Wealth managers should be using structured products to move risks from the edge of the portfolio towards the centre, according to Kieron Launder, head of strategic advisory services at Rothschild Private Banking and Trust.
Launder, one of the most respected structured product portfolio constructors in the country, argues that managers should shift from a mindset that focuses on controlling tail risk – the probability that a rare event will significantly and adversely affect the value of the portfolio – to centralising tail returns as the markets near normalisation.
Historically, wealth managers have used structured products to control tail risk but Launder believes they ought to start thinking about shifting risk in the portfolio to trade tail returns for increased probable returns.
He explains: ‘It’s more about centralising tail return as oppose to eliminating tail risk. As we’ve had a bounce back to more normalised valuations, it’s probably a good time to put a framework over the portfolio in terms of moving risk around from the tails towards the centre in terms of outcomes.
Launder’s observation is based on the notion that investing is more about outcomes then probability.
He says: ‘If you are thinking about distribution, you need to think what is the outcome and the probability
of that outcome.
With this in mind, he believes that maintaining portfolio flexibility while also sticking to a view – despite the unsettling nature of quarterly movements in the derivative pricing of the structured products – is vital.
He says structured products encourage investors to be more explicit about their views and points out that the major equity indices – including the FTSE, which is hovering around 5300 points – may have stabilised after a strong recovery in 2009.
‘With low interest rates and implied volatility still quite high, most structured products will still include soft protection. You are not reducing that tail risk but you are shifting the right tail return. Mathematically it is a tail risk but it’s a positive return on the upside,’ he says.
‘The idea is to move supernormal index returns into the more expected area but because of the low interest rate environment you can probably only get a better return in your expected area by continuing to accept downside tail risk, which you have with equities anyway,’ he adds.
Launder says structured products should also be used to influence distribution, although he points out that asymmetry and added value within private client portfolios is not just about performance.
‘Private clients are generally more sensitive towards losses than gains. Their risk aversion tends to be correlated to the markets, and as the markets go down they become more risk-averse and you’ve got to take that into account,’ he explains.
‘All of this suggests that structured products should be used more because they should help you tailor or affect the distribution of your portfolio returns.’
However, when it comes to managing risk, Launder, who began his career as a volatility arbitrage director
on a proprietary trading desk at an investment bank, believes understanding of the secondary market is key.
‘By understanding the pricing mechanism which drives the net asset values, you begin to understand what might happen to the secondary pricing when you get further market disturbances. Though it needs to be pointed out that when this happens again, the biggest driver of the pricing will be the price of the debt and not just the option.’
Despite increased uncertainty there have been a significant number of longer dated structured products being issued. Launder has noticed that some investors who buy structured products with a duration of five years or more do so in order to increase the effective delta.
He says: ‘By going for five years you get more option spend. People have used it as a way of increasing participation in the rally.
‘People were accepting five-year products perversely to be able to use the structured product as a trading vehicle. They were taking a longer duration period to increase the optionality element.’
Launder also concedes that many structured products had become too complicated.
He says: ‘People have started to retrench from the more complicated products, which is a good thing. Incremental complications were not truly understood and many investors prefer cleaner risk taking with an explicit risk/return trade-off.’
However, the one area where he has seen genuine progress is willingness of providers to offer different credit risk. For example, he believes Catley Lakeman Securities, the outsourced structured product creation and sales partnership which acts as a structured product platform for asset managers, is an excellent example of a company where the credit requirements of wealth managers are taken into account.
He says: ‘They understand that when you are putting a portfolio together that you will want diversification of credit names. They have different counterparties and a suite of ideas that is really useful.
‘Many major issuers such as Morgan Stanley are also addressing the credit issue through Ucits III vehicles, as well as substituting third-party credit, such that the issuer of a structured product does not have to be the credit behind the product.
Looking ahead though, he believes auto-calls and accelerated return products will be the most favoured structured products next year.
He says: ‘An auto-call where you get 10% per annum if the market is up is probably quite attractive.’
Likewise he expects structured products with an accelerated participation with a cap to be popular in 2010. ‘If you have a cap at 40%, you are worse off where the market goes beyond 40% but it’s a good trade off.
Launder also says reverse convertibles which have been rolled up as CGT have proven quite popular and will continue to attract discretionary wealth managers.