Demand-driven structured products attract regulators

Structured products may well be the new mutual funds. But financial innovation inevitably attracts regulatory scrutiny, suggests McCarthy Tétrault securities lawyer Ronald Schwass, especially when it comes to features and techniques that are not typically permitted in a mutual fund structure. Hence, it’s incumbent on advisors to attend to the details in new structured products.

Structured products, he says, “display very strong growth rates begging to be regulated,” adding, “unfortunately regulation is typically by definition a response to crisis,” such as Portus or Norshield.

At the same time, says OpenSky Capital president Steve Marshall, fees are likely to come down on some structured products; they will be more transparent and, equally, more liquid. Others are likely to die out as they fail to achieve the performance investors expect. Schwass and Marshall were both speaking recently at a Toronto seminar on structured products sponsored by the Investment Industry Association of Canada.

To an extent, today’s structured products are simply an evolution from yesterday’s mutual funds, and are sharing some of the growth characteristics of mutual funds in their heyday, suggests Schwass, while Marshall, citing an Investor Economics study, sees principal protected note assets potentially growing to $100 billion in the next five years, for reasons similar to the early drivers of mutual fund growth.

The first impetus was in 1985, Schwass says, as lower interest rates moved investors to mutual funds, which, in turn, grew about 35% a year until 2000.

“What we’ve seen since 2000,” he adds, “is the need, on a risk/reward basis, for set solutions that involve a lot of different techniques and portfolio or assets strategies that are not available in mutual funds.”

However, Schwass warns, structured products do not fit a common template; each has to be analyzed on its own, with attention to the asset class, the instrument used to get access to the asset class, the vehicle in which the instruments are wrapped, the presence or absence of leverage and the liquidity of the product.

Novelty factor

All the same, structured products are by no means new.

In fact, the first closed-end fund in Canada dates back to 1932. Flow-through limited partnerships started to flourish in the early 1980s, while BCE put together the first split share offering in 1987. Even capital-guaranteed notes — very much in the spotlight today — got their start in the late 1980s.

But emphases shift. The late 1990s, for example, saw four closed-end hedge funds launched, of which only one is still trading today. Similarly, from 1999 to 2001, covered call writing trusts, marketed as quasi–principal guaranteed products, boomed. Now, almost all of them have been wound down or have adopted a different investment mandate.

Since 2000, about 80% of closed-end funds have been built around income trusts. That market is dominated by boutique players, Schwass points out, with EnerVest, Sentry Select, Brompton, Citadel, Middlefield, Triax and First Asset the major players. All told, the closed-end market is worth between $15 billion and $20 billion. Still, the federal government’s questioning of income trusts in the fall of 2005 has pinched the tap for new issuance.

The split-share market is less than half the size, with assets of between $5 billion and $10 billion. While there is some boutique presence, with Mulvihill and Quadravest, other players are affiliates of Scotia Capital and TD Securities.

The flow-through market, for its part, has boomed along with commodity prices — $2 billion was raised in 2006. The dominant sponsors are Middlefield, Dynamic, Sentry Select, Citadel and Creststreet.

Significant notes

As other products have waxed and waned, lately, retail market-linked notes have come on strong. Still, they too are not new, says Marshall, despite the recent flurry of coverage in the mainstream press.

“For most Canadians, they started back in 1994,” he explains, when National Bank raised $500 million in its Securibourse GICs. Before then, there were notes issued by Bankers Trusts, Citibank and Wood Gundy that traded on the Montreal Exchange; they were linked to broad Canadian and U.S. indexes but were not really mass-market issues.

Today, notes can include baskets of foreign equity indexes, customized baskets of stocks, mutual funds, commodities and funds of hedge funds.

“The reality,” Marshall says, “is that most of the products are built from demand. I think it’s important to bring that up right now. A lot of people would assume the opposite, in the sense that we like to create these products, and then go out and convince people it’s the best thing they should have. The reality is that the Canadian marketplace is asking for a lot of these products. There’s a specific requirement to understand the level of risk that they want to take, but at the same time, there’s a need to solve a certain problem in their portfolios.”

For the risk level, Marshall suggests, the retail client doesn’t want to lose money.

In the PPN marketplace, the issuers are Canadian chartered banks, along with J. P. Morgan, BNP Paribas, Société Générale, Citibank and the Business Development Bank of Canada.

Still, not all notes are principal protected, he says. National Bank issued a hedge fund note in 2000, and Marshall sees some potential ahead in non-protected notes. Indeed, CI Investments is now launching a non-guaranteed note.

At the same time, while the Canadian banks dominate the PPN field today, in the early 2000s, smaller promoters flourished in alliance with mainly French banks and BDC, primarily in hedge fund notes.

Today, four of the big six banks, along with OpenSky, account for 81% of the issuance of new notes. OpenSky, Marshall says, essentially represents the foreign banks in Canada.

“There’s not that many people sharing the pie,” he says. “To bring these products to market, you need to be a Schedule I or Schedule II bank or BDC.” At the same time, the concentration among banks brings credibility to the product, he adds.

Despite the credibility the bank presence offers, there may be some products that don’t quite fit into a PPN. Marshall mentions hedge funds.

“Most of the hedge funds that have been done have been done as funds of hedge funds. Unfortunately or fortunately, most were done as guaranteed notes. They started off well and quite a bit of money was raised. The problem with that is that funds of funds are clearly not volatile, and to pay for a capital guarantee on these funds of funds didn’t make all that much sense. And unfortunately, at the same time, performance wasn’t there on the funds of funds, and you had pretty well a wash.”

More generally, he argues, “Whether products have capital guarantees or not, the reality is that, for Canadians, performance is what matters. You can have all the protection you want, but the products have to perform.”

Equally, new issues have had a hard time raising capital, and more than that, Marshall observes, “the layering of fees is not attractive to most investors.” Funds of funds normally charge a 1% or 2% management fee, plus a 10% performance fee, while the underlying funds also levy fees, usually 2% for management and 20% of profits. There are also marketing fees and upfront distribution costs. Not least, the Portus and Norshield imbroglios have had a very significant effect.

Structuring trust

While hedge funds have their challenges in Canada, even though they’re booming elsewhere, the new tax structures on income trusts will force the closed-end market to get more creative, Marshall says.

From 2002 to 2005, income funds saw the proceeds from new issuance quadruple, to $7.5 billion. Similarly, preferred equity offerings doubled, to $1 billion. Assets raised for both categories were cut in half in 2006.

“We’re going to see a lot of creativity; we’re going to see a lot of new ideas show up in the closed-end space,” Marshall says. Still, with funds of income trusts, thanks to the new tax rules, “we’re probably going to see that market disappear over the next 12 months.”

With the phase-out of Ontario tax credits, labour-sponsored funds face an equally forlorn future. While they account for 40% of all venture capital raised in Canada, performance dogs them.

“Canadians tend to love performance, but something they love even more than performance is saving on tax,” Marshall says. As a result, “in our view, the industry is disappearing.” Already, 33% of the 54 funds registered in Ontario from 1991 to 2004 have either deregistered or merged.

“Something will remain and stay popular if the performance is there and fees are reasonable.”