A return to simplicity

A paradigm shift is taking place in the structured note market, away from highly mathematical, complex payouts in favour of underlyings that leverage bank research and systematic trading strategies. John Ferry reports

The structured products business has, over the past decade, occasionally resembled an arms race. Equity derivatives desks have rushed to hire the best quantitative experts, able to put together ever more sophisticated, mathematically complex payouts. As sales grew, marketing of products increasingly focused on the next great payout, inevitably a step-up in complexity on what had gone before.

The market is changing, however. Dealers are now moving away from complex payouts in favour of compelling investment themes based on research. The story emerging from structured products desks today is one of investors turning away from the difficult-to-understand payouts. "If you look at the trading strategies that attract the biggest following, they are the ones that use established ideas within a new framework - as ever, the old ideas are the best," explains Thomas Salter, executive director in JP Morgan's equity derivatives group in London. "So momentum, the spread between implied and realised volatility, foreign exchange carry and yield curve carry, are all popular. And on these strategies, investors demand simple payouts."

Two main types of products are emerging. On the one hand, dealers are seeking to offer trading strategies usually associated with hedge funds - for instance, equity long/short or foreign exchange carry - to a wider universe of investors through rules-based algorithms. These products are marketed as providing the performance benefits of alternative investments without the downsides of high fees and a lack of transparency.

Banks are also looking to sell products that, in a sense, offer a return to the basics of investing, but in a systematic way. These strategies use fundamental analysis to extract value from the market. So, an algorithm may choose the top performers from a universe of stocks based on some fundamental criteria, such as earnings performance, dividend yield, momentum or some other signal - or a group of signals - and rebalance the underlying portfolio to keep the investor constantly exposed to the most attractive companies.

All the major dealers are currently punting their own versions of these products. JP Morgan, for example, is looking to combine fundamental analysis with the systematic application of a traditional hedge fund technique. The product, yet to be released, will employ an equity long/short strategy that relies on ranking stocks based on a number of fundamental metrics. The exact make-up of the strategy is still being developed, but JP Morgan's strategists say it is likely to encompass five to 10 different factors, which could include price/earnings ratios, dividend yield and earnings-per-share expectations. The strategy would work by investing in a certain number of stocks identified by the algorithm as being top performers, while going short those companies the algorithm signals should give least value. The portfolio would then be rebalanced monthly as new data comes in.

Marco Dion, JP Morgan's European head of equity quantitative research, says the underlying algorithm works by simply ranking the stocks in each category, then aggregating the ranking across categories. "We always look at consensus data from the street to get our rankings," he explains. "Once you find valuation metrics you're happy with, then you improve the strategy by bringing in new factors to ensure the equation and the algorithm is correct in terms of valuation."

JP Morgan has a number of other strategies on the market at the moment, including one that takes advantage of different carry opportunities across numerous asset classes, and one that uses the principles of modern portfolio theory (MPT).

In the latter case, the product (called Efficiente) is a cross-asset strategy that uses MPT to try to maximise returns per unit of risk. MPT sets out a process for constructing a portfolio that, for a given level of market risk, optimises expected returns for investments in multiple asset classes. It uses historical returns, risk and covariance parameters as the basis for working out the optimal weightings for each asset in the portfolio in terms of risk and return. The product is based on a portfolio of nine global indexes covering the major equity and bond markets, as well as alternative investments, and rebalances every quarter by selecting new weights for each asset in the portfolio. JP Morgan's back-testing suggests that, over the past 12 years, Efficiente (euro hedged and net of a 1% fee) would have had average annual returns of 10.9% with 8% volatility.

Other banks have been just as busy. Credit Suisse has launched various structured notes based on its proprietary Holt equity performance and valuation system. The starting premise for Holt is that the regular fundamental metrics used by the rest of the investment markets are flawed, explains David Holland, managing director at Credit Suisse in London and co-head of its Holt Valuation and Analytics service. "Numbers such as price/earnings ratios, return-on-equity and earnings growth are highly unreliable," says Holland. "It's very easy for management to manipulate earnings, for example - they can change depreciation policy, take assets off the balance sheet or take special charges. Holt identifies the various accounting distortions, reverses them and calculates a return based on the cash invested in a business and the cash generated from that investment."

The aim is to find a pure measure of economic performance for companies. This is expressed through the firm's proprietary cashflow return on investment (CFROI) metric. Holt - the company started as a niche research firm based in Chicago in the 1980s before being bought by Credit Suisse in 2002 - has a database of more than 19,000 companies that have been valued using its CFROI system.

One of the structured products launched by the bank was referenced to the H^S60 Index, an equally weighted index of 60 global stocks identified by Holt's internal scoring system as most attractive. The index is rebalanced annually. Holland says three main characteristics of a company are observed when coming up with its score: "One is operational performance, so we're looking for companies that are beating their cost of capital and creating value. Here, we would use CFROI quite heavily, among other measures. The next category is valuation, where we look at how attractive the company is according to Holt's discounted cashflow model. The third is market sentiment or momentum, where we identify companies with positive changes in expected cashflow generation and positive price momentum." Overall, the system should find wealth-creating businesses that are underpriced and have positive market sentiment, adds Holland.

Benchmarked against the MSCI World index, the H^S60 shows consistent outperformance dating back to 1996. Between April 1996 and December 2007, the MSCI World index doubled in value, while the H^S60 quadrupled in value. Credit Suisse says most investors wish to take simple linear exposure to the index via a structured note.

A different tack

The Royal Bank of Scotland is also looking to issue structured notes on a strategy that shows superior back-tested performance. However, it is taking a different tack to Credit Suisse and JP Morgan, in that it is seeking to take advantage of a statistical anomaly in markets. Shane Edwards, London-based head of equity derivatives structuring at the bank, is looking to garner investor interest in the 'turn-of-the-month' effect that research suggests is prevalent in equity markets. Analysis shows that equity returns immediately before and after the end of the month are well above average, which means simply being long equities on those days and investing in cash the rest of the month will produce outperformance, claims Edwards: "Studies have shown that the turn-of-the-month (TOM) phenomenon has been profitable since 1897 in the US equity market, but our testing shows it to work across many of the world's equity markets," he says.

A number of theories have been put forward to explain the phenomenon, from the fact that fund managers tend to rebalance their portfolios at the end of the month, with redemptions and withdrawals stimulating trading, to basic human psychology affecting the markets. Whatever the reasons, Edwards says history proves it works. He analysed a simple strategy that took a long position on the Dow Jones Eurostoxx 50 index two days before the end of each month and maintained it for a couple of days into the next month. Over the past 10 years, the Eurostoxx index appreciated an average of 5.98% a year. The TOM strategy, however, returned 10% a year - and that is before taking account of the returns on the cash investment for the part of the month the assets are not invested.

TOM strategies are also relatively cheap to run, says Edwards: "Because this is exposed to fewer days of fluctuations, we're doing less hedging, so it's a much cheaper call option." The bank plans to offer the product linked to global indexes and baskets of stocks, as a capital-protected note and as a delta-one Ucits III fund.

Whether it is constructing an automatic algorithm for running an alternative investment strategy, tying the buy and sell signals of fundamental analysis into an automatic strategy, combining both approaches in a single product, or employing what may seem like an off-the-wall statistical phenomenon observed historically in the markets, dealers say the focus of product providers today has changed dramatically. Simplicity, transparency and understanding are now the order of the day rather than complexity and flashy mathematical payouts. It is a back-to-basics approach for a post-subprime era, where anything that is complex could well be viewed by investors, especially retail investors, with suspicion. But how significant is this shift? Is it the end of the era of increasingly complex payouts?

Not quite. "Complex payouts are still happening, but they are not necessarily the driver of products as they were several years back," says Jessica Houtepen, Credit Suisse's London-based head of global equity derivatives structuring. So it seems the rocket scientists still have a place on trading desks, even if what they are doing may be more in the background.