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How fund-linked structured products work

Structured products promise to protect the principal of an investment, but yield is sacrificed for return, Societe Generale's Edward Lee explains.

Societe Generale is offering principal-protected, 1.5-times leveraged notes linked to the performance of actively-managed bond funds, as an alternative to investing directly in fund units.

The product, available since the second half of 2016 to private banks in Hong Kong and Singapore, has had interest from cautious investors as macro events create market risk, according to Edward Lee, head of cross asset distribution for private banks, Hong Kong and Singapore, at Societe Generale.

“When investors don’t have a view on the market, they look at alternative plays,” he said. However, after a very stagnant first half of 2016, not many of them were ready to start trading again, according to Lee.

The principal-protected leveraged note was meant to entice the hesitant investors back into the market and help private banks with their revenue streams, he explained.

How it works

A fund-linked, principal-protected note consists of a bond issued by the note provider, in this case Societe Generale, and a call option on the fund. The buyer does not receive the coupon payments from the bond; they are used instead to purchase the call option.

As the fund price increases, the option gains in value.  If the fund price declines, the option’s value comes down, but never below zero, thus leaving the principal investment untouched.

In effect, the option investor is exposed only to the upside of the fund performance, but yield is sacrificed.

Societe Generale has structured the first few waves of these notes, issued in the second half of 2016, using the best-selling bond funds at the time, according to Lee. They were the PIMCO GIS Global Bond Fund and the Jupiter Dynamic Bond Fund.

The principal of the investment is protected with the credit of the issuer. The low prices of call options on the underlying bond funds, thanks to its low volatility, allow the structuring bank to buy them in higher than nominal amounts, thereby providing a 1.5-times leverage on the return of the fund. The investor receives all proceeds on the expiry date of the note.

Structured products are highly customisable investments, created for institutional or wholesale investors who distribute them to their clients. Product manufacturers are usually very nimble in creating new products quickly in response to market demands. 

Complex products

With their at times bewildering complexity and varying levels of risk, structured products have suffered swings of fortune during the last decade. Popular in the early 2000s but generally out of favour after the global financial crisis of 2008, they slowly started coming back in 2012, according to Lee. 

“The market didn’t have an appetite yet for structured fund products,” he said. It wasn’t until 2015 when the bank scored a significant success with an offering aimed at simplifying operations of private banks.

That year, Societe Generale developed an indexing service that Lee said makes it easier for one of its private bank clients to manage its model portfolios. 

Instead of buying fund units for their clients’ portfolio in accordance with its standard models, the private bank would let Societe Generale construct an index that benchmarks the models. It would then purchase from the structured notes linked to the performance of the index.

This solution aims to save the bank the necessity of purchasing units of individual funds for their clients’ portfolios and ideally addresses the cost of rebalancing individual investors’ portfolios when the model changes, according to Lee.

Part of the Mark Allen Group.