A simple way into Exotic investments

The structured product marketplace continues to flout the traditions of a quiet summer with a hive of activity around solutions that are relatively simple to construct but based on exotic investment themes. For example, one structured product launched this quarter is themed around which stocks will benefit from perceived and real climate change, taking a view on the consequences of climatic change whether positive or negative, not that green is necessarily good. Another offers investors a view on the volatility of the equity markets over the next three months, and exposure to a single asset class that is negatively correlated to these markets. “The market is asking for more simplicity in terms of pay-off construction - determined by which instruments, such as calls and puts, are used - but with more exotic underlying assets,” says Emmanuel Naim, head of equity-linked structured products at Société Générale. Lauren Ash, head of business development for Citi’s retail structured products, views the latest products as having fewer "bells and whistles" with investors seeking products that are clear and easy to understand. “Investors are appreciating that a product with a coupon of four or five times risk-free rates might look appealing but it is unlikely to pay off without some catch. If it looks too good to be true, it usually is too good to be true,” she explains. But a growing demand for more vanilla pay-offs, a phenomenon that began in 2006 but has escalated because of a weak credit market, hasn’t stopped the widening of investment themes that the products are sold on. Investment banks have ratcheted up the supply of thematic indices, leveraging in-house quant research, their sales capabilities, and finally, should they have one, a private wealth unit as the focal point for distribution. “Clients understandably derive comfort from indices based on diversification and, where possible, daily liquidity, but returns are the key though we want clients to be comfortable with the market scenario,” explains Jean-Eric Pacini, head of structured products, BNP Paribas. Mr Pacini adds that the underlying assets on which products are themed are picked based on their return potential, with accessibility, asset volatility and liquidity also key factors. Yet the buyside cautions against any oversimplification when it comes to understanding how the product was built in the first place. “Investors should find out why the underlying asset has been selected for a particular product,” warns Gary Dugan, CIO, EMEA, at Merrill Lynch Global Wealth Management. “Has it been constructed purely with performance of the underlying asset in mind, or is the asset chosen simply because it allows the product provider to offer a more attractive yield?” Donald Leitch, Commerzbank’s head of exotic structuring, sympathises. “The understanding of the underlying by an investor may be less complete than they think. There’s opacity in a number of products and just because the pay-off is simple, doesn’t mean the risk or the product itself is,” he explains. Merrill’s Mr Dugan has found the latest anecdotal evidence from clients largely in tune with the direction that the sellside has taken this summer. “The market turmoil has not reduced the demand for underlying assets such as thematic indices, but it has increased the demand for more vanilla payoffs and wrappers where the valuation prior to maturity is easier to understand, and liquidity is more assured. Most investors have become more risk-averse, demanding principal protection and minimum returns, often over shorter maturities, while paying closer attention to the credit quality of the issuer,” he says. Pierre Mendelsohn, head of securitised products, EMEA, Merrill Lynch, concurs that there has been a shift in approach within the structured world this summer, now the market’s a tougher place to operate. “We helped clients to build bricks, now we’re building walls with them too,” he says. “Indices are no longer on the periphery for the structured product investor and though they’ve multiplied, not every index sells and don’t all do well. However they remain a framework for investing that otherwise wouldn’t have existed,” says Mr Mendelsohn.