Escaping the fees maze

Fee transparency in structured products is a subject of heated debate and a target for critics' accusations of over-complexity. However, fees are disclosed with more candour than is usually assumed. Matt Cameron examines the charges levied on products, how they are revealed and just how issuers make their money

Detractors of structured products can often be heard asserting that the investments are not transparent, display poor fee disclosure and resemble so-called 'black boxes'. In reality, however, fees are disclosed with a great deal of transparency and openness. Third-party distributor fees can be found on almost all term sheets in Europe, the US and in most other countries. More often than not, a maximum percentage charge is detailed as well, and in some cases the entire fee is stated explicitly. The fact that fees are built into products does not necessarily mean that they are withheld or are difficult to discern, and when compared to mutual funds, structured products are considerably cheaper in terms of levied fees.

Issuers are required to adhere to codes of disclosure that differ between regions and markets. In Europe, providers are subject to the Markets and Financial Instruments Directive (Mifid), which, despite being far from perfect, is a regulation that has promoted clarity in the structured products space. Continuing to confound the cliched black-box theory is the current situation in the Finnish structured products market, where fee and product disclosure has been discussed at length. The Finnish Structured Products Association (FSPA) has released guidelines requiring maximum disclosure of products, including the derivative and zero-coupon bond components, in order to obtain heightened product and fee transparency. Over in the US, meanwhile, the prospectuses required by law go into exhaustive detail regarding fees and product information.

When they are deconstructed, structured products charges can split into two categories. The first is third-party distributor fees, which make up the biggest percentage of any product fee, and the second is structurer fees, which comprise legal, listing, administrative, licensing and wrapper tariffs, plus the risk margin taken by the issuer to hedge the underlying derivative.

Looking forward, fee disclosure may follow the example set in Scandinavia, or perhaps the lead may be taken by more innovative products, which charge fees on the performance of the underlying.

In Europe, Mifid requires that all issuers take reasonable steps to ensure the best execution for a client, subject to a few quirks. Initially the relevant part of Mifid, known as the inducements regime, was drafted as a soft commission rule which stated that inducements could not be paid to distributors. But late in the drafting stage more information was added to change it into a commission disclosure rule. Effectively, the rule says that payments made to third-party distributors that are not purely for the benefit of the customer are disclosable.

Several loopholes exist in the commission disclosure rule, says Simon Gleeson, a partner at law firm Clifford Chance in London. For example, it applies only to payments between separate legal entities, and therefore does not apply to a financial institution that creates and distributes products, as it is the same legal entity. If an organisation is split into two entities, the rule only catches cash payments between them, rather than sales credits or bonus arrangements. Finally, the rule does not catch the profit margin made on the transaction. "The Mifid rule is therefore a bad fit for what actually goes on in the market," says Gleeson.

However, in many jurisdictions the maximum percentage charges are often revealed to the client purchasing the product, and includes both the disclosed third-party distributor fee as well as the structurer fee. This allows an investor to work out a maximum fee. For instance, the term sheet for the Barclays Regular Income Bond in the UK states that the returns "are net of all anticipated charges and expenses (excluding any tax). These charges are taken on the start date and are estimated to be not more than 6% of the subscription, excluding any such tax or charges for taxation changes, but including commission paid to any financial adviser who arranged the subscription."

The documentation requirements would appear to be the same in the US, where issuers are required to compile detailed prospectuses outlining distributor fees and the maximum percentage charge that can be levied. On a term sheet for a JP Morgan reverse exchangeable linked to the common stock of Alcoa, the prospectus states "in no event will the fees and commissions received by JP Morgan Securities ... which include concessions to be allowed to other dealers, exceed $60.00 per $1,000 principal amount note for any of the offerings listed above."

The Mifid directive states that the issuer is obliged to disclose details of any fees if a client requests them, which renders all fee information transparent and easily available. The question of whether there should be more clarity in disclosure is ongoing and is being discussed at the trade association level in various countries, although a consensus has not been reached. The problem, says Gleeson, is that there is apprehension in asking for more clarification from regulators for fear of disclosure being taken to unnecessary lengths. "It is the 'be careful what you wish for scenario'," he says.

Northern disclosure

Practices in Nordic countries take disclosure to another level. Not only must the fees be disclosed, but also the actual cost of the derivative, including the zero-coupon components. In Finland, the FSPA has recommended to its members that they disclose structuring costs to increase transparency. The idea is that the components of a product are valued on specific valuation days. The production cost is the sum of the values of these components on the valuation date, hence the difference between the subscription price and the production cost is defined as the structuring cost.

The zero-coupon component is calculated by the common zero-coupon valuation formula, while the derivative component is valued using the best available price. The production cost is calculated on a daily basis by taking into account the change in interest rate, volatility and other market parameters. The subscription price is also adjusted on a daily basis so that both the structuring cost stays at the same level throughout the selling period and each investor gets the product at the same structuring cost. The bank need not hedge its positions on a daily basis but it bears the risk from both negative and positive market movements during the subscription period.

For example, with a five-year product, if the production cost on the first day is 96.65% and the subscription price is 100%, the structuring cost will be 3.35%, which is equal to 0.67% a year. If the issuer sells an unhedged EUR1 million on the first day and volatility rises on the following day the option becomes more valuable, which costs the issuer but not the investor. Assuming that the change in volatility raises the production value to 97%, the subscription price will be adjusted to 100.35% in order to keep the structuring cost (of 3.35%) the same. But as the bank did not hedge from inception, its income from selling the product will now be reduced to 3% - while investors buying on the first and the following day will have done so at the same price. The difference between the 3.35% structuring cost at inception and the post volatility 3% is 0.35%, which represents a trading loss for the issuer. The same procedure acts in reverse if market conditions are favourable to the issuer.

This means of disclosure is practiced throughout the Scandinavian region. "The practice is not in line with European standards, because Mifid only requires the direct costs of the product to be disclosed and not the margin," says Antti Parviainen, head of structured products Finland at Nordea and chairman of the FSPA in Helsinki. "But in the Nordic countries the local FSAs believe the transparency in products should be higher and have voiced their opinions over the matter." Although the practice is law only in Norway, it is applied in Finland, Sweden and Denmark as most of the major local banks have operations that span the region.

While fee disclosure in the Nordic region is transparent, it is not clear how helpful is it to disclose component prices to investors and whether this trend has spread to other regions. Ultimately expert knowledge is needed to fully understand the decomposed components of even a simple equity-linked note and investors in the long run will look only at the structuring cost and not at the actual price of the derivative and bond. "Investors could try and compare plain vanilla products," says Michael Nelskyla, managing director and head of structured investor products for Europe at RBS Global Banking and Markets in London. "But when products involve exotic options, it will be more difficult for investors to determine the absolute value of a product, and they might need to rely on comparisons of the structuring costs."

Typically, products in the UK, Europe and the US do not attract more than 6% in total fees. "If one looks at the UK retail market, the level of fee competitiveness is comparable across all product providers," says James Taylor, manager at Barclays Wealth. "Fees are not normally more than 6%-7% even in products that are considered more exotic or with different payoff profiles."

Assuming that fees for a five-year equity-linked note are the maximum 6%, the note would cost 120 basis points per annum. For the same tenor, mutual funds often charge between 3% and 7% in commission with an additional trail commission - an annual fee paid to an IFA if the investor stays within the fund. Most funds also charge an annual management fee of between 0.5% and 2%. Take a fund that pays 4% commission with no trail commission and an annual charge of 1%. Over five years the annual fees would be 180bp, a full 60bp more than the structured product.

Deconstructing the fees

But one of the issues that surrounds structured product fees is the fact that investors do not necessarily know how the fees are broken down, and where the major part lies. To understand fees, it is therefore essential to deconstruct them. There are two main kinds of charge: third-party distributor commissions, and structurer costs and margins. By far the biggest part of any product fee is the commission paid to the distributor. Structurer costs can be broken down into legal, licensing, listing, management, marketing and wrapper fees, while the structurer risk margin is used to hedge the risk of the derivative in the product.

As a rule of thumb, structurer costs are largely comparable both across different types of products and the region in which they are sold, except for variances in legal and wrapper fees. "From a licensing and listing perspective, fees don't differ radically from product to product," says Stefan Wagner, managing director and global head of structuring and product strategy for retail structured products at Citi in London. "However, if a product isn't standardised or is acutely exotic, fees from a legal perspective can be slightly higher as there is no legal precedent and more effort is exerted in dealing with legal compliance."

There are many different product wrappers and each has its own associated cost, which is reflected in the fees levied. Banking term deposits whose redemption at maturity is a structured product payoff can be issued with ease and are inexpensive, as are warrants and certificates. Generally, medium-term notes (MTNs) are similarly economical, while large costs are involved in setting up a Ucits III platform in addition to the annual maintenance. Offshore funds, predominantly protected cell companies (PCCs), are expensive to set up and involve cumbersome legal procedures, while a large distribution is also required to cover the cost of product issuances. "Product costs will be relatively similar from region to region," says RBS' Nelskyla. "Where it will vary is in how the product is packaged. For example, the investor might be getting a cheap option but it could be packaged expensively."

Third-party distributor fees occupy between 60% and 90% of any deal, says one London-based banker. This is astonishing given the fact that critics of transparency complain no end about the lack of structurer fee disclosure, which they know to be less than the distributor tariff. The commission paid to distributors is largely determined by the target market. In the UK, five-year products usually command commissions of around 3% while shorter-dated products require 2%-2.5%.

In the US there is not a one-size fits all rule with distributor fees, says Philippe El-Asmar, managing director, head of investor solutions Americas for Barclays Capital in New York. "Typically for short-dated products, commissions command between 2% and 3% while five-year products can require as much as 4-5%," he says. "But it also depends on how competitive the distributor wants to be. If taking a smaller commission will in turn convince a client to buy the product, less of a commission may be worth the sacrifice." Indeed when examining six-month reverse exchangeable or reverse convertible notes linked to the common stock of Alcoa from three different issuers in the US, each note is found to pay a different distributor commissions of 1.625%, 1.75%, and 1.85%. Ultimately, this translates into another consideration for an investor. In theory, if less commission is paid the terms of a product will be better, though obviously subject to the prevailing market conditions.

Perhaps the most misunderstood charge inherent in structured products is the risk margin or spread. Essentially, product issuers make their money by hedging the risks of the underlying derivatives of products and charge a risk margin so as to be able to perform the hedging. But the issuers do not hedge each individual product but rather the portfolio of the issuance sold. The risk margin is largely dependent on how risky the option element of the product is.

"If an exotic option is structured with more payouts and a lot of operational risk then that option will be more expensive because the risk is more significant," says Nelskyla. "The risk factor determines how expensive a product will be." If a bank takes on a large risk, say in the specific case of barrier options where there is a high digital risk, meaning there could be a sudden move in the option price, hedging will be more difficult and this is reflected in the risk margin.

"When pricing an option, the structurer is making assumptions about certain market parameters such as correlation that evolve over the life of the product," says Jean-Eric Pacini, London-based head of structured product sales, equities and derivatives at BNP Paribas. "However, because some of these parameters cannot be hedged upfront, the P&L of the option hedge at maturity is uncertain and therefore a risk cushion is priced in and required to cover for uncertainty."

Performance anxieties

An alternative to building fees into products comes in the form of fees based on performance, which will in itself be very transparent in terms of fee disclosure. In practice, however, performance fees can only be applied to a strategy or a product with an active element. It would be imprudent to apply and justify the fees on static pay options on the FTSE 100. The issue of commission being left out of the equation is the major obstacle as many distributors will be reluctant to sacrifice a fee and risk not getting one if the product does not perform.

"Performance fees, traditionally a hedge fund strategy, align everybody's interests," says Lauren Ash, director and European head of branding and business development for retail structured products at Citi in London. "These have worked very well on certain trades, especially constant proportion portfolio insurance products. But in order for performance fee products to gain traction distributors have to accept the model and forego an initial fee."

Whether fees based on performance takes hold remains to be seen, but the products would undoubtedly be welcome in terms of fee disclosure. That said, fee transparency in structured products is better than most assume and has been improved, be it on the light side, by Mifid in Europe, while in the US the advanced prospectuses display a wealth of fee information although can appear cluttered and hard to discern at times. Whether the rest of Europe and the US will follow the example of the Scandinavian disclosure practice one can only speculate, but further clarification and regulation is sure to follow.n