What he discovered appalled and alarmed him in equal measure. “It was clear that this product was all about the firm’s investment bank shoveling c*** down its private banking distribution channel. And the disclosure was appalling,” he said.
He declined to name the bank involved. However, he said it was unclear how the product would achieve its projected payout and what the risks were to the client if underlying assets failed to perform. It also failed to spell out the scale of fees the bank expected to earn.
The anecdote encapsulates why wealthy individuals, and their advisers, are skeptical about structured products. They tend to view them as a way for investment banks to package and sell risk they do not want – and make fat fees in the process.
Private banks tied to big investment banking franchises are often used as distribution channels for products dreamed up by the latter’s derivatives wizards. Independent wealth advisers argue they are in a better position to use structured products intelligently. Many of them have been hiring their own derivatives specialists so they can create and evaluate structures more effectively.
Average fees on structured products are estimated to have halved in the past decade, as the supply has increased. With some banks willing to issue bespoke products for less than $1m (€630,000), it is equally clear that wealthy individuals are calling more of the shots.
This is the key difference between the thriving market for structured products offered to the retail sector and those offered to the wealthy. While retail investors and financial advisers have no choice but to buy products being pitched by the banks, wealthy clients tend to be more discerning.
David Weller, a partner specializing in structured products at UK wealth manager Cheviot Asset Management, said: “Investment banks are pushing out products to independent financial advisers and the retail market, which may be good or may be bad. But we will have a client with a specific set of circumstances and identify a structured product to suit. We then go to the banks and ask them to price it competitively.”
Successful investment in structured products generally results from assessing whether a pre-packaged instrument is a more effective way of gaining the required exposure than buying the underlying assets or securities.
Private bankers say they have seen interest from clients in getting exposure to sectors of the stock market that have seen prices fall since the credit crunch. Introducing a capital guarantee allows them to bet on a recovery without being exposed to the risk of further declines.
However, a combination of lower borrowing costs and increased market volatility means straightforward capital protection structures have become less attractive this year.
Such products usually involve buying a zero coupon bond, which will return the principal amount at maturity, and investing the remainder of the investor’s capital in derivatives providing exposure to the stock, sector or market they want.
Lower interest rates mean the zero coupon bond is more expensive and there is less money to invest in the required asset class as a result. Higher volatility also makes buying protection through derivatives more expensive. More innovative thinking is required.
Robby Hilkowitz, executive director at wealth manager Stonehage, said: “Pricing structured products attractively has been difficult. That said, we have syndicated a couple of deals recently.”
A capital guaranteed product providing exposure to agricultural markets has found favor with some Stonehage clients, for example.
While structured products through which investors are buying protection against market declines have become more expensive, those in which investors effectively sell protection – or volatility – to third parties have become more attractive.
Cheviot’s Weller said so-called auto-callables have been a popular product this year. These are linked to a stock market index, or basket of indices, and offer a big annual interest payment as long as the underlying equity index is higher after 12 months.
The capital put at risk by investors is protected providing the index does not plummet in value. Weller said: “If you are bullish on the equity market it is a good way of capturing some upside.”
