Credit crisis in 2008 highlighted the risks associated with complex derivatives and securitization. However complex and exotic derivatives have also helped to diversify risks in the form of structured products which are an integral part of alternative investments in wealth management and sustainability.
Structured products, as described by the Financial Industry Regulatory Authority (FINRA), are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency and swaps. Structured Products are an integral component of alternative investments as an asset class. Structured products can be a plain vanilla product (composed of zero-coupon bond and put/call options) or can have exotic options (digital options, look back or knock out structures) and can be principal and non-principal protected. Structured products could range from simple index-linked structures which are principal-protected to non-principal protected structures having credit default swaps as an underlying asset class. Globally, low-interest rates have driven investors in search of high yield products apart from traditional asset classes like equities, fixed income, and real estate.
# Rise of Structured Products as an investment class in Asia
Structured products are one of the fastest-growing products in alternative investments especially in Asia in private banking and wealth management for high net worth investors (HNI investors with an investable surplus of $1M.) Structured products help investors to diversify their risk and form an important asset class in Markowitz’s portfolio theory of efficient frontier. Structured products can also be tailor-made by asset managers for investors (HNI/UHNI) depending on their risk profile, investment horizon, and view of the underlying index. Moreover, structured products appeal to the growing investment savvy investors who are themselves sophisticated enough to understand complex derivative structures and investment strategies.
According to Credit Suisse, global wealth is $253T with Asia especially China as the biggest growth market and not surprisingly has the second-highest number of millionaires next to the United States. After credit crises, the appeal of complex structured products which are more common in the United States and Europe is on a decline with simpler vanilla structure products being favored especially in Asia. Strict rules and regulations against complex derivatives and nonexistent CDS market except for a few blue-chip companies and non-convertibility of currency esp. in India limit the scope of complex structured products in emerging markets. In India, about 90% of the structure products are equity-linked products to Nifty while in China trusts and vanilla structures are sold routinely in unregulated shadow banking.
Going forward as capital markets, especially the derivative markets, develop and become more complicated in emerging markets like China and India. Investors need to become more investment savvy; structured products will play a pivotal role as a diversification option compared to traditional asset classes like equities and fixed income. Today, structuring is fast becoming a tool in sustainable finance. Structured products linked to sustainable investing strategies, primarily environmental, social and governance themes are becoming a vital part of the portfolio basket. The global size of Sustainable Finance/ ESG/ sustainable investing is about $31.1T, and asset allocation through bespoke indexes linked to ESG themes is a significant portion comparatively over the previous decade. J P Morgan launch of ESG platform for investing across trackers, principal-protected products, equity, credit and fixed income turned to be a critical enabler.
# Enablers in the financial markets
JP Morgan’s collaborative role with leading multilateral development banks in partnering with the World Bank and S&P Dow Jones for churning out indices linked to sustainable themes including green, social and sustainability bonds proved to be a boon for Sustainable industry. Promoting ESG related asset sales through planting trees based on certain threshold of ESG related sales led BNP Baripas to plant millions of trees. Not withstanding corporate social responsibility such schemes enable customers to understand the importance of structured products in wealth management and sustainability further driving innovation through iterative demand. The burgeoning sale of structured products linked to ESG is not abating with rise of activism for social and environmental issues. Hedging for currency and interest rate is rapidly rising. Cross hedging by the Italian energy giant Enel for its $1.5B sustainable bond sale is fostering market making for investors and asset managers globally. The recent pandemic due to COVID-19 will further fuel importance of sustainable finance as a means of raising capital for social and altruistic issues. The African Development Bank (AfDB) recent $3B social bond to fight the risk of pandemic in Africa is the largest such dollar bond issuance in international markets. As more leading asset managers and supranational follow suit, role of structured products in sustainable finance will increase to enhance participation of high net worth individuals as various avenues increase for attracting capital. Going forward more high net worth and retail individuals will increase allocation to ESG based strategies nudging more structured products linked to sustainability sector.
According to Warren Buffett derivatives might be financial weapons of mass destruction but when used judiciously it helps to diversify risk and add liquidity to the system.
The richest 1% of the world’s population now owns 50% of its total wealth, according to Credit Suisse. Why?? Is this information not disturbing?
The report has been edited for spell checks, elaborated with recent information on ESG and the tutorial added since its original publication.