RAW INVESTMENT PLUS PROTECTION

Mid-March 2008 saw record prices across a range of commodities, from gold and oil to wheat – the latest headlines in the ongoing story of one of the great bull markets of the age. “Clients are looking to commodities much more today than they would have as recently as 10 years ago,” says Paul Sarosy, Credit Suisse’s head of investment solutions for private banking in the UK. “And they are using commodities in a multitude of ways. For example: how can a client play the Asian market theme? Commodities such as coal, steel and aluminum are one possibility. I would also highlight soft commodities. How to feed China is becoming a key question and therefore a key investment theme.” Mark Mathias, chief executive of structured products boutique Dawnay Day Quantum, agrees. “You don’t have to extrapolate to absurdity,” he says. “You only have to ask if China can get to Brazil’s current per capita income within the next 20 years, and you already have virtually a trebling of their oil consumption.” He cites asset allocation research suggesting that the optimum commodities exposure for a balanced portfolio would be 10 per cent. But commodities can be notoriously volatile, and the relatively inexperienced investor who just wants to take a strategic, diversified position may not be prepared for the ride. “Some clients do come in with very clear views on particular commodities,” says Andy Halford, head of structured products at Kleinwort Benson, “but not many.” That makes the kind of optionality you get from a structured product particularly attractive. But common sense would suggest that the more volatile an asset class is, the more expensive it would be to buy downside protection: as equity markets have started see-sawing, for example, the equity-option part of structured products has become more and more pricey. That has not happened for commodities, despite their volatility, because most commodities are usually in backwardation (in other words, forward prices are lower than spot prices – gold is an exception). With the standard, low-risk bond-plus-call structure, upside participation is limited by the fact that the most a client can invest in the risk-generating asset is the discount available on the zero-coupon bond – investors effectively have to pay off some upside to insure their downside. On equities, it is common to boost that exposure with a leverage multiplier, as part of a Constant Proportion Portfolio Insurance (CPPI) structure or the DPPI ‘Dynamic’ version, for example. But with options on commodities so cheap, it is possible to get full or even leveraged participation without the multiplier. “For volatile assets like this, I feel that CPPI is definitely the wrong sort of approach,” says Mr Matthias, whose firm is currently offering three new five-and-a-half-year products with this structure (Protected Commodities Accelerator IX offers 100 per cent protection with 115 per cent participation in the upside of a diversified basket of commodity contracts; Protected Commodities Dynamo offers 90 per cent protection with 160 per cent participation; and Protected Agricultural Dynamo offers 90 per cent protection with 100 per cent participation on a concentrated portfolio of softs). How much does this structuring cost the end investor? Dawnay Day Quantum’s products charge a one-off fee of around 7.5 per cent (just under 1.5 per cent per annum over the product’s lifetime). “If an idea comes to us from another institution, we ensure that their research is in line with ours,” says Mr Sarosy. “We then review the structure and pricing with our investment banking business, to see if we can structure the product in-house. In parallel we take that pricing and see if we can match or better it externally. Fifty per cent of the structures we originate in London are from Credit Suisse – but of course that means that 50 per cent are originated elsewhere.” Kleinwort Benson rarely buys off-the-shelf products for its clients, because it looks for specific investment and tax-efficiency characteristics and control of the costs. In practice, that usually means a one-off charge of 2.5-3.5 per cent, minus the bid-offer spreads on the component parts which it sources at best price from the market. This is still much more expensive than a beta-one product like an Exchange Traded Commodity (ETC, such as those offered by ETF Securities), but structured products offer a much simpler solution to the roll-yield exposure and overweighting to energy that characterize many diversified indices.