Structured products on mutual funds

The equity markets have seen much upheaval in the last three years: volatility has fluctuated considerably; share prices have plummeted; and correlation between different equity markets has risen significantly. These fast-changing conditions have prompted investors to turn to more diversified investments and encouraged distributors to use other asset classes as underlyings for their structures.

Hence, structured products on mutual funds are becoming increasingly popular. They offer a unique combination of benefits: dynamic asset allocation; risk diversification; structuring flexibility; and meet growing customer needs for active management. The wide variety of different fixed income and equity mutual funds also allows a broader variety of combinations in product underlyings than traditional equity-linked solutions, enhanced further by innovation.

Mutual funds: increasingly popular underlyings for structured products

Mutual funds are an efficient alternative to direct investment in equities or bonds, offering diversification opportunities at a moderate cost and with a relatively low level of risk.

Benefits for retail investors: Professional expertise. Investing in mutual funds allows investors to benefit from professional investment management, with active funds employing teams of experts to select assets from a broad yet still clearly segmented universe. Outperformance. Mutual funds can outperform traditional benchmark indices by leveraging on the manager’s ability to deliver returns superior to their benchmarks. Moreover, and unlike indices, fund dividends are capitalised, enabling investors to participate fully in the underlying’s growth. Market access. Mutual funds are an effective way for private investors to access non-traditional markets, such as high-yield bonds, emerging-market equities, Sharia-compliant stocks, commodities and real estate.

Benefits for distributors: Mutual fund underlyings offer distributors and asset managers a number of key advantages:

• They offer flexible structuring solutions and can be used for significantly larger issues than equity structures. For instance, products indexed on mutual funds may be sold with open entries/exits, rolling maturities and perpetual guarantees. Some very popular structures allow asset managers to select the underlying assets on a continuous basis, as opposed to a fixed basket of stocks or an index, and to alter the composition of the underlying according to their views. Open-ended funds are also the most suitable assets for issuing ‘mammoth’ deals while maintaining enough diversification.

• They are more profitable than traditional underlyings. Distributors can increase profitability when using in-house funds by retaining management fees and improving cross-fertilization.

• Last but not least, they are marketing-oriented underlyings. Working in collaboration with a reputable asset manager, a product distributor can benefit from the fund manager’s branding and marketing materials.

Structured products on mutual funds: an efficient mix of protection, leverage and dynamic allocation

Structured products can take advantage of these features of mutual funds, while also embedding value-added features. They can, for instance, outperform direct investments in funds through leverage and/or provide capital security. Through dynamic management, they allow more flexible investment combinations than those afforded by traditional equity-linked assets.

Principal protection: Investments in structured products on mutual funds can be partially or fully protected, depending on the investor’s risk/return profile.

Leverage: Structured products on mutual funds can provide leveraged exposure to the fund or basket of funds to meet the needs of more aggressive investors. Leveraged exposure allows for potential outperformance against a defined benchmark.

Dynamic allocation: Baskets of mutual funds can be managed actively to improve the overall product performance. The basket can comprise funds within a predefined universe that have performed better than their peers, or can be adjusted to retain the top performers. Alternatively, the basket can switch between asset classes – for example, from equities to bonds – to secure gains in difficult markets and to remain overweighted in the best-performing asset class. This dynamic allocation process is more commonly known as constant proportion portfolio insurance or CPPI.

This is achieved by the structuring bank adopting a systematic approach based on qualitative and quantitative criteria to select funds, optimise exposure and increase return potential.

Current trends

These key product features, combined with strong investor interest for diversification and dynamic management, explain the rising success of fund-linked solutions in Europe. Here is a brief overview of some recently launched products:

Spain: Spanish banks such as Santander Central Hispano are quite active in issuing fund-linked products. The ‘Superseleccion’ structure launched in 2003 was indexed on a dynamic basket of top-awarded funds (five-star S&P rankings). A periodic reshuffle was set up to remain exposed to the best underlying per category. Both the best-of feature and the qualitative criteria used were appealing. In total, the structure proved very successful among retail investors.

France: Structures on mutual funds have also been popular with the large French retail networks. Caisse d’Epargne launched ‘Bolero’ in January 2004, which pays the investor at maturity the higher of 8% and 65% of the final performance of a fund basket. Banque Populaire is currently marketing ‘Odeis Garanti 2009’, a CPPI product that provides investors with a return that is the greater of 75% of the highest performance of the dynamic basket during the product’s life and 100% of its final performance.

Italy: Italian retail products linked to mutual funds were very popular in 2003, just as they were in 2002. In 2002, they mainly employed CPPI techniques before switching, in 2003, either to more vanilla options or to options on such dynamically managed baskets. The success of retail products linked to mutual funds has involved both structured bonds issued by banks and structured insurance products. We estimate that products linked to mutual funds accounted for 30% to 50% of the overall structured retail market in 2003.

Current trends showing growing customer appetite for fund-linked products have been confirmed by recent market surveys conducted in France among a representative sample of retail investors. Results of barometers and product tests clearly showed that: a) diversification is a top investment objective. The majority of individual investors (63%) are interested in products on fund baskets offering asset and geographical diversification; b) active management is greatly appreciated. More than 60% of investors like the principle of dynamic allocation between risky and non-risky assets and prefer exposure managed by professionals to predefined formulas; and c) fund-linked structures are the best ranked compared to equity or index-linked products. They are perceived as the most appropriate and best potential structures given today’s market context.

Innovation on the move

Rising customer demand has put pressure on structurers, fostering innovation and the generation of ideas both on fixed-gearing and dynamic allocation structures.

Option-based products: Fund-linked structures have been increasingly embedded with exotic features (himalayas, capturing calls, etc.) to create value-added payoff profiles. Capti-spreads capitalising on the manager’s outperformance compared to its benchmark, and ‘best-of’s paying the maximum between an actively managed portfolio and a traditional basket of funds are some of BNP Paribas’ recent ideas. Going a step further is the ‘best of profiled’ strategy, which provides exposure to a set of different fund baskets with specific risk profiles (conservative/balanced/aggressive) and pays the best-performing strategy at the best moment. Its latest development enables investors to switch strategies to better adapt to changing market conditions, play economic cycles and enhance return – a key advancement allowing tailor-made active management in a secure environment.

Dynamic allocation products: Sophisticated CPPI structures have been launched recently, such as: actively managed CPPIs; best-of inflation CPPIs providing guaranteed inflation-linked returns; and perpetual guarantee CPPIs, offering rolling maturities and step-by-step protection with irregular inflows.

Options on dynamic basket structures from BNP Paribas are new structures based on portfolio management techniques. They use a dynamic allocation process that can increase participation, while maintaining a minimum degree of fund exposure to avoid any trigger risk. Innovative ODBs can be proposed with key features such as: lock-in mechanisms; periodic payment of coupons (with or without cancellability); and baskets of dynamic assets with automatic over-exposure to the best performing assets.

“ODBs have encountered unprecedented success”, says David Choukroun, head of mutual fund derivatives at BNP Paribas. “We are acting quickly to move ahead on new products, leveraging on all the structuring opportunities mutual funds offer”.

Spain France Italy Network Santander Central Hispano Banque Populaire Major insurance company Product launch January 2003 February 2004–January 2005 2003 Product name Fondo Superselección Odeis Garanti 2009   Product type Fund PEA funds + life insurance Equity linked capital protected note Product maturity Five years Five years with 11-month subscription period Five years Underlyings Dynamic basket of mutual funds selected using rotation principle Basket of mutual funds Basket of mutual funds Guarantee 100% 100% of the fund’s highest value during the subscription period 100% Product description Returns a participation in the upside of the dynamic basket of funds. Open ended (semi-annual exit without redemption fees) CPPI offering the best of at maturity (NAV at maturity; 75% highest NAV during product life) Call option on a dynamic basket of mutual funds Advertising Large advertising campaign (‘Simply the best’, Tina Turner) Press No advertising outside their network Comments Asian call with monthly averaging. Optimised tax efficiency An innovative product, both in terms of its structure and its subscription procedure A great success, being considered the next generation of the classic CPPI structure; it guarantees a minimum investment in mutual funds under any market conditions

Contact Christian Kwek, global head of structured products marketing T: [phone] E: [e-mail] Laurence Demarchi E: [e-mail]

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