The urge to converge

Market view

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In the first issue of Structured Products in October last year, I wrote about one of the most significant trends that I believed was developing across global structured products markets. This trend was the convergence between investment bank structured products businesses and traditional asset management.

A year later, it appears that this trend is now fully established. And if anything, it seems to be accelerating, as more and more investment banks move in this direction. It is therefore worth reviewing recent developments and examining the emerging consensus on where the market is heading.

Looking around the world at the evolving market for retail structured products, we can now identify several countries where the convergence trend is taking place. In Germany, for example, it is clear that the certificates market has become the primary route into structured products for retail investors and this market is driven by investment bank issuance. The regular complaints from the local fund management industry only underscore their concern at the loss of business they are experiencing.

Fund managers suffer

On the other side of the world, things are much the same. A recent research report from Cerulli suggested that traditional fund management firms are losing sales to investment bank-issued structured products in Asia, particularly Hong Kong, Singapore and Taiwan.

Shiv Taneja, head of Cerulli's Asian operation, said providers of traditional equity mutual funds feel they are being "cut out of the equation".

Back in Europe, several investment banks have created structured fund management businesses. Barclays Capital's Woolwich Plan Managers and West LB's Structured Solutions both in the UK, Nomura's new Altrus brand and SG's more well-established Lyxor business are all examples of this trend. In France we have also seen the launch of Casam (Credit Agricole Structured Asset Management) as a joint venture between Calyon and Credit Agricole Asset Management. DrKW has also recently set up a retail structured products platform in the UK.

Different class

One of the points I made last year was that this trend is being driven to a large extent by a desire by the industry to establish structured products as a separate asset class. The idea is that investors can more easily identify opportunities for investing in structured products when they can see them as an integral part of the normal asset allocation process. If investors begin to appreciate that holding, say, 10-20% of their portfolio in structured products can genuinely provide an improved risk-return profile, they will move away from regarding them as one-off tactical or speculative investments. This in turn will ensure that structured products become increasingly part of the mainstream investment market.

This idea has been further developed by SG, which published a guide to structured products recently that set out to position them in the context of the overall investment management scene. Figure 1 illustrates how it sees structured products fitting in.

The figure compares the different approaches to investment management on two dimensions. Horizontally it splits the market into active and discretionary investment styles on the left as against more passive or formulaic approaches on the right. On the vertical axis the range of investments being used is compared with the use of physical investments only at the bottom and the use of physical assets, derivative instruments and other new investment products at the top.

As can be seen, the proposition is that traditional active management (bottom left) is based on the selection of a range of underlying physical investments such as equities, bonds, cash, etc with the aim of achieving a superior performance relative to a specified benchmark.

Over recent years, however, there has been growing scepticism about the benefits of this approach and indeed the ability of most active managers to actually outperform their benchmarks.

New approaches

As a result, investors have been switching into newer investment products. Tracker funds, for example, which essentially set out to simply replicate the benchmark or index and do so at a much lower cost that that required for active management. Such products forsake an active, discretionary approach for a more passive and formulaic investment style (bottom right in the figure).

At the same time, there have been significant developments in the range of investments available, specifically in the derivatives markets, both exchange-traded and over-the-counter. This has encouraged new styles of investment management, here characterised as absolute return (or hedge) funds on the one side (top left) and structured products on the other (top right). Both of these approaches aim to capitalise on the availability of new financial instruments to create new kinds of investment vehicles.

The distinction between the two approaches is that whereas hedge funds use the full range of investment tools at their disposal, on a fully active and discretionary basis, to achieve an absolute return, structured products use derivatives and other modern portfolio management techniques such as CPPI, in a more passive or formulaic way.

Clearly this is a simplification, since some hedge funds use formula-based trend following approaches and some structured products combine a formulaic return linked to an underlying actively managed asset. However it does attempt to put into context the so called "structured asset management" approach to investment followed by structured products which involves a passive formulaic approach but uses new financial instruments and techniques. Such an approach lies at the heart of the structured products business.

Moving forward, we can see that for the asset management industry these developments represent a major challenge. If investors continue to lose faith in active management and look for absolute returns, then the investment banks have the right skills and expertise to "eat their lunch". Furthermore the investment banks have not been slow to spot these opportunities with product development teams and delivery platforms now being developed specifically to target the retail markets.

The challenge for the investment banks will be to see if they can capitalise on these developments and put in place the right people and product delivery infrastructure to meet the demand. A key requirement will be to tie in retail distribution and here the asset managers may still have some advantage through longstanding client relationships.

As I noted last year, with the market continuing to evolve, the one clear winner is certainly the end investor. While education of investors and their advisers on the use of structured products will be still be a key requirement, an increasingly competitive market offering a wider choice of products can only be a good thing for investors themselves.

- Robert Benson is managing director of Arete Consulting, the owner of StructuredRetailProducts.com. He can be reached at [email protected].

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