Asset Management

Structured Products Key to Insulating Private Client Portfolios From Market Volatility

Emma Rees, 17 September 2007

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In a recent WealthBriefing poll, a solid 56 per cent of wealth managers expressed the belief that their clients' portfolios were sufficiently insulated against the turmoil in global equity markets for the impact to be negligible.

In a recent WealthBriefing poll, a solid 56 per cent of wealth managers expressed the belief that their clients' portfolios were sufficiently insulated against the turmoil in global equity markets for the impact to be negligible.

A mere 13 per cent believed that the falls will have a significant impact on this year's performance and a further 31 per cent said that it was still too early to say and that there will be problems only if there are more large falls.

We asked a number of industry experts to give us their views on whether there is more volatility to come and how they seek to mitigate the effect of markets shocks on clients’ portfolios.

David Kidd, chief investment officer, Arbuthnot Latham believes that further market falls depends on whether there are further adverse consequences which extend into the real economy ,”although we think this unlikely, he says. “Companies have been reporting good results, directors are buying their own shares and the economy is fundamentally healthy,” he said.

WealthBriefing reported last week that Barclays Wealth believes equity markets may rise by as much as 15 per cent during the next year despite global credit markets remaining volatile into 2008:

"It’s becoming clear that the market has now recovered from the worst of the crisis with the return of some liquidity and whilst we're aware that there may be further bad news to come, it’s unlikely that any of the major financial institutions will default”, says Michael Dicks, head of research and strategy for Barclays Wealth.

Paul Sarosy, head of investment solutions for the private banking arm of Credit Suisse in the UK, says that the fundamentals are still strong and believes that in the next 6-12 months, markets will move north and not south:

“We have recently been repositioning our larger than normal cash position back into the equity markets. We remain long equity but are more neutral than overweight in our core portfolios.”

Philip Watson, head of Citi Private Bank's investment analysis and advice group believes that heightened levels of volatility are to be expected at this mature stage in the equity bull market. “How and when the news flow impacts is open to debate,” he adds.

Rathbone Strategies Fund manager David Coombs is also of the opinion that there’s more volatility to come:

“There is insufficient clarity on balance sheets in the financial sector at the moment and many hedge funds have yet to report their net asset values for the end of August. Things should be clearer towards the end of September,” he said.

“Investors' emotions drive market sentiment”, says Mr Sarosy. “The public are now saturated with information on financial markets, which stimulates action. They also have the ability to transact at their fingertips, which in turn drives volatility."

Whilst it seems that volatility is something that we all have to learn to live with, David Kiddie, chief investment officer, equities at ABN Amro Asset Management believes that it is not necessarily negative.

“Market volatility has historically produced attractive investment opportunities. Investors should look at volatility as a potential opportunity to invest,” he says.

Fredrik Nerbrand, head of global strategy for HSBC Private Bank says that in relative terms volatility has fallen:

“The VIX index has come down from its peak. If you compare the cost of buying put options to protect a portfolio in January, volatility was extremely cheap. Now it is moving towards higher, but we believe more appropriate, levels. We have gone from an era of abundant liquidity through a sentiment shift to one where there are more sensible risk premiums.”

Despite the expectation of continued volatility, investment experts generally have a positive outlook for equities. Citi Private Bank's core asset allocation has not changed and it continues to favour equities over fixed income due to balance sheet strength, high free cash flow, strong interest cover and the fact that earnings remain broadly positive:

"We are positioning client portfolios to benefit from volatility by looking for buying opportunities amongst those sectors that have been severely punished in the recent term and arguably more they deserve - current favoured sectors include insurance, broadcast, entertainment, specialist retailers, publishers", says Mr Watson.

Mr Kiddie says that promising investment categories include emerging markets. “Here the growth profile is strong and financial conditions are reasonably healthy,” he says.

In developed markets he highlights funds with managers with strong stock-selection capabilities, and fund of fund products, particularly in the arena of hedge and absolute return funds:

“I firmly believe that we will see a gradual but continual underperformance of US related equities in the coming years. The likely beneficiaries will be those areas that demonstrate superior growth, such as China,” Mr Kiddie says. In Europe, he recommends a focus on undervalued companies.

Mr Sarosy makes the point that it is better to be partially correct than absolutely wrong:

"We have focused on quality during these volatile times and will continue to direct investors to these positions. Unfortunately, magic formulas don't exist. Our approach is long term and not an aggressive trading strategy. However, we do use tactical opportunities when we see them and aim to enhance returns through the most efficient means available in the market," he added.
Mr Nerbrand says that HSBC insulates clients’ portfolios in a number of ways including diversification across asset classes, as well as style, manager selection, investment vehicles:

“We also use structured products quite extensively and switched into capital protected growth notes at the start of the year. However at this point we see better yields in reverse convertibles which provide partial downside protection.”

Structured products are increasingly popular in wealth management and have been widely used during the recent volatility. Rathbones, for example, uses structured products to target less correlated returns:

“Many of the asset classes popular with investors, such as property and commodities are becoming increasingly correlated with equity markets. We are using shorter dated structured products such as ‘auto calls’ and structures which are aligned to volatility in order to gain exposure to less correlated returns," says Mr Coombs.

With interest rates now relatively high, Rathbones points to structured products as in a “sweet spot” with high participation rates:

“Structured products provide more predictable returns than hedge funds and are becoming increasingly liquid. We also use hedge funds targeting low volatility and look to achieve our equity risk purely through long only equity strategies,” adds Mr Coombs.

Mr Watson says that structured products allow a degree of flexibility in terms of the definition of suitable risk and return parameters:

"We look for structures that monetise the value of high volatility. In these markets, it is hard to time market entry perfectly and so we can provide clients with a 'look back' facility. If a client is long-term bullish on equities, they can enter into a structure which provides exposure to the future appreciation of the equity market, but we can time the entry level to be the most favourable point over a three month period. To illustrate how beneficial this can be, the difference between the high point of the FTSE in the last three months (6608) and the lowest point 5858, is some 13 per cent. Our clients have found this really appealing."

A number of the experts we spoke to warned about the cost of insurance in times of heightened market volatility. Mr Kidd believes that the time to buy insurance was months ago when the market was less volatile and insurance premiums were cheaper:

“The more logical and appropriate way to insulate against market falls is to diversify a client’s portfolio across a broad range of asset classes – equities, bonds, property, for instance, and geographies represented in a portfolio, then damage to the equity content has less of an impact. Government bonds have performed relatively well in recent times for example and are well insulated from the full rigours of recent market volatility.”

Mr Coombs says that Rathbones Strategy Funds mandates have the flexibility to allow them to manage risk more efficiently and, as they do not have an asset weighted benchmark, can exclude asset classes entirely:

“We have no bonds in our strategies at the moment for example. Whilst in the short term they are very defensively positioned, and will continue to be for the next three to four weeks at least, in the medium term we are much more bullish. We see recent events as a useful correction in credit markets. There could be buying opportunities, particularly in corporate bonds, in the next six to eight weeks.”

Mr Watson concludes that whatever a firm believes with regard to equity markets, it is vital to meet individual clients’ risk profiles:

"Fundamentally we're bullish on equities, but we are always client specific in the way we manage portfolios and if they want to be more defensive, we can engineer that."

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