Structured product sellers shift to advice, says Societe Generale

Structured products and derivatives contracts have lost investors plenty of money over the past 12-18 months, prompting a rethink among the investment banks that create them on how to rebuild reputations -- and how to provide institutional clients with services to help them recover losses.

Marc Saffon, managing director and head of financial engineering for Asia-Pacific at Societe Generale in Hong Kong, says the bank has restructured its global equities and derivatives business. This has resulted in a more complete multi-asset platform and an emphasis on both advice and quicker response time to market changes.

This is in contrast to pushing a product or a particular asset class -- which he acknowledges was pursued too much in the run-up to the financial crisis.

One reason to move away from trying to determine a client's asset allocation is because market volatility has been so high, particularly in the six months following the collapse of Lehman Brothers. Rather, being nimble and tactical allowed investors to trade their way to profits -- and broking these has boosted investment banks' revenues.

Today, however, bid/offer spreads are narrowing as more banks get into this game, and the emphasis is changing to helping investors diversify risk and access new asset classes. As a result, SG finds the wrapper (fund, note, deposit) and the payoff structure is less important than getting a client the right asset exposure.

Saffon acknowledges that the crisis has damaged the reputation of structured products, but he says this ignores what these products are meant to do: modify an investor's risk profile. Of course, such products are either effective or hugely problematic if they don't correctly match an investor's objective, or if the market timing is off. "But there is still a need for ways to diversify a risk profile," he argues.

This year SG has been in discussion with various institutional investors and distributors of investment product (wholesalers) about providing advice on portfolio construction or ways investors can deal with impaired assets. Many investors want products to help them recover lost assets, so SG tries to define their goals and work out a structure with realistic return objectives, given certain time horizons and risk appetites.

"The problem for many investors is the liquidity of assets on their book," Saffon says. They want to restructure their balance sheets to have a better understanding of how these toxic assets can be valued. Instead of marking to market -- which would make the assets look very cheap -- more investors are 'marking to stress'.

This means calculating maximum cumulative historical losses as a way to identify which parts of the portfolio are liquid, and which aren't. From there an investor can use a variety of derivative structures to address any problems.

For example, says Saffon, an investor can sell assets, or take a provision, or restructure the portfolio with extra protection or insurance, modify its payoff, or overlay toxic assets with a derivatives strategy that creates a different risk profile -- to either thin out or concentrate risk.

"De-risking is not just about selling," Saffon says. "It is about controlling bands of uncertainty in a portfolio, or across the entire balance sheet."

Providing such advice to pension funds and financial institutions began in Europe in the second quarter. Over the summer, Saffon has begun to hold such conversations with institutions in Asia. He predicts this kind of activity will dominate structured products teams for the next six to 12 months, as Asian investors use bank advice to work out portfolio problems.

"We are creating the basis for the next stage of growth," Saffon says.

One example: SG is working with an insurance company in Taiwan to use interest-rate volatility to boost investment returns. The insurer is concerned about negative convexity on its balance sheet. (Convexity measures the relationship between changing the price of a bond with a change in its yield; negative convexity means as bond yields fall, duration also decreases.) Therefore the investor is selling volatility by buying non-callable products via an option. The result is a positive convexity is restored.

Another example: advising investors that were burned when hedge funds gated their assets. SG can help them transition a portfolio of hedge funds into something more liquid, such as a platform of Lyxor Asset Management managed accounts of alternative investment products. Lyxor guarantees liquidity for its hedge fund suite. It comes at a price, but for investors concerned about liquidity, such a transition can change their portfolio risk.