Structured Notes Offer Flexibility, Less Volatility
Three Experts Discuss Why Institutional Investing in These Products is Growing
Copyright 2000 Barclay Trading Group, LTD.
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In 1988, Dean Witter introduced the Principal Guaranteed Fund. The offering raised more than $500 million in the first day. Unfortunately, the fund was only registered for $250 million and $250 million had to be returned to subscribers.
Within a few months, virtually every major fund syndicator was selling a guaranteed fund and several billion dollars of new money found their way into managed futures. Although these funds provided the investor with protection from loss, many guaranteed funds were unable to deliver enough upside to maintain interest in the product. The most common reason cited for this failure to deliver has been high fees coupled with a deleveraged trading account.
During the past several months, the managed futures industry has seen a resurgence of demand for products that guarantee the return of principal. Whereas in the past, this demand had come primarily from U.S. retail investors, this time around the demand seems to be coming largely from non-U.S. institutional investors.
Rather than investing in futures funds, however, these sophisticated investors seem to prefer structured notes. These notes are securities which utilize a managed futures component in order to provide yield-enhancement to the underlying security.
In order to gain a better understanding of how structured notes work and why they have been so popular, we've assembled a panel of three industry experts who have had hands-on experience in this new area of managed futures involvement. Our panel includes:
Laurent Cunin, Socit Gnrale FIMAT Trading Management. Mr. Cunin has been with SocGen for eight years and has been involved in the futures fund industry for more than three years as the President of Socit Gnrale FIMAT Trading Management (SGFTM). Last year SocGen raised over $500 million USD through structured products in Japan. Prior to his assignment in Chicago, Mr. Cunin worked for FIMAT in Tokyo.
John W. Fryback, Mount Lucas Management Corporation. Mr. Fryback has been responsible for institutional marketing of Mount Lucas Management Corporation's products for approximately four years. He has been a leader in the development of exchange-traded futures and options products for more than twenty years. He has held industry positions with Kidder, Peabody&Co. and Chemical Bank. Mount Lucas offers a wide variety of institutional products including the widely accepted, broadly based MLM Index and the Eurodollar Index which are available as part of structured transactions.
Sarah Street, Chase Securities, Inc. Ms. Street is the Leveraged and Hedge Funds Team Executive at Chase Securities, Inc. Her current responsibilities encompass the development of Chase's "global client strategy" in this sector. Prior to joining her current group in 1991, Ms. Street worked in Chase's Global Risk Management group as part of the Commodity Derivatives Team. She started her career with Chase in London where, having successfully completed the graduate entry program, she joined the Metals and FCM Team for four years before transferring to the U.S.
Q: There are those who say that the concept of imbedding a managed futures component into a structured note is simply a new wrinkle on an old idea-the guaranteed fund. How do structured transactions differ from guaranteed funds?
Cunin: It's true to speak of a new wrinkle of the guaranteed funds; however, structured products offer more flexibility and creativity within the product design. These products also bear a better reputation due to their similarity to existing products (often debt) and help us to walk away from the heavily-loaded reputation that sticks to the traditional guaranteed funds. Likewise, structured products may also offer a better exposure to the underlying fund, which, when successful, benefits the client.
Fryback: A structured note is much more than just a new wrinkle on an old idea, the guaranteed fund. Typically the contemporary structured note or structured transaction, which has a fundamentally different conceptual framework, provides greater flexibility in the purchase and management of the underlying assets and the trading activity.
For example, one transaction which we felt added a new dimension to the product utilized asset-backed securities, which continued to be owned by the investor as the underlying asset, with the futures account returns delivered via a swap. The entire structure was then guaranteed to provide both a minimum floor return and book value protection for benefit responsiveness for the defined contribution plan market. Therefore, I believe that it's an old idea, but one which has been extended dramatically.
Street: The terms "structured notes" and "structured products" include a vast array of instruments, many of which have very different features and wrinkles. Some of these products do have many similarities to the traditional guaranteed fund, including return characteristics that, on a gross basis, are not inconsistent with the original managed futures funds performance. There is, however, one major differentiating factor: institutions are willing to consider these notes as part of their asset allocation programs, while historically there has been very little appetite from the institutional arena for any of the guaranteed funds. Why is this the case?
This interest reflects the fact that the institutional money management arena is seeking product that 1) can be clearly explained in language managers can understand (and subsequently re-explain to investment committees) and2) can be slotted into traditional investment "buckets". Structured products and notes can achieve both of these objectives, which goes a long way towards explaining their success. The increasing awareness of this need has led to the current focus on developing instruments that fall within the fixed income or debt category--with offerings in the form of either notes or bonds--and not within the alternative investment category, which is much smaller and more limiting in nature. These note instruments incorporate the key structural and return components that are critical to institutional investors with the appropriate tax, accounting and regulatory treatments, all of which are significantly different from the traditional guaranteed fund.
To meet these objectives, the instruments typically incorporate such features as listings on recognized exchanges, investment grade ratings, minimum annual coupon payments, and real liquidity provisions (through the existence of puts or independent market-making arrangements). It is the existence of such features--many of which were not attached to the original guaranteed fund launches--that allow the notes and bonds to be categorized appropriately in an institutional portfolio.
It is important to recognize that the critical features can vary significantly from one institutional arena to another. While one group of investors, for example, may require a registered note or bond that carries credit ratings from established agencies, another will want minimum fixed-income coupon payments or flexible redemption provisions. All of these variables can be worked into the issuer's product for the marketplace; finding a work ablestructure is not the problem. Rather, the challenge in many cases is that the products must be tailored to the requirements of each investor or class of investors, forcing segmentation of the marketing effort down to more narrowly focused institutional clienteles.
Q: Guaranteed funds, sold primarily to retail investors, were criticized for their high cost structure. Structured products are being sold to institutional investors who are even more cost conscious. What is the range of fees being charged on structured products and how much are institutions willing to pay?
Cunin: Actually, what is really important is to present a product as transparent as possible, and the decision is then based on the idea. For instance, when we issue an EMTN, the only "non-standard" information will include a given indexation to an underlying instrument (i.e., how much of the note proceeds will be invested in, say, a managed futures fund) and an indication regarding the "stop-loss" mechanism. In addition, a table presenting various yield scenarios shows what a client can expect net of all fees.
Besides, should the fee structure prove to be on the high side, fierce competition between major banks structuring products will always be there for the wake-up call. Similarly, banks having the resources to control all the components (the fund set-up, the clearing, the structuring) will definitely have a competitive advantage in offering an integrated product. It's easier to share profits in a one-stop shop than in a multi-agent structure.
Fryback: I believe that the retail guaranteed funds were justly criticized for excessive fees. The gross fee level, plus the fact that such a large portion of the fund had to be set aside for the guarantee, made it nearly impossible for the investor to earn a competitive return. The gross fees for the structured transactions that I have seen are much lower. There are typically three separate fees that can be bundled or unbundled. First, there is a fee for the issuing financial institution. Second, a reasonable management fee or a modest management fee and incentive fee for the CTA or IA. And third, a negotiated institutional commission rate. The total fees would likely not exceed 2% annually of the notional dollar amount of the transaction.
Street: This is a difficult question to answer, as there are many "fees" associated with any managed account program, not just within structured products. These relate not only to the direct management fees, but also to set-up and ongoing administrative costs, commissions, and incentive participation fees. I think a high cost structure is typical of any retail product, guaranteed and unguaranteed, and primarily it relates to the management and incentive fees charged as well as to the commission rates on the futures brokerage which can contribute significantly to the cost basis.
Without a doubt, the fees that institutional investors are willing to accept are significantly lower than those of some of the retail products. The anticipation of lower fees reflects the generally larger sizes of the institutional capital allocations, which have historically attracted stepped pricing from traditional asset managers. Often the structured note product is tailored to generate a lower overall volatility of total return and therefore is more limited in the potential of the upside opportunity.
In all cases, fees must be tailored to the potential returns of any investment as well as to the level of capital actually directed by a fund manager. In most truly institutional managed futures products, the capital invested in a trading program is lower than the retail product, as part of the objective is to reduce the overall volatility, which implies less risk capital being managed. Fees and costs must be balanced with the overall expected return targets of the paper; the higher the expected return and the stronger the probability of delivering that return, then the more likely an institutional manager will accept higher fees.
Q: The managed futures community has been trying for years to sell its product to institutional investors with limited success. Structured products, on the other hand, seem to be a much easier sale. Is this a result of a change in attitudes/perceptions towards managed futures or is it due to some inherent advantage of the structured product?
Cunin: Most likely because of the latter. On the one hand, selling a debt product is nothing new to institutional investors, so we will focus on the capital guarantee and the fixed coupon, if any, boosted by the potential for a variable return indexed on, for example, a managed futures fund--but it could really be indexed on pretty much anything. In other words, the rationale for the sale shifts from purely diversifying portfolios with anon-correlated asset class (where you have to make your point about the relevance of a new asset class) to investing into a familiar, but non-correlated instrument which happens to be linked to a managed futures component.
On the other hand, a structured product does present a more attractive package, mostly because of its integration, not to mention the recourse to sophisticated instruments which better the conditions of the offer.
Fryback: I feel there has been a slight positive shift in the attitudes/perceptions towards derivatives or managed futures. More importantly, however, the inherent advantages of a structured transaction have made institutional participation more palatable. The fact that the transaction provides a minimum floor rate of return, a fixed term, and is issued or guaranteed by a financial institution with a high credit quality, makes the investment "mainstream". In one case, we were able to make a transaction fit the very specific requirements of an institutional investor. This particular client would not have been able to participate in a traditional managed futures program with a margin account and the accompanying volatility.
Street: Structured products have a major inherent advantage in that they enable the returns of managed futures to be repackaged to fit the pre-defined investment parameters of the more traditional portfolio segments managed by these conservative, risk-averse investors--i.e., institutional investors. The current focus is to develop instruments that fall within the fixed income category in particular, with offerings in the form of either notes or bonds.
I think the critical element is that all the recent institutional product launches have successfully incorporated a credit enhancement into the transaction. This approach, in which the investors are not exposed to any loss of principal if they hold the investment to maturity, effectively limits the investment's downside to the opportunity cost of the capital allocated, significantly reducing for an institutional investor the "career risk" of making this asset allocation. The feature also increases the likelihood of the instruments to be classified as debt instruments by the universe of regulators, accountants and consultants that review an institutional money manager's portfolio.
The form of credit enhancement can range from simple "money back" guarantees at the end of the investment, to a guaranteed floor of anywhere between 90% and 115% of the original investment. Some products give the ability to lock in trading gains with "ratchet-up" clauses.
In addition, I believe that the managed futures community has become smarter in the way they present themselves and their product to the institutions. Many of these firms have hired individuals with experience in marketing traditional fixed income and equity portfolio strategies to the institutional marketplace, who are now applying their expertise to designing product structures that appeal to mainstream institutional users. These new target clients include small- and medium-sized pension funds, foundations, endowments, and insurance companies.
The initial marketing strategies revolved around selling managed futures solely as an independent asset class. Although pockets of success can be identified, in the broader scheme of things -- witness the stagnant $25billion size of the managed futures industry's asset pool-- this approach received, at best, a lukewarm reception from institutional audiences around the world. However, on a positive note, many institutional investors do recognize the value of a managed futures investment strategy as a way of improving the overall performance of any traditional equity and/or fixed income portfolio. This willingness to contemplate allocating capital to managed futures springs principally from the strong negative correlation of managed futures to stocks and bonds.
The high degree of "alpha" inherent in returns on managed futures investing, when coupled with the absolute returns that such programs generate, creates the opportunity for more balanced and more profitable investing with less overall volatility. The positive impact of adding managed futures to the portfolio mix can be particularly noticeable when the traditional markets are producing low to negative returns.
Recognizing these circumstances, certain industry practitioners started to focus on reasons for the industry's failure to attract significant institutional capital into their industry. They quickly identified two principal issues that needed to be addressed for their product to be attractive in the institutional market place. First, to eliminate the label of "alternative investments" within an institutional portfolio, managed futures investments need to be repackaged to fit within the pre-defined investment parameters of the more traditional portfolio segments managed by these conservative, risk-averse investors--i.e., to no longer be "different" from other investment products. Second, in order to establish and retain credibility with this new investor base, fund managers and CTAs have recognized that they must create product that offers a high probability to deliver on promised returns.
Considerable progress has been made in addressing the first challenge through innovative product packaging. Only recently, however, has the high probability of achieving expected "total" rates of return come on the radar screens of many in the managed futures industry as an issue of critical importance. Until more disciplined programmatic efforts to reduce leverage, dampen volatility and manage risk are more widely accepted and implemented by the managed futures industry, interest among institutional clients will be limited. These investors will continue to seek investments that have some reliability of meeting the projected returns discussed in a prospectus and in marketing materials.
Q: Within the structured transaction for the institutional marketplace, should the enhanced return component be an actively managed component or an indexed component?
Cunin: Both present an interest. The indexed component might only be limited by the lack of recognition of common managed futures indexes, while probably requiring more attention in hedging the tracking risk. This may also translate to less profit participation compared to an actively managed component, but can prove more appealing in an attempt to differentiate yourself from the crowd.
Fryback: Using an indexed component to provide the enhanced return offers several advantages. In conversations we have had with prospective and actual institutional participants, they have generally expressed the view that an indexed return performance, for a variety of reasons, is easier to understand, easier to explain to their investment committees and boards, and ultimately easier to monitor as part of the transaction. If index returns are verifiable and quoted independently, historical returns can be analyzed and modeled to gain a greater comfort level for subsequent period returns. Additionally, the use of an index enables us to structure the transaction as a swap that does not require the investor to own futures.
Street: This depends upon the target institutional market, as an indexed component representing a "passive" instrument is a very different product from an "actively managed" program. There are certain institutional investors that have internal guidelines that limit the portion of any investment that can be managed by a third party. In these cases, indexed products are really the only alternative. Paper that includes an actively managed component represents a product where the principal reason for investment is to buy the "alpha" of a particular trader or set of traders that represents the skill of the particular manager.
In general, passive programs are seeking to capture the inherent returns in a particular market or range of markets. I believe that there is a clear and distinct role for an indexed product to play-although realistically, the role of the managed futures industry in a passive approach is more limiting.
Q: Many structured products rely on rated bank guarantees for the repayment of principal at term end. What do you feel is the minimum acceptable rating for institutional participation in a structured transaction?
Cunin: An A rating is probably the minimum you want to go. Below this rating, you may risk losing institutional interest and be too far away from traditional AAA rating structure.
Fryback: Obviously, the issuing or guaranteeing financial institution has to have a credit rating of at least a level acceptable to the institutional investor. However, given the basic terms and conditions related to the structure, varying credit ratings may be acceptable.
If the structure vests ownership of the underlying securities with the investor, and if the underlying assets are triple-A rated U.S. Treasury or agency obligations, the issuing institution could probably be less than triple-A rated. On the other hand, if the investor must rely on the creditworthiness of the issuing institution for the return of the entire investment, the investor will no doubt require extremely high credit ratings. As a result, marketing potential would permit a wide range of credit worthiness, with the marketing approval perhaps narrowing with overall credit ratings.
Street: The level of rating needed is solely dependent upon which institutional segment a particular product is targeted. There are some institutions that are limited by their charter documents or their regulatory environment to buying paper of a certain minimum credit rating (often AAA), while others are afforded more flexibility.
Most transactions have been structured to achieve a credit rating, or implied credit rating, of at least single A. In certain markets, such as the European pension fund segment, this rating needs to be at least AA, while in others, such as the U.S. insurance market, who are traditional buyers of corporate private debt placements, A-rated paper is often acceptable. In other markets like Asia, the "brand name" recognition can be as important as, if not more so than, the actual credit rating of the guarantor.
The credit rating requirement can be achieved in numerous ways, the most common being through the existence of a bankruptcy remote issuer with some form of credit enhancement that carries an investment grade rating. The credit enhancement can range from the use of investment grade securities, pledged to support the issuer's obligation under the debt issue to the investors, to an "insurance" policy-in the form of a letter of credit or guarantee from a bank or other form of financial institution-that ensures the performance of the issuer under its debt obligations.
Q: What new developments and/or improvements do you see on the horizon for structured products?
Cunin: Today, one of the drawbacks of the guaranteed structures resides in the risk of being stopped out well before the maturity of the product. To overcome that risk, options on funds can be used. However, one can expect a lesser participation in the underlying fund's performance, everything being equal.
Fryback: The innovations are likely to come in the means of delivering the return as we learn more about and borrow from financial techniques used in other financial markets. In the transaction I referred to earlier, the issuing financial institution contracted to deliver the return via a swap with the investor. The issuing institution then hired Mount Lucas to manage a hedge account to generate the contracted return. I feel that variations on this structure will allow issuing institutions to better satisfy the needs of institutional purchasers while capturing the maximum hedge account return for an acceptable level of risk. This structure separates the expected return and the actual hedge account return providing maximum flexibility to both the investor and the issuer.
Street: The global capital markets, particularly in the U.S., will continue to evolve, and new product structures will unfold as this evolution advances. I firmly believe that this will offer increasing opportunities to issue a broader range of financial instruments where the returns of managed futures will be attached or embedded. Some current product initiatives, for example, revolve around the use of the collateralized bond obligation structure, where the different components of "risk" within a managed funds program are carved up into multiple capital layers (senior and subordinated pieces) and placed with different investor bases that have varying risk/return appetites. Also, the application of convertible bond issues and exotic options involving managed futures performance within more traditional instruments are being developed.
In the future, as investment professionals operate within the global capital markets under mandates to originate new structures to raise capital for corporates and/or to offer investment alternatives for their institutional clientele, further new product initiatives will emerge, and further innovation will take place. The managed futures industry will be a direct beneficiary of such continued product development, and it will be those practitioners that can adapt to the new philosophy and develop agility with the structuring components in the appropriate asset classes and instruments who will be truly successful in attracting an institutional clientele.
Copyright 2000 Barclay Trading Group, LTD.