Investment banks have become major direct service providers to private client and retail investor portfolios, mostly through their structured products. Yet they are conspicuous by their absence from wholesale manager menus. MICHAEL BAILEY examines whether the banks’ transactional culture can become acceptable to conservative superannuation funds, and whether they might find their biggest role in a new post-retirement universe. Institutional funds management is a relationship business. It has to be. A business development manager can spend months and years in meetings and presentations laying the groundwork for a single mandate with a single super fund. It would be a lonely, soulless existence if they did not develop some kind of relationship with at least a few of the asset consultants, fund investment officers and trustee boards which stood in their way.
Even if it’s just memorising the names of children and spouses and answering when the phone rings, something has to be done to build trust, and be done over a significant period of time. A salesperson from the structured products division of an investment bank, on the other hand, probably doesn’t get to know what a particular private client adviser or dealer group researcher does with their weekend. Even if they wanted to, there’s not been much time for small talk in the way the structured products business has grown within the Australian retail market. The emphasis has been on releasing funds, lots of them, with the deadlines for entry getting shorter and more frenetic as the mums and dads, or at least those advising them, have continued to lap them up.
Protection for the people… A look at the list of latest reports available from Aegis Equities Research, a rater of structured products servicing the private broker and financial planner communities, is testament to the weight and diversity of structured product launches in recent times. As Irfan Khan, the head of equity structured products at Citigroup Global Capital Markets, puts it: “Our trading desk is not that far removed from the street any more.” On June 6, there appeared on the Aegis site a report recommending OM-IP Eclipse, a Man Group fund of hedge funds with a ‘rising’ capital guarantee from Commonwealth Bank, whose investment banking arm will lock in 50 per cent of new profits each financial year after making good any prior years’ losses. Its aggregate fees of 5.47 per cent per annum are accepted by Aegis as “comparable with similar products at the product level”. On June 1 it was the turn of the Macquarie Equinox Select Opportunities Trust, the ninth in the Millionaire Factory’s busy schedule of Equinox releases.
A product that only an investment bank could deliver, the Equinox Trust gives exposure to a ‘reference portfolio’ of hedge funds, mitigated by a ‘Threshold Management’ mechanism which permits leverage of up to 130 per cent if positive returns persist, or shifts exposure to cash if the underlying hedge funds are underperforming. The day beforehand, May 31, UBS had gotten in on the act, offering a rising or falling guarantee (a Constant Proportion Portfolio Technique note, if you ask them) over a Rubicon global fund of hedge funds. May 29, another day and another investment banking risk management technique was on display in an Aegis report. This time it was JPMorgan, offering 90 per cent capital protection over a basket of emerging market indices in an Ord Minnett-distributed STRIPES offering. Retail investors nervous about riding the emerging markets rollercoaster are calmed by JPMorgan’s averaging methodology, which references capital growth to the averaged growth of the indices basket in the last two years of the five year vehicle. One only need go back a further two weeks, to May 16, for the previous investment bank structured product – Citigroup Global Capital Market’s Asian Income Plus fund, which truly gives the lie to any notion that the retail market is uncomplicated.
The fund is actually an offer to buy into Citigroup’s third tranche of Yield Income Enhanced Listed Deferred Securities, under a ‘deferred purchase agreement’ where the final price is determined by six years’ performance of a buy-write strategy over 30 stocks from the MSCI Asia Index. Income is derived from call option premiums and any dividends paid from the underlying basket and an exit strategy is covered by a capital guarantee and a Citigroup pledge to make a market for the securities. So in a period of less than twenty business days, just about every major investment bank had emerged with a structured product, displaying a dizzying array of risk management techniques, all aimed at delivering a relatively predictable rate of return with limited downside risk.
This pace and diversity of product release has now become typical, as Australians become more comfortable with derivatives and financial engineering. The number of options trading accounts lodged with the ASX is at record levels, the number of listed warrant instalments has ballooned from about 1000 in 2001/02 to about 4000 today. Ordinary Australians, along with the ordinary Dutch, are the only retail investors in the world able to access collateralised debt obligations. Given that these same Australians are all members of superannuation funds, and these same funds are becoming known for their alternative asset appetites, it was only a matter of time before the investment banks cast their eyes above the now-saturated retail structured product market, and began wondering how they could access the wholesale billions. …and now for the institutions It will surprise no-one to learn that Macquarie Bank’s Equity Markets Group is among those investment bankers scouting for opportunities in the wholesale market.
By her own admission, Cathy Kovacs, the group’s director had “never thought” about the institutional market for structured products until early this year, when she took phone calls from a couple of super funds interested in the group’s portfolio protection capabilities. Kovacs’ team itself has now begun making approaches to institutions, for whom she says investment banks are able to offer a wide gamut of services around their capabilities in risk underwriting and derivatives management, made possible by their large balance sheets. Kovacs says most of the institutional interest so far has been for capital protection wrappers around particular member investment choice options, as well the group’s “access” products – where an investment bank will provide synthetic (and possibly leveraged) exposure to a basket of underlying ‘exotic’ funds managers or indices, with an optional capital guarantee thrown in, that usually limits both the potential upside and downside performance. One of the major differences between retail clients and potential super fund clients is their investment outlook.
The structured products released to date have rarely had a life of more than five or six years, whereas retirement investing is for the serious long haul. But Kovacs is unfazed, saying the beauty of structured products is that they live up to their name, and can be built to adapt to all kinds of environments. “We’ve got no problem with the longer investment horizons of institutions. Earning an income from a piece of business over thirty years would be great,” she says. Macquarie is not the only investment bank to have noticed that the wholesale market could be an untapped gold mine. UBS hired Patrick Liddy from the superannuation-friendly milieu of National Custodian Services early last year, originally as head of transition management. However his title has since expanded to head of wholesale services, and he is marketing a three-pronged product offering to lure super funds – portfolio protection strategies, mandate transition management, and a buybacks service not offered discretely elsewhere.
Under this service, UBS will go where funds managers focussed on pre-tax outcomes often fear to tread, and will participate in a buyback on behalf of an institution, consolidating its holdings in the stock and purchasing a call option to hedge repositioning risk. JPMorgan and Citigroup are also gearing up for institutional business. Citigroup’s Irfan Khan thinks super funds will eventually embrace protected products as a way to “lock in” gains, particularly now that the extended bull run of Australian equities looks like it could be over. He also thinks that investment banks’ “rules-based, set-and-forget” access products will be useful for funds who are seeking to separate alpha and beta, given they offer replication strategies for the most exotic of asset classes, free of keyman risk. Investment banks aren’t the only ones making concrete changes in preparation for their playing a bigger role in wholesale funds management. When Intech Investment Consulting announced it was looking for a 50 per cent equity partner last month, it said a major reason was the need for capital to fast-track the development of innovative products, which managing director Michael Monaghan said would emerge due to the “convergence of investment banking, technology and know-how”.
Image problem Macquarie Bank’s Kovacs is acutely aware that along with the extended horizons of super funds comes a more conservative culture, within which investment bankers will need to tread sensitively if they are to win business. “The thing we have to come to terms with is the longer lead times in getting the business, the one or two years of listening to the institution, tailoring the product and matching it to their needs,” Kovacs says. “The key to building those relationships is strong product knowledge, and we are all conscious of the need to be more patient,” with Kovacs adding she has so far taken on most of the institutional marketing herself, with no immediate plans to hire up for a wholesale sales push.
“I know it’s not like selling Mars Bars – it’s not like you can front up to Mr. Telstra Super and say ‘have I got a great new product for you today’.” An objective observer of investment banks’ first forays into the institutional world, Brett Sanders of Grove Research & Advisory, says some over-zealousness from the bankers during the first wave of structured product offerings, two or three years ago now, still needs to be corrected. “There was a bit of mis-selling in the early days. We have a lot of local government and endowment clients for our research, a few of them who bought into some of the early collateralised debt obligations (CDOs) without advice subsequently came to us for tips on selling out,” Sanders says, adding that most structured listings are still trading below their issue price today.
“Floating rate notes were offering 30 or 40 basis points over cash at the time a couple of years ago, but CDOs were advertising 80 to 120 over and a few instos thought ‘wow, that looks pretty good’.” “But before going into structured products, you need to stop just thinking like a depositor, where you only look at yield and credit rating and assume everything will be fine. You need to start thinking like an investor, and consider risk and volatility and fees,” Sanders says. Fees indeed. Say “investment banking” around most institutional gatekeepers, and the ‘f’ word is not far away. “Investment banks have got to get over the trust barrier, and more transparency around fees will help,” says David Neal, the managing director of Watson Wyatt.
“There is just a feeling out there that these structured products are opportunistically priced, the old ‘how much are they making?’ syndrome. Within the swaps they use, it’s not always easy to determine how much you’re actually being charged for the thing.” Neal’s colleague at Watson Wyatt, Tim Unger, points out that when it comes to the over-the-counter derivatives which the investment banks use to make a market for many of their products there is only a limited amount of price discovery. “You’ve got to take it or leave it, and when it’s tactically the best time to buy is usually when they are most expensive,” he says. The image problems which investment bankers might face with an institutional audience are not confined to their fees.
The head of structured products research at Aegis Equities Research, Matthew Bullock, bemoans the fact that many providers are defiantly ‘black box’ in their attitude, limiting their market. He picks on the Macquarie Winton Global Opportunities Trust, a structured product based on managed futures whose underlying manager, Winton Capital Management, won’t even disclose its investment process to its own staff. “There are only two or three people on Earth who know how it works,” Bullock says.
“The best we can do in our reports on products like that is say to be aware of the volatility, and decide from what you know about them whether you can trust them.” It’s a sentiment one suspects would be laughed out of the average trustee board meeting. And if investment bankers think they are some big cultural hurdles to jump over, they might be better off not calling Frontier Investment Consulting just yet. Managing director Fiona Trafford-Walker considers structured products, with their fee levels imported from retail land, to be unsuitable for her clients full-stop. “We look at the odd one but as a general rule they are too expensive. They are structuring things for a particular moment in time. If you are a long term investor with a prudent strategy, you really don’t need protection.
At the super fund level, it’s probably not advisable to invest in a single item like a collateralised debt obligation – do they, or we, have the expertise to pick which ones are best in comparison to an experienced bond manager who does nothing but invest in fixed interest? I don’t think so,” she says. “Funds are too conscious of MERs to accept structured products. They should only be worried about net returns to members but let’s face it, you can touch and feel MERs so they’re very conscious of their spend on each product.” Not surprisingly, funds managers are also dismissive of their potential new competitors in the wholesale space. A marketer for one, who used to work for a funds manager under the same umbrella of a big investment bank, says that apart from their balance sheets, the banks don’t offer anything that managers could not access themselves. With funds facing more reputation risk than ever, he says that the wheeling-and-dealing image of investment banks, and regular media reports of their executives’ massive salaries, do not chime well with trustees’ self-preservation instincts.
“It’s a legal liability issue – my feedback is that most boards are uncomfortable signing a contract with the structured products area of an investment bank,” he says, adding that many funds still have trust deeds which prohibit such investments. Watson Wyatt’s Tim Unger concurs. “Our clients have a natural wariness and hesitancy to engage directly with an investment bank. They would certainly be looking for a three-way partnership, involving us as a cross-check.” Cultural revolution There is some evidence that investment banks are beginning to get a foot in the door of super funds. A handful of funds, such as Westscheme, have invested directly in collateralised debt obligations, while UBS’ Liddy says there have already been institutional clients for the buybacks service and capital protection strategies.
At a recent Sydney seminar, UBS was bold enough to distribute a flyer entitled “Portfolio Protection Strategies for Industry Funds”, boasting that in the past 12 months its team, under head of derivatives Steve Boxall, had implemented single portfolio derivative protection strategies in excess of $1 billion. Citigroup’s Khan knows that super funds with internal investment teams may be tempted to “DIY” a derivate-driven protection strategy – after all, buying protection for exposure to a listed company can be as simple as dividing the allocation between its bond and a call option over it. However, Khan points out that the more strategies the funds attempt to implement, the more “balls they have to keep in the air”, particularly if loans become involved, and the more distracted they will become from what he sees as their “core responsibilities” such as asset allocation. UBS’ Liddy argues that investment banks make the markets and are thus closest to them, enabling them to have the best “overall macroeconomic view” of a fund’s position.
“Using a bank to consolidate your approach to a transition or buyback gives you uniformity, security and better returns than letting your funds managers take a piecemeal approach,” he says. Grove’s Brett Sanders observes that the investment banks are beginning to give a “better deal” on their structured products, with an institutional audience in mind. “I attribute it to a number of factors. One is Standard & Poors tightening up their methodology for assigning these products a credit rating, another is increased competition, and a big one is the importation of better practices from the US and Europe, because Australian investors are often getting marketed repackaged versions of existing products from overseas,” he says.
For funds with liquidity concerns, Sanders says that many structured products now come with monthly pricing to facilitate early exits (others just list), and it seems in most cases the associated fees are “something like the true unwinding cost”. Terry Charalambous, a Russell Investment Group research associate for alternative assets, says trustees he’s spoken to welcome a greater role for investment bank asset management products, albeit more through fund-of-funds than directly at this stage. “I see them as quasi-placement agents, they are opening up deal flow and diversification which super funds need going forward,” he says. UBS’ Liddy argues that the ‘image problem’ of investment banks among wholesale investors has been exaggerated.
“Don’t confuse trust with familiarity. The institutions have known the funds managers for years, but they’re getting to know the banks and in a few years it won’t be an issue,” he says. “It’s like the master custodians, when they came out everybody threw up their hands and said ‘what do we need this for?’, now everyone understands and uses them.” Even so, Liddy predicts investment banks will soon embark on a major recruitment drive to poach well-connected wholesale business development managers from the funds management market, and hints that UBS will not be left out. Longevity of relevance Whether or not investment banks can win direct business with super funds on the accumulation side, many are tipping they will have a big role to play for defined benefit funds, as well as for the post-retirement product offering of defined contribution schemes.
As mentioned earlier, Intech’s Michael Monaghan is basing his future business strategy on a bet that investment banks – with their ability to provide collateral, to understand risk and evaluate reference portfolios – will be huge players in the retirement draw-down phase, which he expects super funds will dominate in the years ahead. “Twenty years ago, it was defined benefit funds and insurance companies which pooled and carried all the risk. Now of course, it’s all of us who are carrying it. But opportunities [for investment banks] will be created as that begins to reverse,” he predicts. As a baby boomer himself, Monaghan knows that his generation will in retirement demand a different kind of product to what’s come before, as they have at every other stage of their development. “When the baby boomers start to understand that they will live a long time, there will be a clamour for products that can sustain a high living standard, but have some kind of guarantee as well. My observation is that most people don’t know a lot about investments, so they want security more than anything else,”
Monaghan says. The post-retirement products currently on the market will not be acceptable to most baby boomers, he believes. Baby boomers want the high returns which market-linked allocated pensions currently offer, but will not want to bear their downside risk, or the risk they may outlive them. Meanwhile, the current crop of ‘lifestyle’ products draw down too quickly and require too much upfront capital commitment, Monaghan contends, providing a poor deal for those who live either much longer or much shorter than statistically expected. Then there are the ethical concerns around reverse mortgages. A product with a more sophisticated approach to longevity risk will be needed, Monaghan argues, which may incorporate the responsible use of leverage and “mismatching” to support the higher returns and downside protection being sought.
Citigroup’s Irfan Khan agrees that products which pool risk are set for a comeback, but unlike the old insurance policy model, where premiums keep coming in and actuaries could manage the risks over a long period of time, the new-style products will have finite inflows and will need to work harder to meet expectations. Monaghan thinks Australian investment banks are best placed to provide such a solution. He actually contends that BASEL 2, far from being a compliance burden, has sped up IT development and improved banks’ portfolio construction and risk management techniques in time to meet the retirement incomes challenge. “BASEL 2 means that if you’ve got poor risk management techniques, you’ve got to carry more capital, so it’s really sharpened them up. Super funds need to have risk statements and a few bits and pieces that ASIC require, but their risk management regime is nothing like what the banks face,” Monaghan says. Indeed in Europe, two investment banks have already been the first to produce what many are saying could be a panacea for pension funds and pensioners grappling with mortality issues – the longevity bond. Longevity bonds The Australian pensions market has been much slower to tackle the challenges of longevity risk and liability matching than have its US and UK equivalents. The reasons are understandable, according to Watson Wyatt’s Tim Unger. “Australian defined benefit funds are generally in a healthier position than their counterparts overseas, because our market did not go down as much,” he says. “Also, the new international accounting standards ended up allowing companies some scope to smooth their defined benefit liabilities on their profit/loss statements, which means firms have been more willing to carry some investment risk.” However, as Australia’s biggest population segment retires in earnest over the next 10 to 15 years, pension funds will have to consider products which seriously tackle the risks associated with the longevity of this group. Enter the longevity bond. First academically proposed in 2001, longevity bonds are annuity bonds whose annual coupon payment is tied to the mortality of a specific reference population. As members of this reference population die off, the coupon payments gradually fall. The academics who proposed the longevity bond, David Blake and William Burrows, suggested such bonds would be a suitable hedge for the annuity book of a life company or the liabilities of a defined benefit pension fund – after all, if cancer was cured after they bought such a bond, their coupon payments would stay high as a result, allowing them to service longer-living members. Blake and Burrows proposed the obvious counterparties for a longevity bond would be capital markets investors – most obviously, investment banks – who would view longevity exposure as a low beta diversifier from their more conventional risk factors. In late 2003, the investment banking arm of Swiss Re was first off the mark with a three year mortality bond, raising $400 million so that Swiss Re’s insurance arm could lay off some of its extreme mortality risk. Similar to the ‘catastrophe bonds’ issued by general insurers, the bond offered 1.35 per cent above LIBOR, but the final principal payment would be reduced if a mortality index, based on the number of ensuing deaths in five major countries, went above a predetermined level of ‘normal’ experience. An event similar to the Spanish flu pandemic of 1918 was actually conjured in the bond’s marketing material. That bond was quickly subscribed, chiefly by UK pension funds. After all, they face risks which are exactly the opposite to those of Swiss Re – while the insurance company would suffer financially if many people died, pension funds suffer financially if too many people live too long. The next longevity bond to appear, a 25-year issue released by the European Investment Bank and BNP Paribas in November 2004, had a structure more closely resembling something that would appeal to Australian super funds and post-retirement members, according to Watson Wyatt’s Unger. Launched with the aim of raising £550 million, the banks had promised to pay bondholders an annual coupon of £50 million multiplied by the percentage of English and Welsh males aged 65 in 2003 who were still alive in the given year. For example if 50 per cent of the men were still alive 10 years after issuance, that year’s coupon would be £25 million. Ultimately, that bond failed to reach subscription and was withdrawn, pending remodelling work. Two problems were blamed – one was the high level of upfront capital required for the income provided, something which could be solved, as Michael Monaghan suggests, with the increasingly sophisticated leveraging techniques available to investment banks. The second problem was the relatively narrow reference population of English and Welsh males, which UK pension funds were reported at the time as saying made the bond less correlated to their particular longevity liabilities. Another investment bank, Credit Suisse First Boston, went some way to solving this problem last December, when it launched the CFSB Longevity Index, with the stated aim of providing a benchmark against which a range of longevity derivatives could be calibrated. The Index only references the US population at present, but the bank says data on further countries will be forthcoming – global actuarial firm Milliman is working on providing this, from publicly available sources. Unger says that Australian study on the potential uses of longevity bonds is in its infancy. However, he foresees that a longevity bond ‘choice’ option could be made available to post-retirees in a particular fund, who might then form their own reference population off which the actual bond was constructed. As in the UK experience, well-constructed longevity bonds would be a natural investment for Australian defined benefit funds, Unger adds. Intech’s Monaghan points out that a trend in investment banking has been rapidly improving technology, allowing greater flows of data and greater compartmentalisation of data. He argues that if investment banks can now easily isolate the mining royalties or drug patent royalties from a parcel of stocks and securitise them, it is no great leap to effectively securitise the longevity of Australia’s superannuants, and take risk out of the equation for everyone.
