The hybrid domain has seen a spike of interest from a broad spectrum of the investment community: from retail clients eager to venture out of a pure equities/bonds portfolio or private banking clients and high-net-worth investors looking for new structured investments, through to institutionals pursuing a more accurate management of their portfolio risks. Distributors and product manufacturers alike have sought to boost their sales by developing original solutions offering exposure to various asset classes and precisely addressing the needs of their various client segments.
As a result, ‘hybrids’, i.e. cross-asset class investment products, have become the new buzzword for structured investors, and are consequently the most rapidly growing area of derivative and structured investment.
The widespread acceptance of cross-asset allocation, further boosted by an increasingly en vogue commodity sector, is rooted in the rise of multi-asset structured products, itself prompted by previous drops in equity-linked returns witnessed in the uncertain and slower equity markets of a few years ago.
This environment drove investors away from the traditional spheres of equities and bonds, and led them to seek out new options. Alternative asset classes such as currencies, gold, oil and real estate benefited from this investor reticence towards traditional assets, and were regarded as the solution for investors trying to recover from downturns in the equity market.
The floodgates were open, and thus even in today’s more comfortable equity and bond environment, alternative assets keep growing in the shrewd investor’s portfolio.
How does it materialise?
Hybrid volumes have increased ten-fold since 2003 up to almost €60 billion, according to BNP Paribas estimates. This is largely because many underlyings, upon which many investors have not previously been able to access and manage direct positions, have recently become tradable as part of structured products.
However, it has not all been plain sailing, the hybrid industry has suffered from a lack of familiarity and transparency, high fees, and a highly complicated structuring component. The latter represents a significant headache for derivatives houses, as multi-asset products require gathering and managing expertise from normally segregated investment banking divisions.
What do hybrids do?
Many hybrid solutions replicate asset management techniques with a view to efficiently diversifying a portfolio. This would involve the management of different types of risk, an optimisation of allocation strategy, and ultimately a view on a diverse set of assets that effectively mimic asset management, all under the umbrella of a structured product.
The main advantages of the diversification and de-correlation of hybrid products are two-fold: they reduce the average volatility of a portfolio, and optimise the potential benefit arising from different market cycles.
Non-traditional asset classes may well complement a standard portfolio, as they balance out detrimental fluctuations of volatile asset classes, improving the Sharpe ratio of stand-alone equities or bonds (see figure two download file).
Diversification and risk/return optimisation not only depend on the number and weightings of portfolio assets, but also on their relative levels of correlation with each other. Non-traditional asset classes, such as commodities or FX rates, have historically outperformed equities or bonds over certain time periods, as their economic cycles are often disconnected from trends in traditional markets. In such periods, these assets may offer a positive performance, which balances that of low-performing equities or bonds. Therefore, a portfolio comprising a mix of different, loosely correlated asset classes can achieve good yields even in periods of adverse equity/bond markets.
Hybrids enable the investor to act on different investment views over several markets: metals, energy, equities, bonds, currencies, etc. and to trade broad market views in one single investment.
Together with the advantages of a solidly structured product, created in accordance with investor requirements (capital protection, leverage exposure, profiling features…), hybrids allow investors to implement precise asset allocation strategies based on specific investment views for each asset class, both reducing the overall level of volatility, and achieving a more stable performance. Moreover, these benefits can be obtained with higher participation rates for a given level of capital protection than in the pure equity/bond world, due to the effects of diversification and reduction of volatility.
