Lest we forget, accumulators are equity derivative products that were wildly popular with private banking clients in 2006 and much of 2007 but lost many people a fortune last year.
Issuers of accumulators are required to sell shares of an underlying security to a buyer at a predetermined strike price. It allows an investor to accumulate holdings over the term of the contract.
They work well during bull markets as investors can buy shares at a discount with an up-front margin – typically around 30% to 50%. However, when equity markets started falling, investors were still obliged to continue buying the shares at the strike price over the term of the contract, which in many cases stretched for up to a year.
Inevitably many were left facing huge losses. Those who couldn’t meet margin calls had to unwind the positions at a major realised loss, plus a premium representing the early unwind of the trade. And that hurt.
Unsurprisingly demand for these structures evaporated, particularly among high-net-worth clients whose investible wealth falls between US$5 million and US$25 million. Ultra-high-net worth individuals, who generally understood the risks and had deeper pockets, were better able to withstand the losses.
Of course, accumulators weren’t the only products to lose clients money during the downturn. Basket equity-linked notes (ELNs), also known as worst-of-basket structures, had also been popular, and they were typically up to two years in duration.
These notes typically comprised of between two and four liquid stocks covered by an in-house research team, with overall performance dependent on the worst-performing equity in the basket.
But any efforts at diversification didn’t matter late last year, when stocks fell across the board amid widespread panic after the collapse of Lehman Brothers last September.
While investor memories are notoriously short, are we to understand that wealthy individuals have regained their faith in equity-linked instruments already?
According to senior industry figures interviewed by Wealth Management, the answer to that question is yes, and no.
“For the ultra-high-net-worth guys, to be honest their appetite has not gone down too much at all,” says Kenneth Ho, Asia-Pacific head of products for Julius Baer. “There was a kind of three-month hiatus after the Lehman situation, but they’re back. It’s like nothing ever happened.
“But for the high-net-worth guys, it is very different. Accumulators are much rarer than before, and we don’t see these basket structures any more. People have moved towards simple, vanilla, short-term products.”
Lionel Kwok, head of investment solutions for North Asia at Credit Suisse’s Private Banking division, adds: “The whole market cycle is very different to 2006/2007 and clients’ risk appetite is very different.
“Those investors who remain active in structured products right now have a very strong financial capacity to support their own investments in case the market turns against them.”
Short and simple
Min Park, Credit Suisse’s head of equity derivative and convertibles sales, Asia-Pacific equities, says that while the market for structured products has picked up in Hong Kong since May, volumes are still only 10% to 20% of the average seen in 2007.
Only accumulators and ELNs are gaining any traction in the marketplace, and both have shorter tenors than before.
Now ELNs typically have a one-month duration and mostly contain a single stock, while accumulators have maturities of between six and 12 months.
As both instruments typically include a knock-out feature – in which the notes are terminated once a pre-determined share-price gain has been achieved – the tenor is potentially even shorter than that.
In terms of single-stock ELNs, Park points out that there is some diversification in terms of underlying stocks. “They are not all bank stocks and property stocks. On a daily basis we do see 30 to 40 different stocks, and of course sometimes they buy US stocks and other-country stocks.”
Wealth Management research would suggest that up to 70% of an investment bank’s structured product universe right now comprises of ELNs and about 20% to 30% of accumulators, with almost nothing else.
And simple flow products make up about 95% of structured products business in Hong Kong, with razor thin margins similar to cash products.
And Park points out: “There were 20 to 30 providers [of structured products] in the market before Lehman’s collapse. About half have closed down their businesses now.
“Yet there are still more than 10 players and there are only two products, so the competition is still very severe. These players are focusing on the same kind of product, so it is a very price-driven market.”
In other words, the equity structured products teams in banks are not making very much money in what has become a volume-driven business.
Park confirms that Credit Suisse has one of the bigger structuring teams in Asia, and says the bank is maintaining its structuring capacity.
“We keep showing them [clients] new ideas which we believe offer attractive opportunities and balanced levels of risk.
“In general, clients remain quite conservative for the time being. But we are confident they will embrace a broader range of products in 2010, providing that markets remain stable or continue to perform well.”
For his part, Kwok notes that wealthy clients have gradually moved back into equities gradually, having held up to 70% of their assets in cash and 20% in fixed income in the midst of the crisis.
“They are coming back into ELNs and other simple structured ideas, and it is not just stock any more,” he says. “ETFs [exchange-traded funds] can be China plays and mainly are Hong Kong ETFs. They [clients] believe they have the financial strength to hold onto these investments for long-term growth.”
But he is quick to point out that ETFs and ELNs are used as a tactical trading tool, and that short-term structured products generally take up between 5% and 10% of a balanced portfolio, depending on respective clients’ risk preference.
“It is not the only investment vehicle for our clients,” he adds. “There are also funds, fixed income, and commodity-linked products, plus discretionary portfolio mandates. People are more willing to look into a portfolio approach for better risk diversification and more sustainable returns.”
Anurag Mahesh, Asia-Pacific head of global investment services at Deutsche Bank Private Wealth Management, states that a lot of clients who believe markets will continue to rise are simply choosing to buy cash equities instead of, for example, exotic structures.
“It is not as though we don’t have it [exotic structuring capability], it’s just that we don’t really see that to be a huge area where clients are looking to invest,” he says. “I am not saying any product is good or bad, it’s just about doing it in the right amount and in the right context.”
Still, he concedes that Deutsche’s definition of structured products may differ from that of other bankers in the marketplace.
“Structured products and derivatives essentially include all bespoke discussions that we have with clients to create solutions for risk management as well as risk monetisation around clients’ specific needs across different asset categories,” he explains.
“I am not defining structured products as ELNs or accumulators. To my mind they are derivatives, they are risk-hedging instruments as much as they are smarter ways of taking risk for the things that you like.”
And he says that clients are very keen on risk management solutions for their investment portfolios: “What we see is that people are a lot more focused not just on the return side of investing, but also on the risk side of the equation.
“For every single element of risk that is embedded in any product, even one as simple as a bond, they [clients] really don’t want to take that risk where the potential reward is not commensurate. They only want to keep the smarter risk returns. That is really what we see happening across the board.
“So, for example, clients don’t see much value in the interest rate risk embedded in a bond, but do see a lot of value in the credit risk embedded in the same instrument. So we use derivatives to strip out the former, yet keep the latter.”
The structuring desk at Deutsche has also been coming up with ideas for clients to profit from capital market dislocations, including arbitrage opportunities, says Mahesh. One example of this is the bond-CDS (credit default swap) basis trade.
He explains: “We have been doing what we call bond CDS basis trades, where you buy a bond and take out even the credit risk along with the interest risk, so that you are left with Libor plus 3% to 6% ‘risk free’ return.
“Of course, this excess return has become a lot lower now as capital markets have become a lot more efficient and liquidity has increasingly been available a lot more easily than, say, six to nine months ago.”
Asked whether he sees any demand for new products among wealthy clients, he responds: “We are clearly seeing demand mostly on capital market dislocation trades.
“And we are seeing demand for hedging on existing assets, for example fixed income and credit, as in taking out the more expensive element of risk from an asset category and leaving [clients] with the cheaper part of the risk.”
Asked what the most popular products are now among wealthy clients, he replies: “From an asset class perspective, it is clearly rates and credit.
“For example, it is about doing bond asset swaps where you essentially buy a bond and asset swap the interest rate risk out, so it would just be credit risk. Also, if a client has a loan, then [they tend to be interested in] doing liability hedging and FX swaps.”
Mahesh is firmly of the view that the appetite of wealthy clients for risk management solutions is only going to increase in the foreseeable future.
“We also feel that relative value opportunities are going to be the focus,” he adds. “We see that clients are not only focused on return, they are focused on risk and return. They are looking at returns relative to the risk they are assuming.”
Fear of losing out
Ultimately, the key question about structured products in Asia is whether enough demand exists to sustain the industry at its present size. Inevitably, this is closely linked to capital market performance, so if the market goes down, the demand for equity structured products goes down.
Ho of Julius Baer reflects that wealthy clients have more fundamental considerations than products and pricing. “At the end of the day, what they are looking for is a safe bank, one that is going to be around for another 100 years. They want to be with a bank that is looking for total solutions, not just products and pricing.”
Yet investors’ mindsets have also undergone a perceptible shift over the last few months.
“While investors initially worried about losing money, now they worry about losing opportunities,” notes Kwok. “A massive double dip scenario looks more unlikely. We have been advising clients to increase equity exposure for each market correction.”
Overall, Kwok remains positive on the market outlook for structured products. “We believe the recovery trend will continue and that more people will be coming back to look at structured products and increase their tactical trading returns,” he says.
“Then you will see some interesting variations in products, not just ELNs and accumulators.”
That would come as a relief to structuring desks and their paymasters at banks the world over.