Are structured products back on the table for private clients?

Yuri Bender: Our aim today is to achieve some kind of consensus on structured products investing: are these opportunities suitable for all private clients? Should they be at the core of portfolios? How does their use vary between discretionary and advisory channels? What is a suitable allocation to particular themes? How do we select wrappers in underlying investments, and is there a big difference in quality between products? After a couple of very tough years, is it fair to say that structured products, within private client portfolios, are emerging from the shadows once more?

Nick Coghill: I see private clients falling into two different camps. There is the discretionary institutional market, which has been growing for the last several years and was not affected as much as the retail advisory side in 2008. This strong growth continues, and institutional managers, funds of funds and discretionary asset managers actively use structured or securitised products for a part of their core asset allocation. I estimate that in the UK wealth industry, probably about 5 to 7 per cent of assets under management is allocated to structured products. It is a very different market in terms of liquidity and how people view the products.

The retail or advisory channels represent a very separate market and that is where we have had to deal with the spectre of Keydata and other sagas. Clearly that side has been dented by what has happened with Lehman Brothers and other events as well as a changing landscape; with the independent financial advisor (IFA) community diminishing rapidly, who have traditionally been the main portal for delivery of these investments, they have shifted a lot of their investments or assets to the private banks, wealth managers and so on. As buyers per se, they have definitely been hit. Whilst still an active market, we do not see as big a flow in that space anymore.

James Bevan: In terms of the financially advised client group, how much of the reduction in demand might reflect previous poor experience of products held? It would be my expectation that a number of people bought the headlines – lots of participation in markets, no downside risk – and ended up being disappointed with the return path they experienced.

Nick Coghill: Clearly when you are buying any product you need to know what is under the bonnet. There are good IFAs and probably poor IFAs. I think the client experience has been disappointing for some, but not only because the headline rates did not deliver what they were meant to do. To be fair I think that was mainly due to underlying counterparties going bankrupt or, as we saw with the Keydata affair, what was meant to be under the bonnet was not actually there.

James Bevan: For a number of manufacturers and their related distributors, structured products became a mechanism to take egregious amounts of money from clients without the clients necessarily realising what they were giving up. The premise that there might be a free lunch in terms of having participation in risk asset returns with no downside risks clearly was never going to happen. Do you think that one of the things that will have changed is a much more grown-up understanding in the market in general that fees are a really very important determinant of returns, and risk cannot be taken off the table without materially affecting potential return?

Oliver Gregson: Currently you have a twin squeeze on the industry to both the supply and demand dynamic with regards to structured products; the demand side affected from the experience investors received during the Lehman crisis and the regulatory issues driving the supply-side pressures, where the regulatory capital requirements under Basel III of structured products are going to have a much higher risk rating.

In addition, the disclosure requirements at the point of sale are going to make it much harder or more burdensome to do this type of business. For the vertically integrated institutions like the big banks where they both manufacture and distribute, significant changes will need to be made.

Yuri Bender: One of those is UBS in Switzerland. We do not have any representatives from that organisation here, but several years ago we had a summit in Zurich, and the head of wealth management there, Jürg Zeltner, made an apology for excessive and inappropriate selling and incorrect hedging of structured products prior to the financial crisis. He was saying, ‘I am doing this on behalf of the industry.’ Is that a scenario you recognise?

Oliver Gregson: The industry had to put its hand up, and a little bit of humility with what we experienced goes quite a long way when you are dealing with an individual, where emotional elements are as much a part of that relationship. I hope that a lot of the themes that came out of what we experienced in the crisis, if adhered to, will stand us in good stead longer term: simplicity, transparency and liquidity, although liquidity is less of a concern for clients these days. I do not think these are bad things, particularly when dealing with individuals, to have at the core of what you are trying to do.

Regarding the regulatory environment, we live in the age of big governments now, whether we like it or not, and that is a dynamic that is not going to disappear in the foreseeable future. I think one should go over and above the de minimis, albeit often with an increasing level of regulation, and have a duty of care towards your clients. That will only enhance the client experience and engender a much better scenario for both the client as well as the commercial benefits to the organisation.

Daniel De Fernando: Coming from Spain, I had a good view of the recent Real Madrid v Barcelona games and how they were refereed. Having an impartial referee – or regulator – is critical. However, fair play goes beyond the referee, and the players have to exercise it as well. It is not a question of having a proper referee, but the players helping the referee.

A lot of what we have had is players not helping the referee to do their job, both in football and in structured products. If we just lay our hopes on a good referee, it is very difficult if the players do not want to play fairly. It is the responsibility of all of us, collectively, especially because in the financial world clients, advisers, private banks and sellers are at a different level. Advisers are much better equipped than clients.

Structured products may have a role in some clients’ portfolios, but we have seen the machines creating the products with no thought of the clients’ needs, then twisting the needs of the clients to get the products in because of the compensation and incentives mechanisms. Large clients can usually get the same protection by diversification and allocating risk properly and risk budgeting across their portfolios. Usually, this is much more efficient and transparent.

We have all learnt that liquidity is much more valuable than we tend to think when things are going well. Structured products become very illiquid at difficult times, and they are very expensive if you want to get out of them. Capital protection may be something they bring in, but we have seen many of them that do not have it. Therefore, I think what we need is more fair play.

Jeremy Beckwith: There is an inherent issue with structured products, in that they are one of these things that, when you sell them, the distributor gets all of the profit up front for the most part. That inevitably gives huge incentive to sell aggressively just to generate revenues.

James Bevan: There are other challenges which need to be considered, and transparency is clearly one. However, I do think that, for those of us who have ploughed through the inch and a half of issue memoranda which comes with some structured products and the mastery of financial mathematics that is required to understand the tail risks, that is a very big ask. I would also say that, if one goes back to the global financial crisis, it would be inappropriate to say that we did not have very capable people in all of the big banks believing that they understood the nature of the risks that they were taking and the forms of diversification that they had in place, and that these crises do come and that they do necessarily swipe people very badly.

James O’Neill: Some complex retail structured products were sold in a very simplified way. Explaining all the different factors that influence a product’s payoff (for example reduction in dividend payments) is very detailed and can be unnecessarily confusing for a retail audience. Regulation is forcing manufacturers to be more transparent, and as with all reputable manufacturers, we aim to be as transparent as possible in our literature and sales process. It comes back to what you were saying earlier on, Jeremy, about how these products were sold and why they were sold – because of the upfront fees that were being granted.

James Bevan: There is a subtext which I perhaps disagree with, that people who recommended structured products through the bull years were only motivated to sell with no focus on client need and risks. A large community of advisers, many of whom put forward Lehman products, were appalled at what happened because they, along with the overwhelming majority of the financial markets community, did not anticipate that the global financial crisis would occur with the scale, ferocity and contagion with which it obviously came to pass. It is near impossible to plan for those sorts of extreme events. Nobody in the financial markets industry wholly anticipated the global financial crisis. Therefore, to say that we have to wag a finger and say, ‘You knew all about this and should have managed the risks’ is unrealistic.

Daniel Freedman: We started plain vanilla index structured products with deposit accounts in 1995 and the experience has very much been to do with risk and liquidity and what the clients are looking for in those two areas. The regulators have a large part to play and blame to take, because with products like the Keydata products that were bandied around from a retail point of view, most of us probably looked under the cover and thought that it was a pile of rubbish.

Those types of products are still pervasive in the retail market and are still being allowed to be sold, whereas I think the type of structured products the institutional markets are looking at – which have much more plain vanilla, clear and precise delivery mechanisms – have a place in client portfolios. Where we see things is split very much between the retail and institutional, and if you look at what you are trying to deliver from your client portfolios, structured products may well have a place. Products sold into the retail space are generally accompanied by very misleading marketing literature.

Philippe Bongrand: Selling structured products is essential for the private banks, both because it is a way to differentiate themselves on the product side and also from a revenues standpoint, but also because it clearly fulfils a need from the client side in today’s market environment. That need for uncorrelated products is going to grow with clients and, working with private banks, we see that many have not yet fully translated these opportunities in their sales processes.

Institutions are at very different levels of maturity on this, and at the relationship manager level, many will tell you that they won new clients with these solutions. Although the industry is very profitable, the key issue is that there is still a gap between what banks deliver and what clients expect, both on the service side (eg basic service and regular contact) as well as on the performance side. Many clients are saying that banks are excellent at managing their own prosperity as an industry, and they do not understand why their banks are unable to manage their clients’ prosperity – therefore asking: “If my bank can manage its risk-return profile so well, why can’t they do this properly for me as a client?”

This is where structured products will play a critical role – provided they are well explained to clients. In the end, the whole issue of structured products is all about one very simple thing, which is: education, education, education. It is about education of the relationship manager who has to spend time with clients. It is about education of the client, who should see what value structured products will bring to its portfolio and education of the management to see how structured products fit in the bank’s business model.

Daniel De Fernando: Can I give an example? Two weeks ago, a client of ours was offered a structured product by a bank on a very high yielding telecom, obviously with no recognition of the dividend that was embedded in the structure of this three-year product, where the client would take any loss beyond 50 per cent. This is today, but it has all the ingredients of the rosiest years.

James Bevan: I could argue from first principles that structured products should play a far bigger role in investor portfolios than is presently the case. For example, if your future liability is to buy a house, buying a structured product that gives you geared participation to house price inflation may be a very prudent product to consider, and potentially far better than buying a very transparent, plain vanilla, multi-asset, equity-biased portfolio whose path of return is going to be materially distant from the return on houses. A bank that issues shared appreciation mortgages theoretically has a pool of returns that it is receiving on the shared appreciation mortgage that it can wrap up and push back out to people, who buy off the bank’s balance sheet.

For me, that is absolutely natural turf for a structured product, allowing banks to manage balance sheet risks effectively, and at the same time addressing the needs of investors who want to allocate against the future purchase of a house.

Daniel De Fernando: Yes, but be very, very careful when the client is solving the balance sheet problem of the bank, because they are not in any of the discussion, and I know who is going to lose on that.

Maybe the idea is good; you buy a structured product to hedge you against house price inflation, which is what you need, but you then have to see which index is used, who calculates the index, what fee is embedded into that, what happens if the client has to buy the house early because there is an unexpected child, and see how they can get out of it, what happens if the issuer of the note has a problem and what happens to the client’s house? There are so many things around that good idea about which I would be very, very careful.

Yuri Bender: Daniel Freedman has said that the quality of products being distributed at the moment takes him back to 2006, and he is not impressed with what he sees. What do the manufacturers think?

James O’Neill: I break up the retail market in terms of products sold through branch networks of large commercial banks and those sold by boutiques. In the UK, for example, the vast majority of commercial bank products are ‘capital-protected’. In the current very low interest rate environment we use cheap options to generate upside: digitals, annual digitals and cliquets, so the expected returns are limited.

Moving away from the commercial banks with their branch network of sales, into the boutique and IFA advisory market, these products remain as they did in 2006, 2007 and 2008. Not much has changed really, apart from the increased focus on counterparty risk. Therefore, it makes sense to differentiate between the two channels.

Separate from the advisory market and boutiques is the private banking and discretionary management space. We treat the investors as more sophisticated; they are intelligent, can make their own decisions, and understand the investment risks.

It depends on how we are delivering the products as to what is afforded in terms of protection via deposit or compensation schemes and other protective clauses.

Nick Coghill: Where we have seen divergence is in private banking and up the food chain, where there has been a lot more education both internally and to the institutional buyers; they do a lot more trading, intra-day dealing and bid offers, coming back to what we need to do as providers. Banks have had to up the ante in term of collateralisation of products, putting them into Ucits wrappers and other vehicles to try and mitigate the credit risk.

However, when we are dealing with more sophisticated clients, like a private bank, we do not just say, ‘Here is a product, take it and we will see you in five years’ time.’ It is more than that: we go through the details of what they are looking for and deconstruct the product into pieces a lot more. Over the last two or three years, we have had to provide more scenario analysis and simulations in terms of: ‘If x happens, volatility does this, rates do this and markets do this’ – what is going to happen?

We now launch into those spaces, and my view is that we as providers have to think of ourselves as fund managers. We are going to have to have a constant presence, and what we do for many clients every six months or so is put a report together on how it has performed versus benchmark, ‘Why is the market up 10 per cent and this is only up 4 per cent?’ or ‘Why is this 14 per cent versus 10 per cent?’ and explain it so if it is an institutional buyer they understand it, or if it is an advised channel for a private bank they can explain it to their clients. Every provider should be doing that now.

Yuri Bender: Jeremy, you are now with an independent private bank, which used to be part of Commerzbank and Dresdner. James Bevan has told us how structured products can be used in a positive way when there is a particular scenario where a client needs help. However, with big German banks it was very different. Themes of the month were identified at the top and were the products advisers were told to sell. Was that the way it worked for you?

Jeremy Beckwith: That was in Germany. I had to fight quite a few battles when I arrived, and I refused to play any part in that and they left me alone. I was never actually forced down that route. My view has always been that I decide if I want a structured product in a client’s portfolio where I have a particular view on an asset class, then I design the structured products and go out to the market and get the best price. I do not get people offering me structured products now because they know that I will never take them. I design them rather than the investment banks. That way I know it is our investment ideas that are being pushed through.

Philippe Bongrand: We have talked a lot about retail, but if you look at wealthy investors, not all high net worth clients are sophisticated. So while most private banks would advise their clients to have between 10 and 20 per cent in structured products in their portfolios, the selling dynamics to clients still depends on clients’ levels of sophistication and their involvement in the management of their wealth.

With discretionary clients, the relationship managers will explain the uncorrelated role played by these products in client’s portfolios. For advisory clients, while past experience has impacted client’s perception and behaviour, the dynamic has changed. As many wealth managers now advertise their structured products in the newspapers (you see adverts from Vontobel, UBS, Credit Suisse and Julius Baer) you now see many wealthy clients coming to see their advisers saying, ‘I have seen this product and it seems to be something that I would want to have in my portfolio.’ The discussion is very often “client-led” because clients know that they need new products to get to the return that they expect in our current market environment.

Oliver Gregson: There is going to be a polarisation in that dynamic, because the high net worth individual, whether they are categorised by the regulator as retail or not, is going to move increasingly towards the bespoke, customised reverse enquiry and/or advised structure, working with your counterparties and a wealth manager to put something together that is very tailored. The more retail client is going to get simpler, flow-based sorts of products, because you have this twin squeeze on the providers and manufacturers. It will be more expensive under Basel III capital rules to use this as a funding source.

Therefore you will need to get scale and volume into that end of the market, and that will allow a bit of flexibility and resource to provide customisation at the top end.

Yuri Bender: In these relationships, Jeremy, are clients coming to you and saying, ‘I have concerns or feelings about particular trends in the market at the moment, inflation, oil prices, commodities. What can you do for me in that area?’

Jeremy Beckwith: Yes, certainly the interest we have had back from our advisory client base has been very strongly, ‘I am very worried about inflation,’ and we have put together a product to try and meet that so it pays out a lot in the event of high inflation. That was a client-demand-led product. Our own house view is that inflation will not be an issue, but we say to them, ‘If you are worried about inflation, here is a product that will offset that risk for you.’

What we have done is use structured products for access to unusual investments, so for example last year we bought the FTSE 100 Dividend Index, which was trading at a crazy level. That is not something you could normally buy in a client’s portfolio, but in a structured product that was very straightforward. I try to create our structured products by timing. If you go back to March 2009, we put together a super tracker leveraged FTSE product, one for one on the downside and 175 per cent of the upside for three years, and you could get fantastic terms. There are points in the market when volatility spikes or collapses, and you can make use of that to say these are very good terms for a certain product.

Daniel De Fernando: When I first started working in this business, I remember that Dennis Weatherstone was the chairman of JP Morgan, and he had a motto which I think was: ‘If someone has a product that cannot be explained to me in two minutes, I will never buy into it.’ I have never forgotten that.