Proprietary indices have thrived in recent years by providing a viable alternative to generate market-neutral returns but they have also raised questions around conflict of interests as issuers provide both the index and structures linked to them. Charles Firth, the head of equity derivatives structuring for Asia-Pacific at Credit Suisse, which manages the Spear proprietary index series, spoke to SRP about the latest developments and the challenges in the region in this space.
Structured products linked to proprietary indices have shown significant traction in some markets such as South Korea and China among private banking and retail investors. What is your view on these indices?
These products have been around for a long time. The first generation of algo products were generally focused on having an upward bias on risky assets, and as such experienced difficulty in adapting to the paradigm change following the global financial crisis, and therefore suffered from poor performance. In May 2013, Credit Suisse introduced its Spear family of proprietary indices which has now gathered around $2bn across its variations. Sales over the past year and a half have created positive momentum for the whole market while good product performance and the increased choice of strategies have prompted investors to reconsider such indices as an integral part of their portfolio.
What are the driving forces behind the demand for prop indices in Asia? How important is this segment to offer a unique value proposition to clients?
What has made the new generation of prop indices appealing is their migration from the “black box” to a much easier-to-understand format in the eyes of the average investor. For instance our Spear series is quick and relatively easy to explain as it implements two forward-looking market stress indicators and systemically allocates to long or short exposure accordingly. Secondly, the performance has been strong for many algo trading strategies compared with traditional static products. The Spear Dynamic Asia Index, for instance, has delivered a positive annualised return of some 15%, with 7.6% volatility since launch, versus the basket of underlyings it invested in which only gave an 8% return on 15.3% volatility in the same period.
Thirdly, there is a general lack of available and effective hedges for Asian equity portfolios. As an illustration, the amount of notional of 90% strike three-month put options on Hong Kong’s Hang Seng Index that an Asian institution could execute in one shot without impacting the market is often $50m-$100m. As a consequence, such institutions might resort to using S&P500 options for much better liquidity or VIX options which have historically strong negative correlation with the S&P500. However, neither method can translate to a suitable hedge due to the diminishing strength of correlation between the US and Asian equity markets. The Hang Seng index and Nikkei also have their own version of VIX products but, again, they lack the much required liquidity to be accessible by institutions on a large scale. Given the limitations of the existing alternatives, things get very difficult when attempting to hedge portfolios above one billion notional. This is where algo products potentially serve the demand for cost-efficient hedges apart from their primary use as an investment vehicle.
How does the Credit Suisse Spear Series respond to the diversity of needs in the market?
The first question we need to consider is how we can take advantage of liquidity in markets to execute our strategies as efficiently as possible for our investors. In Asia, the instruments which have the highest liquidity in Asia are equity index futures, and it is for this reason that Spear uses such futures as underlyings.
The second question we ought to ask ourselves is what indicators we should use in constructing the allocation methodology for our indices that have been historically reliable and which we believe have the potential to beat the market going forward. When designing Spear we conducted a lot of research on assessing the appropriateness of various methods and finally selected a combination of indicators from both equity and credit markets. We must bear in mind however that there is no holy-grail or single “best” market indicator. While certain indicators have historically proven to be valuable in detecting risk building up inside the financial system, they have no way to predict external shocks such as the 2011 Japanese earthquake and the subsequent market reaction.
Our Spear-based products can be customised for institutional and private banking clients, in that the weights of equity indices referenced by the futures contracts can be set to match a given client’s portfolios. For example, a particular investor with more exposure to the US and Europe stockmarket might choose a configuration which puts more weight on US and European equities as opposed to Asian ones.
Credit Suisse is a leading player in the investment strategy market segment; by some estimates this market is already $4bn-$5bn notional per year. What is your forecast for this segment?
I believe the market is well positioned to grow on the back of strong demand and product performance. At the same time, client suitability is also something we consider very carefully at Credit Suisse. It is important to ensure the products are marketed to the right customers who are sophisticated enough to understand the risks and rewards in a balanced way.
What next? Does CS have any prop indices in the pipelines?
Last year the big story for us was the launch of the Spear Dynamic Asia Index, which is a rule-based algorithmic index that allocates exposure into either a short position or a long position on a basket of Asian equity index futures. The dynamic notional exposure allocation is based on a model which aims to predict equity downside by translating signals from the equity volatility and credit markets into quantitative indicators.
This year we launched a global version of Spear which applies the same concept to global equity index futures. Additionally, we have spent a lot of time researching superior ways of doing asset allocation products which aim to provide a convenient package which can meet investors’ demand for diversification. While many investors are aware that diversification can boost returns, in practice some investors may not be confident in investing outside equities and bonds. We have created Echo, a new product that aims to do this cross-asset allocation systematically. The product implements an enhanced version of Markowitz’s “efficient frontier” asset allocation model.