The renewed appeal of structured funds

Greater regulatory scrutiny, weak financial markets and counterparty risk fears on the part of investors have all contributed to structured funds enjoying a new lease of life as an investment that can tackle tougher requirements and market conditions to create new sources of performance. Sarah Nowakowska reports

Structured funds: flexible investments

In a market environment that has become regulatory heavy and hard to navigate, investment propositions that offer performance, market access and also liquidity and transparency with limited counterparty risk stand out. In contrast to structured products and notes, the scope for the fund industry has hardly looked brighter: structured funds are home to increased volumes of new business, while innovation in the exchange-traded fund side, in particular, is unrelenting.

"Investors are increasingly seeking new ways of creating performance or trying to find a more diversified approach to their investments," says Eric Bensoussan, head of global equities structuring for Europe, the Middle East and Africa at UBS in London. "What you see now is a strong development of new sources of uncorrelated absolute performance."

Investment fund assets worldwide stood at €19.49 trillion in the second quarter of 2011, with the combined assets of the investment fund market in Europe, which includes Ucits (Undertakings for Collective Investments in Transferable Securities) III and non-Ucits markets, standing at €8.104 billion for the same period, according to the European Fund and Asset Management Association.

New European regulations have worked to the advantage of funds, to the extent that Ucits rules offer a widespread stamp of approval. Such is the case for the Ucits III framework in Europe, which evolved into Ucits IV when amendments to the directive came into force in July, and whose quality is now recognised even outside Europe, such as in Asia. "Ucits III was the starting point that really allowed the asset management industry to use the breadth of instruments available in the market with the comfort of deep regulation," says David Moroney, global head of retail structuring, fund structuring and structured funds at Royal Bank of Scotland (RBS) in London.

But the removal of issuer risk and a more regulatory-friendly framework come at a cost, with funds relatively expensive and slow to set up, often needing a minimum size to recoup costs and ensure their profitability.

Historically, structured funds were launched as one product... but now we're able to give investors a lot more choice for them to proactively decide which underlying to use, the type of protection they want and what maturity, and that trend will continue

Back in the mid-2000s, structured funds often took the shape of funds of funds repackaged into leveraged products, with providers offering loans to increase initial investments and therefore returns. At the peak, 17 banks were active in a business that was then predominantly about leverage: greater market uncertainty and the illiquidity that followed quickly saw the number of active banks become a small handful.

There has been a change in the availability of cheap money (and therefore leverage), but that has not prevented the latest revival in structured funds. While they are back in many forms, with little consensus on what the required criteria are, structured funds now put bank structuring abilities together with more sophisticated or innovative strategies suited to the current volatile market conditions.

 

Creating performance

Structured funds could be best described as funds that can deliver a specific risk profile with a systematic approach, and which incorporate the use of derivatives to achieve performance.

With simplicity of payout structures and transparency on many investors' minds, one challenge has been to come up with innovative ways to offer performance in terms of returns, and the ability to blend banks' own index strategies - be they algorithmic, quantitative or systematic - into a structured fund has garnered interest.

Added to that is the ability to get structured funds onto platforms, which brings the benefit of such things as daily liquidity and diversification that can in turn boost the secondary market and allow investors to be more opportunistic in their approach, says Richard Henry, director of investor solutions at Barclays Wealth in London.

Given the low interest rates and high volatility that continue to make it difficult to structure capital-protected solutions, the trend has been to look at alternative strategies and access to uncorrelated asset classes for diversification purposes, for which structured funds can lend themselves well with the bonus of having the flexibility to come in a regulatory-friendly format. "The ability to reduce correlation when other assets are falling is highly sought after by portfolio managers and is one reason for the rise in popularity of alternative strategies," says Danny Dolan, managing director, structured funds at Royal Bank of Scotland in London.

As such, hedge fund and commodity trading adviser (CTA) strategies have proved popular in recent months to try and offer more liquid alternatives and the development of managed account platforms has enabled end investors to get more liquidity through structured funds, says UBS' Bensoussan.

Giving investors access to a liquid investment strategy on an absolute return basis through a hedge fund or an absolute return fund which can be delivered in a transparent and regulated vehicle has been a core focus for Credit Suisse, along with working on asset allocation products to try and resolve the issues investors are facing in terms of the volatility that has been affecting most asset classes. "We see investors looking for a very diversified and risk-managed exposure to the market given the volatility in each asset class recently, be it equity, commodities or even bonds," says Walter Cegarra, director, fund-linked products at Credit Suisse in London.

The bank recently launched its Arrow index, a long-only, multi-asset strategy where liquidity is provided via investment in daily-liquid underlyings. The index can be delivered in a structured fund either as a direct exposure or in a capital-protected format for institutional investors as well as high-net-worth individuals and private banking investors, while retail investors could access it in a principal-protected format.

Being able to offer capital protection in a fund format, especially when it is open-ended, is not as simple as it is to incorporate in a structured product format, however. BNP Paribas is another bank that was able to offer capital protection in an open-ended type of fund when the bank teamed up with Janus Capital Group to provide protection for the Janus Protected World Growth, a US-based mutual fund launched in May.

Credit Suisse has also focused on trying to answer gaps in the market for more individualised types of structured funds that can give more flexibility and choice to investors and distributors. "Historically, structured funds were launched as one product and all investors had to go for the same product at the same time," says Cegarra. "There was quite a bit of a shortfall but now we're able to give investors a lot more choice for them to proactively decide which underlying to use, the type of protection they want and what maturity, and that's a trend that will continue."

The bank developed its first product, the Micro CPPI, as part of its Micro Platform aimed at the long-term savings space to offer products at the individual retail account level, thus offering individualised protected investments where investors can choose funds from a pre-agreed universe of funds, but also change their fund allocation and protection levels. Although retirement products have usually been provided by insurance companies, changes in the market in the last two years have created a shift, says Cegarra. "Investors realise they need to increasingly take care of their own pension on an individual basis across Europe and even globally and that they can no longer rely as much on public pensions," says Cegarra. "On the other hand, insurance companies now have very strong capital requirements under Solvency II and because of that they may not want to keep the market risk they take on such products on their balance sheet."

However, the infrastructure required to not only bring together the expertise of both the asset manager and that of a bank's structuring abilities, but also support the costs involved in setting up a fund, means banks must bear in mind that the more customised a fund is, the more difficult it can be to sell it or raise enough to make it profitable. "Difficult markets require a nimble response, and the only way to be nimble when you're dealing with heavy infrastructure is to make sure you're integrated," says Florent Josset, managing director and global head of Nomura Alternative Investments Group in London. "We also differentiate ourselves by delivering a strong Asian or emerging markets story. The alternative is to go out and promote the product with distributors."

Nomura started building up its structured fund capabilities a little over a year ago following a two-pronged approach of consolidating its structuring and asset manager capabilities along with distribution channels. Its C10 fund, launched in September last year, sought to offer a unique exposure to China by incorporating a forex strategy that gives access to Chinese growth via exposure to the country's 10 biggest trading partners. A strong fund infrastructure can also provide more flexibility in how a fund can be delivered. "If a client likes the C10 fund idea, for instance, but didn't want it in a Ucits format and needed a leveraged version, we could arrange it," says Josset.

Meanwhile, the regulatory-friendly aspect of funds has led some banks to become more solution-driven, focusing on the institutional space to bring solutions to those institutions under greater regulatory constraints, such as insurance companies whose capital requirements under the upcoming Solvency II directive will make it more punitive to invest in risky assets. "A lot of buyers who would have previously invested in other formats, such as notes, certificates or offshore funds, have decided post-Lehman to invest via onshore regulated vehicles going forward, primarily Ucits-regulated vehicles," says Dolan. "There's been a big flight to quality in terms of the vehicle heavily regulated end-investors such as pension funds and insurance companies choose to invest in."

The Japanese bank recently launched a bespoke fund that was customised to the needs of a European insurance company interested in hedging against inflation and where accounting treatment, choice of vehicle and underlying indexes needed to be taken into account.

A stronger focus towards institutional investors has also been shaped by the greater regulatory scrutiny on the retail space, especially surrounding the issue of product suitability and complexity. The flurry of upcoming regulations, such as the Retail Distribution Review (RDR), are also leaving many uncertain as to the impact these will have on the retail market structure and distribution channels for fund products.