In the wake of the global equity markets meltdown, wealth management services providers are dusting off a variety of equity derivatives products to help clients preserve their capital and boost returns. By Ellen Leander
Gone are the days when the wealth management services arm of a bank could offer clients returns of 20% per annum on a moderately risky stock portfolio. Now, many clients are distinctly risk-averse. One banker jokes that when private banking personnel ring their clients, “the clients start saying bad things about their mothers, that they’ve destroyed their chance for their kids to go to college – there are all sorts of war stories. As a result, they are very reluctant to push any single stock – it’s a non-starter. Even stuff that used to be considered really benign is under a huge microscope.”
Remarkably, this environment has been a boon to equity derivatives, partly because certain derivatives structures can help preserve wealth, while others can enhance performance in a more protected way than a single investment could. For example, prepaid variable forwards have been more frequently used than collars in the US during the past 12 months, according to Jeff Sparks, managing director and head of high-net worth equity risk management at UBS Warburg in Stamford, Connecticut. “It is a hugely popular product,” he says. “And a way for clients to hedge or monetise large concentrations of a single stock.”
These products have been christened with a variety of marketing names at different firms, but the concept remains the same – a client with a concentrated position in a single stock sells a forward contract on the value of the shares and purchases an equity collar. He then receives up to 85% of the value of his holding tax free, until the product matures and the stock is actually sold. Downside is protected by the collar, while upside exposure remains. In the bull market, many clients did this to diversify their equity risk position, but Sparks says clients are now doing this to help pay off margin calls on other positions. “It gives them the proceeds to refinance their debt, but it also gives them asset protection and a chance at upside, thanks to the equity collar,” he says.
Unfortunately, at the moment the tax-free status of variable prepaid forwards is being given a second look by the US Internal Revenue Service (IRS), in a case brought against Bobby Stevenson, chief executive officer of Ciber, a Colorado-based technology firm. The IRS is asking him to pay 1998 taxes on the gains from his variable prepaid forward contract, which matured in 2001 after the bursting of the technology bubble. Although some Wall Street executives say this is a one-off case brought by a field agent, US legal experts are urging caution with these types of contracts, until a resolution of the case is reached.
Principal-protected products, particularly in the form of equity-linked notes, are also proving to be very popular with US private clients. “Those investors who don’t have exposure to the equity markets because of a fear of volatility could gain that exposure through principal-protected products,” says Mitch Cox, head of structured products for private clients at Merrill Lynch in New York. Some principal-protected products are being written on individual equity indexes.
In addition, he says that principal-protected mutual fund structures are “an actively developing area right now”. In these structures, the mutual fund shifts the capital between stocks and bonds, and the principal itself is protected by guarantee from an independent institution.
In Europe, private clients are also dabbling in these products. “We have to make more products that are based on volatility rather than return,” says Geert Bossuyt, director of structured products, global equity derivatives at Deutsche Bank in London. “When a client walks into our office, the first assessment is not to know what kind of a return he is looking for, but rather what kind of volatility he can cope with.”
Deutsche Bank is in the process of launching its own family of mutual funds in Europe. Called ‘Profile Funds’, they will shift between asset classes based on volatility models and risk/return trade-offs.
Other European products are even more sophisticated. Altiplanos – an option that entitles the purchaser to a large coupon if no stock in a given basket falls to a preset level during a given period – are seeing renewed interest from investors, Bossuyt says, adding: “Of the capital protection products we do, 60-70% are based on the constant proportion portfolio insurance (CPPI) technique.” These products split their investment between two different types of assets – a riskier asset class and a less risky one – based on market movements. If the risky (equity) asset goes up, more will be invested into the risky asset. If the risky asset goes down, however, more will be invested in the non-risky asset, protecting the capital.
But with all these equity derivatives products, private client executives are emphasising the renewed importance of transparency with clients. “Derivatives done improperly can be complex,” says Merrill’s Cox. “Customers won’t completely understand what they are getting, and at the end of the day if a customer doesn’t understand what they have perfectly, they aren’t going to be happy with that investment.”
