Structured retail products are launched on the UK market every working day of the year. More than 539 have been launched so far in 2004, according to StructuredRetailProducts.com, and the year-end volume is likely to total around £6.5 billion.
But unlike private banking-style products designed for high-net-worth individuals, which tend to be bespoke, retail products have a long sales period during which time the price is fixed and the issuer and hedge provider are forced to assume the attendant ‘pipeline’ risk. This means that by the time a retail product reaches its strike date it may have sold far more, or far less, than was originally anticipated.
Several factors determine the likelihood of each of these outcomes. Movement in interest rates and changes in volatility levels will obviously affect the attractiveness of a product from a purely pricing point of view, but other, more qualitative factors will also influence a product’s appeal.
Design is crucial to the future success of any product. Following the pack is not the best way to maximise sales, as products that have sold well recently are not guaranteed to maintain their attraction. It should also be remembered that speed to market for these products is slow, and that products are essentially being launched into anticipated future market conditions.
So let’s explore the vital ingredients for effective product design in the ultra-competitive world of retail investments, where future investor appetite must be gauged prior to developing a product.
Best of breed
In a highly competitive marketplace where tranche sizes are shrinking, all structured product providers are constantly searching for the best retail proposition for their particular investor base. Unfortunately, many overlook basic product design issues and instead focus on price. If a competitor launches a product with 105% participation on the FTSE 100, then for many providers the natural reaction is to attempt to beat these terms. Holding market variables and fees constant, this is only possible by extending the maturity of the transaction or changing the underlying investment benchmark, both of which may affect underlying demand.
The first rule of marketing is as relevant to the structured retail products market as any other. First and foremost, you need to define your target market and find out exactly what your retail investors want. In too many instances in the structured product market we find that the product is driven by the participation rate because the provider thinks that this is what will attract investors. This approach suggests that investors have simple needs and are generally in pursuit of high returns above all else. Consequently, when term rates decline (producing lower Zero Coupon Rates and less residual option spend) there will be a marked increase in product duration – five years will stretch to six years in order to preserve participation levels. But investors don’t necessarily value higher potential returns over earlier access to their funds; experience shows a big fall in demand as product tenor extends beyond five years.
Indeed, many investors look for the shortest investment term possible so long as returns are considered ‘respectable’. So, for example, during times when rates are rising there will be a noticeable increase in shorter maturity products. This year has not only seen a shortening of product tenor compared to 2003, but also the launch of some two-year structures. There were none of these in 2003, when term rates were as much as 2% lower than their peak in 2004 and volatility was double its current level.
Diversification of the underlying
Switching from an investment anchored to the FTSE 100 to one with a payout linked to a basket of indices, such as the S&P500, DJ Eurostoxx50, FTSE 100 and Nikkei225, can provide a significant boost to participation levels. But the chances of this extra participation translating into increased returns at maturity will depend heavily upon the correlation of the four indices. If there is low correlation, returns will be materially constrained. This is not exactly a good deal for investors, and even if they don’t appreciate this fact, there is no doubt that they will find it much harder to visualise the likely range of outcomes from an investment in an index basket. This factor alone will tend to reduce the number of potential investors in the product and will therefore limit sales.
When designing a product it is important to remember that investors will often have a view on likely future market performance and this will influence their appetite for one product over another. At present, for example, the economic backdrop in the UK is dominated by high oil prices, a mixed outlook for interest rates, a likely downturn in house prices, political uncertainty resulting from a General Election on the horizon, slow economic growth in Europe, and the prospects of higher US interest rates. That’s a very confusing picture, and one that a growing number of investors believe will limit the scope for significant gains in the FTSE in the short- to medium-term. These investors will shy away from products that promise only high potential returns – after all, 100% participation in a market that rises by just 10% is not that appealing.
In this scenario, investors may gravitate towards minimum-return structures. The rationale here being that they are content to accept reduced scope for high total returns in exchange for a guaranteed minimum. At present, product can be offered giving either a 25% minimum return over six years OR 50% participation in the FTSE 100, or, alternatively, a 20% minimum OR 65% participation. In a raging bull market these structures would simply not sell, but in more subdued times they are ideal.
Different institutions have different investor bases, and this needs to be taken into account. Some institutions, for example, have a high proportion of clients that simply deposit funds as savings. These institutions will do best offering simple products with as short a maturity as possible. On the other hand, an institution may have a wealthier client base with more sophisticated investment requirements, in which case it may be possible to introduce more adventurous products with longer maturities. The product wrapper is important in this case, as the taxation treatment of the final returns may relevant to higher-rate taxpayers. The product developer will therefore need to consider whether to structure the deal as a deposit, an MTN inside an ISA, a Life Bond or an offshore fund or OEIC. Post-tax returns may be the main driver for sales rather than whether the product promises 100% or 105% participation.
Demand-driven sales approach
Before any actual product design takes place it is imperative that the sales force is consulted. After all, they are the people who should know what their investor base is looking to buy. Once initial feedback is received the product development team can start to put together some product ideas. These ideas can then be discussed once more with the sales force and the product refined further based on a productive two-way flow of information. This process of continual refinement ensures the buy-in of the sales force and also guarantees that the product is truly demand-driven. This latter point is very important because however highly engineered or ingenious a structured product may be, it will sell only if it is what people want to buy. Product looking for a market is a recipe for failure.
Intense competition in the structured retail products market is here to stay. The providers that will flourish are likely to be those that offer products that are appropriate to investor demand and sensitive to market sentiment and economic conditions, not those that offer the cleverest ideas or the widest range of structures. The secret of success in a highly conservative and suspicious market is to work with your sales force and focus on client needs, not product features.
| Step 1. Product development area consults sales force about investor demand |
Step 2. Product development area/hedging specialists propose a small number of product ideas based on sales force feedback, market outlook, product pricing, fee structure, market-pricing variables plus relevant competitor information if appropriate
Step 3. Two-way discussion between product development and sales areas, selection and refinement of optimum product for institutions client base. If product hedging takes place outside product development area then hedging specialist will also be a party to all discussions
Step 4. Final pricing, hedging and product launch
Christopher Taylor is the London-based director of the structured retail product group for HSBC Corporate, Investment Banking & Markets. He can be reached at [email protected]