Having been burnt by plummeting equity markets in the late 1990s, investment certificates have become the investment vehicle of choice among German investors. "Investment products (certificates) account for more than 99% of the country's structured investment market, leaving warrants or leveraged products with less than a 1% market share," according to 2005 figures released by Germany's recently established Derivate Forum, which is made up of the country's five largest investment banks. Five years ago the warrants market was the larger of the two, says Wolfgang Gerhardt, derivatives expert from Munich-based Sal Oppenheim.
In the first six months of 2005, investment certificates enjoyed a turnover rate of about 70% while leveraged products had a turnover of just 30% during the same period, adds Gerhardt. And this growth is expected to continue unabated, according to Frankfurt-based Klaus Oppermann, head of public distribution for Europe equity derivatives at Commerzbank.
There are around 60,000 warrants and certificates in the German market, but it is certificates that are growing fastest, Oppermann says. To explain the difference between certificates and warrants, Oppermann draws a distinction between leveraged products and investment products. Leveraged products are generally called warrants in Germany. They are securitised options and futures that tend to be riskier because they offer leveraged exposure, and are sold to high-net-worth and institutional customers via discount brokers. Investment certificates, on the other hand, are unleveraged and are therefore more popular with retail customers.
And structured note certificate issuance is on the up. Deutsche Bank, for example, started off in the warrants business, says Frankfurt-based Stefan Armbruster, director of investment products group at Deutsche. But today it has an equal mix of warrant and certificate products. It's a similar story across the board, with some 50% of the structured note market dedicated to certificates, says Martin Weithofer, managing director and head of structured retail sales at HVB, which is totally focused on investment products, rather than leveraged products.
Unlike warrants, certificates are not traded frequently on the secondary market. Customers tend to buy and hold them for between two and eight years. According to Oppermann, the majority of certificates are sold via "offline channels", which include private banks and savings banks, whereas warrants gain exposure through the media and are made available via broker platforms.
There is, however, some confusion surrounding so-called turbo certificates, which are leveraged products sold through broker platforms. A turbo certificate is a knock-out product, explains Gerhardt. Though they are similar to unleveraged certificates in so far as they participate on a ratio of one to one in the movement of the underlying, they expire as soon as they reach their knock-out level. The risk that the turbo certificate might expire worthless prior to its maturity date means it would be misleading to label them 'certificates', Gerhardt adds.
The rise to the top
Seven or eight years ago, when equity markets were at their peak, the certificates market was nowhere near as big as it is now. In 2000, certificates listed on the German Stock Exchange (DAX) had a turnover of just 24% compared to 76% for warrants. By 2004, certificates saw turnover in traded volumes jump to 47% (these figures are from the German Stock Exchange, feature some double counting and do not take into account products made available through private placement).
But the downturn in equities sent customers in search of higher levels of protection, HVB's Wiethofer explains, encouraging them to turn to capital-protected structured investment products.
Oppermann says retail customers initially learnt about the capital-protected structured note market through the media, which was used extensively to promote warrants to ultra-high-net-worth individuals and institutions. Retail investors caught wind of these products through the press and began demanding that their banks provide them with similar products, he adds. This "push-pull" situation left traditional sales channels with little choice but to open themselves up to investment banks, the main manufacturers of certificate products.
With certificates offering variety, safety and attractive risk/return profiles compared to fund structures, private banks and savings banks had to invite investment banks into an area typically associated with asset managers, Oppermann says. "Five years ago the retail distribution space was very much dominated by asset managers. Then as investment banks were able to conquer more and more traditional distribution channels usually dominated by mutual funds, certificates began to grow significantly," he adds.
Today, investment banks are in complete control of the retail structured products market. So strong is their dominance that asset managers are finding it hard to compete for a slice of the pie, explains Martin Theisinger, country head for Schroder Investment Management in Germany. "It is difficult to compete with investment banks because they pay higher fees to branch networks," Theisinger says.
As a result, fund-linked structures have failed to take off in Germany. "Fund-linked products are an exception in the structured products business," says Oppermann. Certificates, unlike mutual funds, are not licensed by the German regulator Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin). This unlicensed status allows them to use riskier underlyings, such as commodities, that are not usually permitted in a retail fund structure, and means they can quickly be brought to market, explains Horst Nottmeier, head of hedge fund section, securities supervision for BaFin.
Germany's growing appetite for certificates has also fostered the development of some innovative products. 'Express certificates', which are callable capital-at-risk products, are growing so rapidly that Oppermann says Commerzbank is considering making its 'side-step certificates', as they are called internally, a standard product family. "These products are popular at the moment, especially if you believe markets are unlikely to alter dramatically over the next few years," he adds. They also reflect a growing confidence in the equity markets, HVB's Weithofer says.
Express certificates began flooding the market six months ago. They are coupon payout structures that allow investors to redeem their full capital plus 10% if the underlying stays at or above the strike price at the end of its first observation date, usually a year from the close of the subscription period. If the underlying dips below the strike price at the first observation date and early redemption is not exercised, the certificate automatically continues to the next year.
It is typical for express certificates to have at least four or five attempts before reaching final maturity, Gerhardt explains. If the index still fails to meet or outperform the strike price, investors receive the initial strike price if the underlying does not drop further than 20–40%. But according to Gerhardt, back-testing has shown that express certificates tend to pay out after their first two maturity dates. There is something like a 70% chance that the coupon will be redeemed after the first year and an further 20% chance after year two. "Although express certificates are equity-linked, they are conservative structures," Deutsche's Armbruster notes.
Unlike capital-guaranteed certificates, express certificates benefit from favourable tax treatment, further encouraging investor demand, Gerhardt notes. If certificates with no capital guarantee feature are held for longer than 12 months, profits are exempt from tax.
Two years ago, bonus certificates were all the rage in Germany, mainly due to their conditional capital guarantee. And while capital-protected structures still account for around half the market, the burgeoning take-up of express certificates shows that active retail investors are displaying an increasing appetite for capital-at-risk structures, Weithofer says.
HVB, the largest provider of express certificates, has launched 35 products to date. According to HVB's product development manager, Susann Cudok, express certificates account for 13–15% of all products in the structured products market. Sal Oppenheim has so far launched four express certificates, which are available through private placement, while Deutsche says the sale of its express certificates have picked up considerably in last six months.