This article was written by Karim Faraj, Bloomberg’s Global Head of Front Office Derivatives and Abdessamad Khaled, Head of Structured Product and Derivatives Pricing.
The $7tn structured products market is on the rise again – and the market is sizeable to say the least. While structured products account for only 1% of the $700tn derivatives market, structured products still outsize the total ETF market ($5.3tn) and more than double the total hedge fund market ($2.9tn).
After the financial crisis of a decade ago saw investors pull back from the broader structured products markets, especially more exotic instruments, the past year has seen a surge in the products’ popularity.
It’s easy to see why. In an environment when ultra-low interest rates – negative benchmark yields in many cases – and declines in capital guarantees are driving investors to ever more exotic products and more risk taking in search of yield, structured products are providing dependable returns. According to data from Lowes Financial Management, none of the 381 structured products that matured in 2018 lost money.
But that’s not the only reason.
Structured products offer a range of benefits that make them attractive to both institutional investors – who make up the lion’s share of the market – and the retail sector, with which the assets are often most closely associated. Chief among them is the ability to customize assets to an individual investor’s expectations and risk appetites.
Flexibility, customization
Securities can comprise multiple parts that derive their value and performance from underlying assets, be they individual stocks or an index. The savvy investor can structure into product positions that will mitigate specific downside risks in the rest of her portfolio.
Say, for instance, you think Brexit will have a negative effect on the UK economy. You can structure a product that bets on a decline in domestic British stocks and a slump in the pound. But, because you can’t be sure that we are heading for a no-deal Brexit, you can put a conditional capital protection that would minimize your losses in case your projected scenario doesn’t materialize.
While there is no safe bet in the financial markets, structured products do at least enable inclusion of caveats to hedge against specific risks while expressing a market view. This is why they are so popular among retail investors, who usually have a lower risk threshold.
Institutional interest
Such customization also enables institutional investors – the pension funds, asset managers, hedge funds and the like – to use the products strategically. Outcomes can be defined, and this lends them a predictability that makes them suitable for use not only as an investment but also as a hedge.
Structured products have become more popular also because the types of assets investors are willing to incorporate into them have widened. Exchange-traded funds and strategy indices, for example, are finding their way into products. More sophisticated investors are also bridging asset classes by structuring hybrid products that include underlying from different asset classes.
Among the broadening range of underlying components are green investments, the so-called environment, social and governance (ESG) securities that are among the fastest growing asset classes in today’s markets. These are proving attractive not only to retail investors, who want to put their money where their eco-friendly beliefs are, but also institutional investors, who are capitalizing on growing corporate awareness of the risks of climate change and pollution.
Technological boost
Like everything else today, structured products are benefiting from technology. Banks and traders had been slow to adopt the securities because they require a lot of calculations and modelling to get right. But the arrival of new technologies for contract representation, lifecycle management as well as new pricing techniques has provided the tools and processing power to structure the most complex of products.
Technology has some way to go yet, however. Many market players, especially in the buy side, still lack systems that can handle structured products in a portfolio context along with traditional asset classes. Moreover, those players are often unable to run essential analyses like stress testing and scenario analysis at the portfolio level – critical to design the optimal product for a given portfolio with a target investment or hedge goal. While the outlook for structured products is positive, their growth is unlikely to be reach full potential until full automation and management has been achieved.
Even that would require another lever – better understanding in the market of the securities’ potential. The onus here is on advisers who can help unlock the huge investing power of the retail sector, which still remains largely skeptical about derivatives.
Bloomberg has provided tools to help in that evolution. By integrating our DLIB and MARS functions we’ve created tools that allow better understanding of the products through pre-trade workflows like back-testing, scenario and what-if analysis. DLIB has also been integrated with our Trading and Order Management System, TOMS, giving clients an end-to-end solution that allows them to manage their cross-asset trades offering state of the art risk management and lifecycle operations.
While structured products currently account for about 1 per cent of total assets in global financial markets, that’s still a sizable chunk of investing firepower. And the combined notional value of institutional and retail commitments are more than double that of the hedge fund industry and bigger even than the ETF sector. With greater understanding of the products and continued technological evolution, that power can only grow.