Outlook 2014: Appetite for indexes, complex algorithms will grow

By Emma Trincal

New York, Dec. 31 - Indexes that give investors access to asset classes, strategies and themes are growing in complexity and scope in the structured notes market but also in popularity. Market participants see them as an important development for 2014.

"In this upcoming year, we're going to see more and more of these themes-oriented types of trades with the use of increasingly sophisticated indexes. Those can give you a tailored exposure to a particular market, asset class, volatility or strategy," said Glenn Lotenberg, managing director, head of structured products trading and distribution for Incapital LLC.

The market is moving toward a greater use of algorithms and rules-based indexes that can reflect a specific view or strategy, he said.

"Any issuer can price a five-year point-to-point S&P product. But not everyone can do an Efficiente 5 index, a GS Momentum Builder or a Barclays Schiller index," he said.

He referred to the JPMorgan ETF Efficiente 5 index, a JPMorgan proprietary index designed to provide exposure to a range of asset classes and geographic regions based on the modern portfolio theory approach to asset allocation.

The GS Momentum Builder is a systematic trading strategy that dynamically allocates across a basket of assets based on historical price momentum and volatility.

The Shiller Barclays CAPE US Core Sector index selects sectors using the sector CAPE methodology.

Despite the complexity of those indexes, some financial advisers are interested in learning more about them on the view that they can benefit from the underlying strategy they offer.

Cost issue

"We've found some to be great tools. You get some that are relatively complex, some on volatility, but theoretically the so-called black box is really a quantitative model. If you agree with the concept, the black box system can be reconstructed," said Steve Doucette, financial adviser at Proctor Financial.

"It has complicated our lives a little bit but has added some opportunities for us even though getting exposure to those algorithms is not cheap.

"Despite the cost issue, we think those strategic indexes have a future in the structuring space.

"I don't know how much demand there is for those products among RIAs and retail investors, but for sophisticated investors, the appetite for financial engineering solutions is growing."

Access to top stock-pickers

One motivation for investing in notes linked to those complex indexes is to gain access to well-established stock-picking equity research firms, said Serge Troyanovsky, BNP Paribas managing director, head of retail distribution North America for structured products.

Rather than just focusing on the structure, investors are now seeking alpha with the underlying index they believe may outperform the market.

"It may come from a research-based static basket of stocks or from a dynamic index designed to alter allocations over time based on an underlying algorithm," he said.

Some of these algorithmic indexes are designed by investment banks, in which case they are referred to as proprietary indexes, he explained. But many third-party research firms offer high-quality models as well, he noted.

"We do believe such strategies are becoming much more commonplace and will continue to grow in 2014," he said.

Retail wraps

Keith Styrcula, chairman of the Structured Products Association, said that indexes give structurers the tools to deliver complex strategies used by hedge funds or private equity firms via "retail wraps."

"Indexes are becoming more and more relevant. We'll see more of them this year," he said.

"I can see structuring desks making those sophisticated strategies more accessible using the simplicity of an index.

"Long/short strategies will be provided by derivatives tied to a note. Those types of indexes are likely to grow and to be used in notes.

"Another theme will be to find clever ways to be long the VIX."

The rapid emergence of a multi-trillion dollar market with ETFs and ETNs suggests that investors are interested in the benefits of indexes and algorithms offered in a simple instrument.

"What the industry is not doing and should be doing is follow the example of mutual funds and ETFs," Styrcula said.

"With mutual funds and ETFs, we've seen the emergence of a huge new market. If we present structured investments as the superior way of gaining exposure to these indexes, we should be grabbing big market shares from those industries."

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