Structured products in South Africa have lagged the growth experienced in offshore markets principally due to an equity market with no negative returns over five-year rolling periods, a higher yield and inflationary environment, the requirement of a FAIS category licence (required for advising on listed products) and the cost of the platforms required to access directly.
In the first part of an interview as we approach the 2nd Africa Structured Products & Alternative Investments conference, SRP spoke to Roland Rousseau (pictured) and Andrew Wolfson, two investment bankers at Rand Merchant Bank (RMB) Global Markets about the structured products landscape in the country, what factors will help to grow the market, and how developments in the exchange-traded funds (ETF) segment could also open up new opportunities in the structured products market.
According to Rousseau, one of the main reasons holding back the ETF market in South Africa is the fact that the market is still stuck in an undertakings for collective investment in transferable securities (Ucits II) framework. “This means that all products must be physically replicated in contrast to the rest of the world that has shifted to a more efficient methodology which allows synthetic replication (Ucits IV and V),” says Rousseau. “Once the industry accepts that synthetic replication doesn’t add additional risks, when compared to full replication, there should be a shift in product development to provide clients with more efficient product solutions.”
All financial advisers in South Africa are required to hold the necessary FAIS category licenses to sell unit trusts, ETFs and life products, but many do not have the licenses to sell deposits, notes, equities and other listed securities, according to Rousseau. “Because of structured products primarily being sold with advice, they are issued as life policies – potentially adding a layer of administrative costs and loss of full liquidity,” says Rousseau. “This may not be the best, nor cheapest mechanism to meet clients’ needs.”
On top of this, says Rousseau, the South African Financial Services regulatory framework does not permit synthetic replication of a fund (like Ucits), which means this replication can only be done in note or certificate format. “This again may be limiting to best serve our clients,” says Rousseau.
According to Wolfson, banks are very eager to grow this product set although there is some work involved in addressing both needs of the client and the industry. “The regulator could benefit from understanding global best practice on such products to expand the current regulatory frameworks to allow greater investor choice at a reasonable cost,” says Wolfson, adding that the different players in the country are getting together “to provide a more co-ordinated front to deal with the regulators, but there is still a long way to go”.
“There is some convergence between the research around index strategies best serving client needs, and structuring, which will assist in promoting structured products,” says Wolfson. “In the past, structuring was a way of packaging an index strategy or a portfolio of assets, with or without capital protection. The focus has now shifted to use structuring skills to build the underlying performance engine and then apply structure to them. We have seen this kind of development around factor indices, smart beta strategies and custom risk-based strategies (including mechanisms such as risk control) – all aimed at improving the payoff before designing the final products.”
According to Wolfson, the industry has an ongoing responsibility to educate the end investor and to guide them towards strategies that can help them achieve their goals. “Advisers and wealth managers are best placed to introduce these products, but they must have the flexibility to promote them as part of their clients’ portfolios to meet their investment needs,” says Wolfson. “Continuous education will help educate investors about the market and how structured products (as strategies) can help them achieve their goals in a defined risk and return framework.”
In addition, holding rewarding risks or having a net lower option cost, will result in better terms and conditions that are passed on to the end investor in the form of potential higher growth or enhanced yield, according to Wolfson.
Rousseau points that the South African market is “quite large when measured by market capitalisation, yet smaller when accounting for liquidity”. “This limits the choice of local underlying to build index strategies and structured products,” says Rousseau. “This is reflected in the products that are offered on local underlying, since they feature the most liquid assets and most efficient pricing.”
The use of offshore underlying on rand-denominated structured products allows for a wide range of products, according to Rousseau. “This is because the optionality is significantly cheaper on a large range of liquid underlying strategies to help the market move forward,” says Rousseau. “In addition, the offshore segment (where clients externalise their funds to an offshore currency) also provides for another range of product solutions on liquid underlying to offer investors a form of rand hedge.”
The use of offshore underlyings, according to Rousseau, will remain because it provides retail investors with market access, portfolio diversification and the potential to achieve yield enhancements in excess of the fixed rate. For delta one products, the offshore space offers access to “greater liquidity and choice” that can’t be found locally, according to Rousseau.
“This highlights the need for ongoing investor and regulator education,” says Rousseau. “Investors will increasingly demand products with exposure to offshore markets. This is why we anticipate to see a wide range of products being offered to meet the pricing, liquidity, marketing and distribution demands.”
Despite the challenges ahead, the market outlook remains positive as several banks are building the infrastructure needed to make the listing of these products easier, according to Wolfson.
“The market has made some progress over the last few years, not specifically around structured products, but around index-linked strategies and ETFs, which have pushed some of the developments in the market,” says Wolfson. “Once you have opened the door to offshore ETFs, it is only a matter of time before this is replicated in the structured products segment. This will also help the market with more choice to invest offshore and hedge in the local exchange.”
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