Imagine the following sales pitch. A structured products marketer is sitting in the office of a large UK pensions fund manager. He asks the manager if one of his key drivers these days is liability matching. The manager replies that, yes, it is. The marketer then asks how the pension fund manager can get 100% liability management by taking punts on markets where there is no certainty attached to the outcome, and where, at best, hindsight can be used to predict that outcome. The manager admits he can’t. Now comes the closure. The structured products marketer explains that his trading desks have the ability to manufacture specific solutions that will exactly fit the pension fund manager’s risk and return perspective and exactly match his liabilities.
It is not difficult to identify the potential benefits that the use of structured products could offer a pension fund. But the question is, do the fund managers themselves recognise the advantages? “We’ve had those types of solutions presented to us, but we haven’t made any investments,” says Stephen Lowe, London-based head of asset strategy at Railpen Investments, a pension fund for railway workers. “We are risk-taking investors, and we don’t generally like to pass some of the returns stream of an investment to a third party.” (See profile, p.17).
Some dealers can see the logic in this. “Pensions funds in general, and certainly those in the UK, are very wary of buying structured products,” says Rashid Zuberi, head of the insurance and pensions group at Deutsche Bank in London. “In the past, continental financial institutions have used structured products actively for their asset pools, but less so for their liability-side hedging.”
Don’t mention the product
Chris Gottardo, director of the financial institutions group at SG in London, says pensions fund managers are currently asking him to put together portfolio-hedging solutions, rather than specific structured products. “Pensions are being forced to look at asset and liability modelling and management of their pension schemes,” he says. “That could include some sort of structured product, but rather than capital-guaranteed-type structures, there is an equivalent that we have a couple of pension schemes looking at quite seriously, which involves guaranteeing the future value of the equity portfolio.”
Gottardo notes that instead of pushing a particular product, his team will work from the top down. “We’ll say: ‘What do you believe your issues are?’ and ‘Let’s try to find a solution to your problem.’ Much of the time that involves using derivatives, but it’s not coming up with a product and pushing it. Pension trustees are very conservative, and generally will only use derivatives as a hedging tool, as opposed to an outright investment tool.”
Deutsche Bank’s Zuberi echoes this sentiment. He says the typical five-year or six-year duration of a structured product is at odds with the usual liability of a pension fund, which can run to 15 or 20 years. “The ideal trade for a pension fund or liability manager is one that closely matches his duration and his cash flows,” Zuberi says. This type of arrangement is known as an immunisation trade.
Another explanation concerns the way in which the asset mix of a pension fund evolves over time. As a pension scheme matures, the pension fund manager tends to reduce the equity exposure because the shortening time horizon means that less risk can be taken. “After 40 years the pension fund’s exposure to equities may only be 20%,” Gottardo says. That presents problems when using structured products because they can limit the pension fund manager’s flexibility to rebalance the portfolio.
“Because [pension funds] change the asset allocation over time, we have to provide them with the ability to reduce the volatility of their portfolio but also provide them with tools to assist the shift from equities to bonds,” Gottardo says. Again, that results in a portfolio solution rather than a single-product solution. “They tell us what they need their equity portfolio to be in 10 years’ time and we guarantee that value for them.”
It sounds as if the pensions fund market is simply a no-go area for structured products manufacturers. But not everyone is so pessimistic. Take, for example, Chris Taylor, head of UK structured and specialist products at HSBC Asset Management in London. He believes pension funds will inevitably embrace structured products, and that in fact they are currently on the cusp of doing so. “Structured products have been off the beaten track for pensions specialists – particularly in the institutional and consultancy world – when viewed against traditional and familiar asset class choices, such as equities, bonds, property, private equity, cash and less familiar alternatives such as hedge funds and commodities. But they are rapidly beginning to emerge as credible and viable mainstream options,” he says.
Taylor says pension fund advisers are now starting to accept that structured products can be manufactured to meet specific investor needs and investment scenarios. “Investment terms, formulaically defined to provide explicit product features, from both a risk and a return perspective, are highly attractive and beneficial,” he says. “In a low growth, low-return environment, a pragmatic portfolio approach is not just prudent but potentially most effective, especially when increasingly the key driver for the pensions world is liability matching and not necessarily high or unconstrained alpha.”
He adds that a solutions-based approach is ideal in mandates that are constructed to precisely match specified minimum returns criteria, time horizons and risk tolerances. But he warns that if the pensions market is to develop then lessons should be learned from the mis-selling controversies that have at times soured the retail structured products market. “This is clearly a marathon, not a sprint,” he says. “If providers can balance their determination to open the market up rapidly with ensuring genuine integrity of products, then the future is bright. Those providers who recognise the requirement to work with the pensions industry for the longer term will ultimately differentiate themselves as investment partners.”
Taylor foresees the emergence of specialist instruments created for pension funds, using the whole range of traditional structured product technology, from zero-coupon bond structures to constant proportion portfolio insurance. “Many of the familiar retail product structures transfer to the pensions world, from minimum return or digital payoffs to geared or leveraged growth,” he says.
Optimistic words. But if there is a market for selling structured products to pension funds then it is one that is still at an early stage of development. John Wilkinson, head of institutional investments at Man Investments in London, says he has worked with pension funds on solutions where the pay-off is linked to a fund-of-fund portfolio, but he admits that only a minority of institutions invested in the vehicle. “Pension funds are starting to use funds of hedge funds as a source of alpha, so we are in discussions to produce solutions that combine a fund-of-hedge-fund portfolio with exposure to a pre-determined asset class, which could be European equities, for example.”
Structures linked to alternative strategies may be the one area that could entice pension funds to use structured products, simply because it can be a relatively easy way to gain legitimate hedge fund exposure. “We’re starting to see pension funds become more innovative and entertain ideas that are different from what they’ve been doing historically – looking at the equity and bonds mix to meet their liabilities.”
European pension funds
The continental pensions market should, in theory at least, be more open to using structured products. After all, retail investors across Europe are used to making personal investments in structured products. So surely they, and the pension trustees that guard their money, will be more adventurous than their UK counterparts?
“We sell alternative products to pension funds, among others,” says Jean Francois Valicon, head of structured products at Barep Asset Management in Paris. He says the popularity of structured products with pension funds varies greatly between national markets. “In the French market there is a need for safety among pension funds, so the use of structured products is quite common,” he says.
Safety is the main selling point, notes Valicon. “For me, structured products are a transformation of basic products into safer products. You know your maximum loss, or your maximum cost of opportunity, and you can estimate an expected return, depending on the indexation and the style of formula that you apply to the underlying asset.” Another selling point is the fact that the returns on a capital-guaranteed product will not be closely correlated with the returns on a regular cash investment in the underlying, thereby improving an investment portfolio’s ‘efficient frontier’ – its overall risk/return trade-off.
The use of structured products to gain exposure to hedge funds is proving valuable in Europe, too, says Valicon. “Hedge funds are sometimes seen as risky, so the use of structured products means more safety for hedge fund investments.” Barep runs a range of hedge funds across various investment strategies. Valicon says a typical product for a pension fund would be an eight-year capital guaranteed investment indexed to a basket of hedge funds, using its internal hedge fund product. “We would build a dynamic portfolio of internal hedge funds – so the weightings can change over time – and we would index the capital guaranteed product to this basket. Depending on market conditions you would have part of the upside. This varies depending on the pay-off structure and the market conditions, but it can be close to 100%.”
Deutsche Bank’s Zuberi says that although the rest of the European market is slightly more open than the UK, it is far from established. He notes that, ultimately, what is essentially a passive investment will always be difficult to sell to a pension fund. “If you completely hedge a portfolio against interest rate and credit moves, the asset manager can’t generate alpha,” he says.
This could be the big problem for sellers of structured products. In the final analysis, it might be a question of control, or the lack of it, for that matter. Pension fund managers like to feel that it is their expertise that needs to be brought to bear, rather than the expertise of an investment banker. The potential is there, as are the selling points, but it is always going to be a hard sell.