Dressing up for the distributors

Take one product, change its packaging and presentation, and turn it into a solution which is specific to each distributor’s client needs. Yuri Bender examines the process of structuring products.

Europe’s high net worth individuals are turning to investment banks for wealth management solutions based on derivatives, according to Stefan Wagner, managing director of equity structured products at Citigroup.

Investors can risk a small stake, invested in an underlying fund, index or basket of shares, which is leveraged through futures, options or warrants to allow huge potential gains.

The beauty of these designs is that they are attractive in volatile markets. In 2002, private clients bought over E70bn of products structured around equities, according to Merrill Lynch. They also bring much needed revenue to investment banks, fund managers and distributors such as private banks and insurance companies.

It is Mr Wagner’s team that designs and packages the products for these intermediaries. While the product works on the same principles, each distributor requires different packaging to reach two types of final investor:

• Very high net worth customers, investing over E5m, familiar with the concept of leverage and focused on “investment-type” products.

• Mass affluent clients with up to E500,000, focused on a capital guarantee with a minimum return. These investors require an alternative to a savings product, but with an “equity kick.”

Advanced investors

“The first group of investors are a bit more advanced. They are trying to get exposure to underlying strategies,” says Mr Wagner, during a break from supervising Citigroup’s product factory conveyor belt. “Most people who have amassed E5m have made a distinctive value judgement of what they want to do. They are not shy of making a call on a market or strategy.”

According to Mr Wagner, rich investors are usually familiar with hedge funds, because they understand the concept of a company borrowing capital to achieve greater returns.

“High net worth people don’t generally need capital protection,” says Mr Wagner. “They are willing to take a direct investment, an opportunistic position.”

Before the war, Citigroup saw many clients investing heavily in oil and gold through a basket of stocks, structured as an offshore certificate, with no tax implications.

Which channel the product is purchased from depends on its term. The general rule used by Citigroup is that anything up to five years is sold through the group’s own banks, or external banks and asset managers. Any long-term product over 10 years, linked to a specific index, is generally sold through an insurance company.

One of the recent products designed and packaged by Mr Wagner’s team is Premium Zins Zertificat, a four-year capital-protected certificate with a yield linked to the performance of the Nikkei 225, Eurostoxx 50 and S&P 500 indices. Sales through Citigroup’s consumer bank in Germany have raised over E40m for this product.

Mr Wagner also draws attention to Aurora, a principal protected note linked to managed futures, already in its fourth incarnation, with E430m raised. The March 2003 product has a five-year term. The trading advisers chosen by Citigroup subsidiary Smith Barney Futures Management include Barep, Chesapeake and John W Henry. These advisers trade technical futures programmes not usually available to private clients.

“This is a new underlying investment for people to go with,” says Mr Wagner. Whereas much of the distribution of the German product is internal, Aurora has been “internalised” in order to save costs. Citigroup has used its own private and retail banking channels to sell this product, with only 11 per cent sold externally.

“The futures are cleared internally, the distribution is done internally, so it is a better product for the end customer,” says Mr Wagner. “There are not too many people involved who take a cut. This allows us to keep down the fees.”

Brand vs white label

Most Citigroup products, however, are manufactured for a 50/50 internal/external distribution split.

They can be sold with the Citigroup brand, as Aurora is, or re-dressed in the distributor’s clothes and style. However, a company that chooses to white label the product can lose out.

“With Aurora, we give full service to the end customer, including a helpline, updates and training for the sales channel. If a bank white-labels our product, then we don’t give that kind of service to the end customer.”

There are generally at least three players involved in building a structure, and often four:

• The product structurer, generally an investment bank such as Société Générale, BNP Paribas or Citigroup. They design the concept and structure the derivatives.

• The provider of capital protection or a money back guarantee – this can be the product structurer, or an externally selected party.

• The investment bank’s client – generally a retail or private bank, insurance company or independent financial adviser (IFA), known as a distributor or promoter, and with a strong say in the packaging of the product.

• A provider of underlying funds or indices – this is often a third-party fund manager, but can be the bank’s internal fund management house.

Capital protection

According to Mr Wagner, products are increasingly being structured around mutual funds as underlying investments, with a capital guarantee for mass affluent clients.

“There is a big, big trend to capital protection, which cannot be offered in a traditional index-tracking or stock-picking fund,” says Mr Wagner. “But we can link a structure to such a fund and make it capital protected. It is currently difficult for fund managers to sell products and increase their assets without such a structure.”

Société Générale, one of France’s premier investment banks, has been in the vanguard of using mutual funds as underlying investments for its structures. It has recently structured three products of this kind, which have been white-labelled by distributors:

• The JPMF Star Guarantee was structured for JPMorgan Fleming, based on a basket of 10 JPMF funds. The product is sold by JPMorgan through IFAs.

• Banques Populaires’ subsidiary, Asset Square, is a client for a structure based on a diversified basket of top performing mutual funds, including some managed by Société Générale Asset Management.

• A product designed for General Electric’s Capital Assurance subsidiary is based on 10 underlying funds chosen in a poll of the company’s IFA distributors.

Before structuring products around underlying funds, Société Générale tried to create similar structures by buying baskets of equities in its “Mountain” range.

The bank’s Himalaya structure, launched in 1999, was an eight-year product, based on a 10-stock basket.

“We were replicating active management,” says Jean-Francois Castellani, Paris-based marketing manager for structured products at Société Générale. “At the end of each year, we take the best-performing stock out of the basket. We are selling the best performers after taking profits, just like an active manager would.”

At TradingLab, the Milan-based investment banking subsidiary of Italian institution Unicredito, a young and energetic workforce is busy designing structured products for the Italian market and beyond.

“Our challenge this year is to diversify our revenue mix from covered warrants into other products,” reveals Leonardo De Benedetti, deputy managing director of TradingLab Banca. “We are leveraging on our covered warrants presence to testify we have strong pricing capabilities for other products such as derivatives.”

Key distributors

Germany, France and the UK are seen as key growth areas, with banks and insurance companies the key distributors.

“There is a significant segment of clients who always want to participate in equity markets with safe protection,” believes Mr De Benedetti.

“The concept can be compared to managing a mix of equities and bonds in a balanced fund. Structured products have the same kind of investment philosophy, but are even less risky.”

But Mr De Benedetti admits one potential flaw. “There is always a danger of mis-selling. We are just a provider of these kinds of products, so we have no direct relationship with the final investor. Our approach is to look for the simplest kind of structure that the market will allow us to package. We believe the final investor must be given the opportunity to understand the final return he will be able to expect from the product.”

This concern is shared by Stéphane Rougier, managing director of structured products at BNP Paribas Asset Management.

“Trading rooms of investment banks have a different mentality to asset managers,” says Mr Rougier. “Asset management has its own rules, which include the protection of the investor. But these are not shared by trading rooms. We think more about the life of the fund and the distributor, who we want to keep for a long period as a client, to sell more products to investors.

“Even if we give an explanation of the technicalities to all sellers of the product, in some cases there will still be mis-selling. There are more than 20,000 people in contact with clients through BNP Paribas bank branches alone, so a percentage of mis-selling is bound to happen.”

Uiversal appeal of structured products

Ask investment managers in Europe which type of distributors they are aiming their funds at and there is a general consensus: promoters of structured products.

“The placement from banks for structured notes with guarantees has captured the majority of fund flows,” says Matteo Bosco, managing director of Credit Suisse’s Italian fund management operation. “Banks shifted money into equities when the markets were going up and even in 2000 and 2001, when they were already falling. Now there is a huge re-allocation to structured products.”

Fund managers are hungry for management fees, although the promoter may take a substantial cut of these.

“Some of our clients are taking an aggressive approach to these products,” says Stefano Russo, managing director of European distribution at Morgan Stanley Investment Management. “This is particularly important in Spain, where the BancoSantander concept of capital protection is appealing, even in bull markets. Now it is even more appealing, as it is a difficult market. Spanish banks have strong control of these products. They push the button, and it sells.”

But excessive sales can lead to an unstable business mix. “In the event of a market downturn, a fund whose investor base has grown significantly due to this type of deal may find themselves facing sizeable redemptions,” warns Alex Fletcher, head of European distribution at Goldman Sachs Asset Management. He says funds should consider limiting exposure to protect performance.

For the investment banks, the profits lie in structuring as many products as possible. “We try to make products with more and more people around the table,” says Stéphane Rougier at BNP Paribas. “When we trust a lot in the concept, it’s better to make it available through more channels. One distributor saying ‘give me 10 of these’ is not enough. We need 60 distributors, then we can make a product for at least 200 people. Economies of scale mean there is no extra cost in making more products.”