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What do you think?
Is there a place for structured notes in the staid world of trust funds? JPMorgan Private Bank believes there is.
“Traditionally trust companies have had a very narrow view around portfolio allocation and didn’t want to take a lot of risk. So a trust portfolio would be a typical large-cap stock portfolio, some core bonds and some cash,” says Bill Norris, chief fiduciary investment officer for JPMorgan’s private clients.
“Over the past few years, as it has been tougher to generate good, consistent returns and excess returns within the markets, we have been looking at how can we take our trust portfolio allocations one step further.”
In November last year, JPMorgan started including structured equity notes – in this case, investments that are tied to an underlying equity index and can offer a combination of downside buffer and leverage on the upside – in trust portfolios over which the bank has full discretion.
To do so, it has linked up with Merrill Lynch, Barclays and Morgan Stanley to issue the registered securities. The reason is two-fold – to reduce credit exposure to its own institution and avoid the issue of self-dealing.
“As far as we know, we are the only ones doing it in a discretionary capacity in trust portfolios,” Norris says. “It’s an additional tool we are using to manage risk and generate excess returns in our portfolios. It’s not a stand-alone product.”
JPMorgan is targeting trusts with investable portfolios of more than $2m. In order to determine which trusts are suitable for structured equity notes, it has embarked on a screening process that includes reviewing the trust documents; determining whether the trust is due for a near-term pay-out; and assessing the sensitivity of the beneficiary to moving into new types of investments, among other things. So far, 1,200 trusts have been approved out of about 40,000.
“Using structured notes is not going to be for every trust,” Norris says.
As most structured notes do not pay a dividend, the bank has to evaluate the needs of the income beneficiary to determine whether forgoing the dividend would be acceptable.
In some cases, JPMorgan, acting as the corporate trustee, has the “power to adjust”, which enables it to make adjustments between principal and income and thus make up for the dividend shortfall.
Rhian Horgan, global head of equity derivatives for JPMorgan’s private clients, says that for 15 years derivatives have been a core part of how the bank manages equity exposure for clients.
“We think of how we manage equities with three different tools – the traditional equity manager who can either be a fundamental or quantitative manager; exchange-traded funds, and structured notes,” Horgan says.
“I think of a structured note as a smart ETF – you’ve already decided that for a portion of your assets you are going to give up some of the manager alpha but now you’ve got to decide between an ETF and a structured note and what the ETF doesn’t give you is either leverage or downside protection.”
JPMorgan only uses structured equity notes but may look into fixed income. “It’s a trust environment. We are changing the way we are thinking about investing for trusts but we don’t want to get too far ahead of ourselves on this. We are staying with the equity component and staying with well-recognised indices,” Norris says .
“Our view on the use of structured notes is that it is not going to be a predominant part of the overall portfolio.
“When we think about diversification, this is a component of the equity component, so even though it may only be 20 per cent of the income piece, we want to be sensitive to the income beneficiaries as [the notes] don’t pay income. We also have to be sensitive to the capital gains treatment of structured notes and so we try to structure these with at least a year or more in term so we are getting favourable tax treatment.“
The use of structured notes, like many investment products, is not without downsides.
One is that the notes have a specified entry and exit date, so there is no flexibility. “You can sell the security but you don’t have the ability to elongate the term,” Horgan says. “One of the ways we manage the entry and exits of these strategies is by diversifying our entry levels and deploying the assets over a six- to nine-month period.”
Then there is the loss of the dividend. “You need to be taking a view that the leverage you are going to get in the strategy is worth giving up the dividend stream,” she says.
Some trustees may be put off by the complexity of structured products. But JPMorgan says it has tried to keep the investment offering fairly basic.
“We want these strategies for two reasons – either downside protection or some leverage and we don’t need to add a lot of extra bells and whistles to try to make the optics look more attractive,” Horgan says.
Another risk to bear in mind is that buying and selling structured products is technically an over-the-counter transaction as most structured notes don’t trade through exchanges.
So, Horgan says: “You are dep-endent on the dealer who structured the investment to give you a bid and an offer”.
To help get round this, JPMorgan has put in place the ability to get intraday liquidity on the securities during normal market conditions.
The key to successfully including structured notes in trusts lies in melding fiduciary experience with derivatives expertise – what Horgan refers to as “firing on both cylinders”.
“The average person with derivatives expertise isn’t going to fully understand the nuances of a trust and the average trust professional isn’t going to understand all the nuances of derivatives,” she says.