Climbing the mountain


Canada's financial market has in the past been characterised by its insularity - dominated as it is by the so-called 'big six' native banks and protectionist regulatory authorities. This did not provide the markets with immunity from the international credit crisis on any level. Domestic institutions have suffered multi-million dollar writedowns as a result of their sub-prime exposure.

The key question here is whether a backlash against the complex derivatives responsible for these losses will harm the progress of the nascent structured products market in Canada against rival financial instruments. "There is a part of it which will, but people will see that structured products can be used as a defence mechanism and a hedge," said Desmond Alvares, director of member education services at the Investment Industry Regulatory Organisation of Canada, during a roundtable discussion on the use of structured products versus mutual funds.

It is a testing market, confirmed Michael Clark, head of retail structured products Americas at Credit Suisse, who estimated that volumes were down about 30%. Nonetheless, he highlighted that "people are still interested in the risk mitigation that structured products can offer," while conceding that the difficult conditions mean nothing is selling as much as it should be.

Mutual funds have enjoyed a long-held dominance in Canada, but structured products might now face stiffer competition from the booming exchange-traded fund (ETF) market. It is experiencing phenomenal growth akin to that of its US neighbour, and was the strongest performing market of 2007, according to Hamid Omoumi, managing director at National Bank Financial. The ETF market in Canada is valued at between C$19 billion and C$20 billion, he said, but is estimated to be worth closer to C$40 billion, as around half of the ETFs traded by Canadian investors are US listed. This is an impressive climb up from the C$3.5 billion to C$4.5 billion that the market was worth six years ago, with ETFs now representing 5% of Toronto Stock Exchange trading volumes.

Market-linked industries have experienced growth across the board. According to Omoumi, as of September 2007, annual issuance had hit C$41.1 billion in market-linked products, with roughly a 50% split between the notes and Guaranteed Investment Certificates (GICs). Omoumi highlighted low interest rates and tax law changes as two of the main drivers of the popularity of PPNs. The government has been progressively lowering the percentage of capital gains that must be included in taxable income since 2000, he said. This removes one of the significant barriers to growth that has stunted the development of the US market - the 'phantom income' tax situation which makes notes inefficient in tax terms (Cover story, Structured Products March 2008).

However, other speakers highlighted the limitations of structured products against the exchange-traded space. "Structured products have the ability to offer tailored exposure," said Bryan Snelson, vice-president, financial adviser and branch manager at distributor Raymond James, "but their liquidity relative to ETFs confines them to a supporting role in a portfolio." He highlighted the unique opportunity now presented by the imminent retirement of baby-boomers. "The maturing of the baby boomer generation will be very important," he said. "It is all about control - this is what baby boomers are about; they want it all and they want it now." He described it as a generation that has had its needs consistently pandered to, which will have longer and more active retirements than anyone else.

Regaining trust

One of the biggest market challenges, he warned, is that "the well of consumer trust has run dry". Regaining that trust is a priority, which has been reflected in the new regulations that have been issued surrounding disclosure on principal-protected notes (see this issue's News section). The Ontario Securities Commission (OSC) described the rationale behind the whole package of regulatory changes that have been implemented. "There were concerns about investor protection," said Jo-Anne Matear, assistant manager of the corporate finance branch of the OSC, with reference to the disclosure on linked-notes.

"They are similar to investment funds but not subject to the same regulations with regards to disclosure." The OSC was also concerned that base shelf prospectuses were not providing adequate disclosure, and neither were the subsequent supplements used for products issued from off the shelf. Unless these contained 'novel' derivatives (ones that have not been issued in Canada before, or were structurally different to previous notes) then the issuer did not need to clear them with the regulator.

The approach that has been taken is based around the idea that prospectuses must contain "full, true and plain disclosure" of all material facts relating to the notes. "The essential information should be front and centre and summarise the main features of the notes," said Matear. This has been made all the more pertinent by the 'retailisation' of complex alternative investment strategies that are used as underlyings for the notes - for example linking to hedge funds, explained Leslie Byberg, also of the OSC, and manager of the investment funds branch.

Up until now, principal-protected notes have suffered from some misleading marketing, explained Peter Loach, vice-president and managing director, investment fund research at BMO Nesbitt Burns.

The main problem areas have included a lack of transparency, no investor understanding of the construction of PPNs, disappointing CPPI performance and poor comprehension of fee structures, said Loach. "With CPPI, the fees are disclosed. But with option-based products it is built into the option - you don't know what the fees are," he said. "The marketing spin that sometimes accompanies option-based notes is 'no management fee'. Investors may believe that such notes are inexpensive - as far as fees go - but in fact, the cost to investors may be similar to that of CPPI." However, he expressed confidence that the situation is improving: "Every month the sector becomes more retail friendly, and it will continue to get better," he said. "There is more and more compliance every month, which puts more pressure on advisers. It protects them to do full disclosure."

Underlying themes

What may make future sales easier for regulators and advisers alike is that development seems to be shifting to underlyings rather than structures. Thematic investments are increasing in popularity among Canadian investors, as investors seek exposure to new asset classes outside of Canada.

"Opportunities for structured products are moving away from just 70/30 on Canadian and global equity markets," explained Steve Masson, director and head of products and services consulting at UBS Canada. Masson named several themes which are as yet not represented in mainstream indexes: China infrastructure, solar energy indexes, climate change, the iPhone and home building rates among others. A UBS product linked to the latter, the Home Builder Bear Certificate, offers downside exposure to the Philadelphia Stock Exchange Housing Sector Index. Credit Suisse is also planning to release its series of Holt thematic indexes into this market. "It is in the early stages in Canada, we are still getting regulatory approval," explained Michael Clark of the bank, which has already offered global warming and water notes to Canadian investors.

Thematic notes can serve specific hedging strategies as well. "For one client, their biggest risk was drought in Canada over the summer," explained Chris Kruczynski, investment executive at investment dealer Scotia McLeod. "So they went to ScotiaBank and asked for a note which would pay a positive return if there was a drought."

Given the writedown woes in Canada, financial stocks have also emerged as an attractive underlying for notes. As NBF's Omoumi emphasised, these products are very thematic, yet also invite investors to take a view on markets. Such adaptability in the face of a negative outlook provides further reassurance that the credit crisis will not be the sinking of the Canadian structured products market.

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