SPA Conference: Indexers extract asset class themes for customized structured products

By Emma Trincal

New York, March 26 - Using current market themes, structurers are designing index-linked notes that allow them to customize a client's risk return profile based on a tactical allocation to a particular asset class.

These themes - indexation and customization - were the main topics discussed at an asset class panel at the Structured Products Association's seventh annual conference in New York Thursday.

Ade Odunsi, head of FX structuring in the Americas at Barclays Capital, gave his view on the currency markets, stressing that a new theme is unfolding after years of dollar devaluation.

A perfect storm

"For us, the recent move of the dollar is a perfect storm. The story for the past 10 years has been to invest out of the U.S. into Asia or in the BRICs," Odunsi said.

BRIC is an acronym for Brazil, Russia, India and China.

"You were short the dollar against everything else. Now basically we're in a very different world," he said.

Odunsi said that investors at the present time are uncertain about China and about the future of the Greece crisis, which has now become "a European situation."

A lot of the currencies investors used to short only a few months ago are now very popular long trades, he said.

"People are long the dollar now. The big shorts right now are the yen and the euro," Odunsi said.

"People are long the Mexican peso and Brazil. They can't get enough of Canada because the banks are strong over there and also because Canada is a commodity story."

Nuanced game

Odunsi explained that the currency investment theme has become more "nuanced" since the dollar began to rise against the euro as a result of Greece's fiscal crisis.

"Now the trend among investors is to pick a basket of shorts versus a basket of longs," he said. "It's not short the dollar against everything else. It's a more nuanced approach. You pick and choose the regions you want to be the most exposed to."

This new approach offers two advantages, he said. First it offers a "more natural diversification." And secondly, "it's much easier to explain to investors."

Customization

With this increased diversification, indexing has become a tool of choice for banks looking to structure notes that fit their particular clients' requirements.

"Our big theme right now is customization," said Odunsi. "The products we offer clients ... closely match their needs."

Retail versus pensions

Odunsi noted a difference between retail and institutional investors.

"Retail clients focus on tactical trades. They take a directional view. For instance, they will short the yen or the euro," he said.

In contrast, institutional investors tend to combine a tactical approach with a passive investing approach, he said.

"Pensions are still interested in tactical view but at the same time, they show a lot of interest in currency beta. They may want to get passive allocation to a region, for instance, while getting exposure to a theme," he said.

Hedging better

Odunsi explained that indexing can be very helpful as a hedge.

"We create customary baskets for our clients in particular on the institutional side. Institutional clients follow a benchmark, so we create an index specifically designed to track their benchmark. As volatility increases, we can reduce exposure and vice versa," Odunsi said.

"Historically all indexes are static. We have the ability to offer algorithms indexes with different styles of investing such as carry, momentum, value. We can allocate these indexes between different types of strategies. It's much more effective as a hedge," he added.

Uncorrelated commodities

Michael McGlone, senior director of commodities at Standard & Poor's, talked about the benefits of investing in hard assets.

"One of the advantages of commodities is to augment the portfolio with equity-liked returns but without correlation to equities," he said. "Commodity indexing historically has provided equity-like returns but with low correlations to other major asset classes."

McGlone showed a slide displaying comparative returns between the S&P 500 and the S&P GSCI over the last year but also over the last decade as of December.

In 2009, the equity benchmark gained 26.46% versus 13.48% for the commodity index, a result that reflects the strong equity rally seen most of last year.

But for the past decade, the S&P GSCI "significantly" outperformed the S&P 500 with a 63.69% gain for commodities versus a loss of 9.10% for stocks, McGlone said.

"Commodity index fund flows remain strong," said McGlone, who estimated that commodity indexing assets increased from $6 billion in 1999 to near $125 billion in 2009 - an increase of almost 2,000%.

Contango

The biggest challenge last year for commodity investors was the energy contango, McGlone said.

"The crude oil contango reached its most extreme point in 2009, making contango risk the biggest broad indexing issue for last year," he said.

Contango describes a carrying charge occurring when commodities destined for later delivery are priced higher than commodities delivered earlier. Resulting from storage, insurance and financing costs, the cost spread erodes the performance of an index tied to rolling futures contracts.

McGlone said that "reducing exposure to contango" was one important goal of S&P's commodity indexing research team.

S&P toolbox

Other objectives, which have led to the creation of recent products, include lowering volatility exposure to the commodity market, indexing managed futures strategies, creating indexes that comply with regulations or potential regulations and integrating commodities into traditional asset classes.

Another theme is the firm is adding more regional commodity indexes as there is a growing demand among investors for commodity investments allocated to certain geographic areas, McGlone said.

McGlone cited several new indexes in the "pipeline" such as the S&P WCI, a world commodity index; a covered call composite index; and the S&P CTSI, a commodity trading strategy index.

"Commodities are not just a real asset class. They are real assets. Virtually everyone is inherently long equity and short commodities. It's a simple prudent insurance to have commodities in a portfolio," said McGlone.

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