investment market is still the crucible of innovation for equity derivatives. New ideas are exported from Europe to Asia (especially, Hong Kong, where the warrants and principal-protected funds business boomed) and the United States (a market that could boom this year).

But 2002 saw the limits of European innovation tested. The central challenge was that, as interest rates continued to fall last year, investment products nominally marketed to protect capital actually became more risky, as returns became increasingly geared to the performance of a single stock, for example, in order to generate the margin for capital protection.

There has been a backlash against more complex products that appeared to offer high returns in addition to the ever-popular capital guarantee, but that also included ‘worst-of’ features that wiped out any gains. In December, for example, the Banca d’Italia was reported to be considering a cap at twice the annual euro Libor rate on interest coupons offered to retail investors in the same package as equity products – the implication being that only unacceptable risks could pay for such a rich optical return.

UBS Warburg’s Stolz believes there is a clear “flight from complexity” among investors, which plays to a key strength of his firm in developing and selling ‘plain vanilla’ certificate products, in Switzerland and Germany especially. UBS Warburg has successfully tapped into new distribution lines for such products. For example, it was mandated by Deutsche Telekom to provide its employees and pensioners with a monthly saving scheme to invest mostly in Dax index and Eurostoxx index certificates.

The best equity derivatives business is coming to UBS Warburg via its wealth management business, which is headed by Marcel Rohner, the 38-year old former group chief risk officer. Inflows into the UBS private banking network from European clients are at record levels, while in the US PaineWebber has increased its market share of the private client market from 11.7% in November 2000 when the broker was bought by UBS, to 13.7% in the third quarter of last year.

According to Jeff Sparks, the firm’s Stamford-based managing director in charge of high-net-worth client products, the plan is to create two tiers of distribution – one to the “mass affluent” market of buyers of structured investment products, and the other to investors with $5 million or more.

Other derivatives firms are not making that distinction, says Sparks, and that is reflected in UBS Warburg’s lead last year in bringing ‘top end’ products such as principal protected hedge fund-of-funds and hedge fund call warrants to the market.

Although only half a dozen or so dealing firms have the kind of access to hedge fund assets required to develop products for the high net worth market, this is a highly competitive business. As in Europe, UBS Warburg has more than enough room to grow its business: so far only around 40% of PaineWebber’s 8,400 brokers have sold products structured by Sparks’ group.

And while the market for corporate finance products has been terrible over the past 12 months, this has nonetheless been a field in which UBS Warburg has been an innovator. The product with greatest potential is Tops, UBS Warburg’s tradable executive options programmes, which companies can offer to employee option holders as a means of hedging part of their exposure to the company’s share price. The option holders sell some of their options to UBS Warburg, and options are then sold on to investors in the form of covered warrants.

Again, this is a simple product. The devil is the administrative detail, as Vito Schiro, managing director in charge of equity risk management at UBS Warburg in Zurich, explains. “While Tops does not change the accounting treatment of share options schemes for companies, you do have to be careful that you do not breach any sales restrictions with the scheme, especially when US investors are concerned,” he says.

The Tops product has taken off quickly in Switzerland, where it has been used by a dozen major companies so far, including pharmaceuticals giant Novartis, largely because Swiss tax authorities are unique in using Black Scholes-based models to price the time value of share options schemes and to levy up-front taxes accordingly. As a consequence, Swiss share option holders tend to be keen to realise the time value of the options they hold.

Tops is perhaps the best example of how UBS Warburg has been able to link its expertise in equity derivatives to the UBS private banking franchise. Executives that have just succeeded in cashing in some of their wealth using a Tops scheme are more than likely to be ready to be sold other wealth management products.

Tops’ international potential will become clear over coming months, as the treatment of such schemes by the International Accounting Standards Board becomes clearer. But UBS Warburg says it is confident of signing some major Dax-listed companies to Tops schemes in the near future, following an extensive marketing campaign in Germany. It also believes the product has a promising future in the US, where Tops schemes could help companies mark their executive share schemes to market.

Mike Collins, UBS Warburg’s head of US corporate equity risk management, predicts a growing number of companies will be restructuring employee compensation programmes in the light of new accounting standards – and of course weaker share prices. For example, they will be considering restricted stock programmes or programmes linked to peer group performance indexes. The premium will be on maximising the flexibility. “For the first time in my experience, companies are coming to us and telling us they are interested in providing their employees with the ability to hedge and trade their compensation schemes,” says Collins. One sign of UBS Warburg’s ability to grab that kind of business: it is one of two firms being used by Coca Cola to provide core advice on marking the company’s employee share options scheme to market.

As in Europe, the firm’s share of the cash market in equities is will help. According to Autex, the securities trading database, UBS Warburg ranked number five among investment banks, with an 8.7% market share, in trading of listed US stocks in 2002.

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