Equity and Fund Derivatives, Nomura-Style

Mike Fullalove's team is cooking up a feast

Originally published in the May 2007 issue

Two years on from its first fund derivatives trade, Nomura’s star is rising high in the structured products universe. At the time of our first interview (The Hedge Fund Journal, Issue 8, May 2005), the Japanese bank was keen to bring its expertise in the equity derivatives business to the already booming European hedge fund community, and was feeling its way into a new marketplace. The opinion at the time was that the two areas – derivatives and asset management – were moving closer together, and that there were synergies to be capitalised on by a bank that could hire the right people to do the job. The opportunity was ripe for the launch of a cutting-edge structured funds solutions division within a respected banking organisation. Starting with a blank sheet of paper, Mike Fullalove and his colleagues have been able to do just that.

Building a structured funds team

At the time, Nomura was faced with the challenging prospect of marrying the benefits of the asset management world with the benefits of the trading world. Nomura set out to build a team of experts from both fund management and equity derivatives backgrounds, bringing on board staff from 14 other banks and asset management houses to achieve it. “It’s definitely something we’ve succeeded in,” says Mike Fullalove, Co-Head, International Equity and Fund Derivatives at Nomura.

He points to the presence of three fund platforms which Nomura has established in the two years since it was first profiled in the pages of this magazine: a UCITS III platform has been established in Dublin, a SICAV platform in Luxembourg, and an investment trust platform in the Cayman Islands. A number of sub-funds are now active on each of these platforms, and public distribution has been achieved for each of the markets Nomura was keen to get access to, namely the UK, Italy, Germany, Spain, Norway, and Sweden. It is also distributing to offshore life companies.

“We’ve created the platforms, we’ve signed up the clients, we’ve got assets in the funds,” says Fullalove. With the infrastructure now in place, the focus will be on increasing sales and building the asset base. “What we’re not doing is trying to compete with a large cap equity fund or a UK fund.”

Instead, Nomura is aiming to build funds that are structured around investment ideas that will appeal to clients rather than bread-and-butter offerings, and then to cement some form of structure on top of that fund which will modify its risk-return profile.

There is increasing evidence in the marketplace today that large institutional investors are seeking to fund their specific investment requirements in a more precise fashion than has previously been the case. The ‘suck it and see’ approach of a decade ago is being replaced by a more precise, even scientific, approach to investment that requires those with product offerings to think harder about tailoring their funds to the needs of big clients.

Nomura’s menu is a case in point: it is currently basing products on global emerging markets, the S&P DTI (Diversified Trends Indicator), a commodities and financials investment, Japan, and even global property. It was one of the first banks to offer a global property product based on its own index of international property firms. The Japanese bank worked with Morgan Stanley Investment Managers, which was managing regional property funds, to build a global allocation that could be brought into the market in index format. Also on the shelf is a multi-asset product, which is gaining popularity in the UK. “That’s just an idea of what we’ve come up with in the funds space,” says Fullalove.

Fullalove has been keen to build a separate identity for the fund management capability under his aegis, to the extent of launching a separate website for funds, and printing distinct marketing material. Sales people have been hired in from the asset management sphere. The aim is to be treated just like any other of the established asset management houses out there at the moment.

“We wanted to create a fund management company that could create structured funds, and sell them as funds with fund distribution, because the structured fund, with a different risk return profile, did not exist two years ago,” says Fullalove. “We’re still at the forefront of that – it doesn’t really exist in many places now.”

He sees the asset management business as a very service-driven and client-driven industry. Nomura wanted to grapple with that prospect while bringing its structured solutions into the marketplace. The non-hedge fund part of the business has progressed well in the last two years, and Nomura has won the industry awards to recognise this. “If you look at structured funds to retail, we’re probably still the only people doing that,” says Fullalove. “We’ve really carved a niche for ourselves there.”

A white-labelling formula that allows banks to sell the products under their own branding has proved successful in Europe: one fund is being sold by an asset manager as part of its discretionary portfolio, for example, while another has been distributed with more of a retail focus. Fullalove expects this area to grow within the UCITS III framework, and says he will be spending more time on this going forwards. It has the potential to be a big part of the overall business offering.

Nomura has been keen to develop its web-based marketing and reporting capabilities, and this is something Fullalove frequently refers to. He has received plenty of positive client feedback in this respect. Apart from asserting the identity of the various areas of specialty within the portfolio, it also allows customers to download volumes of data on investment products. This whole strategy was built from scratch, using the blank sheet of paper the team was allowed to start with two years ago, and Fullalove has been happy with the way it has developed.

Delivering derivatives with fund underlyings

The next leg of the business has been launching certificate and note products, many which use funds as underlyings. “Many of our competitors were already in that market,” says Fullalove. “We had to find a way to differentiate ourselves in order to be able to compete.”

Flexibility, a slightly different approach to risk management, and an emphasis on client service, have helped Nomura to break into this market, where there were already some very well established and successful players (eg SocGen, which acquired Bank of America’s structured solutions business, and BNP Paribas, which added to its own internal capabilities when it acquired Zurich Capital Markets in 2003-04). A number of Nomura’s successful deals in the past two years have come down to quicker turnaround on pricing and superior service: “We were trying to build a business, and were a bit more ambitious than our competitors in trying to win the next trade,” says Fullalove.

Nomura is specialising in three types of products in this space. Delta one trades, predominantly into the German market, have seen some good performance numbers, especially from some of the slightly leveraged versions which featured near the top of the league tables performance-wise. CPPI products linked to single hedge funds, funds of funds, mutual funds, commodity funds/commodity-linked receipts, leveraged loan funds, and property funds demonstrated the vast amount of ground this house has been able to cover in two years, and its ability to consider a wide range of investment vehicles with exposure to a broad universe of alternative and conventional investment types. It is partly demonstrative of how Nomura’s client base is changing as well, with investors prepared – and indeed eager – to consider funds trading non-correlated assets, so long as the appropriate protection is on offer.

Numerous features are attached to such schemes – for example the level of protection, lock-ins, profit-taking mechanisms, leverage, and so forth. Speed of turnaround can also be a factor. Selling a note on a private placement basis, linked to a fund of funds that is overweight in a particular strategy that is in vogue at that point, can take about two months. Much boils down to the ability to process the due diligence, and speed of delivery is something Nomura has spent a lot of time focusing on. Within UCITS, such products will take much longer of course – more akin to launching a new fund, it is not something done on a whim.

Leverage trades comprise the third product. Here Nomura is speaking directly to hedge funds and funds of funds, using three main ways to create that leverage: an accreting strike call option; a total return swap; or a credit facility (a financing swap in Nomura terminology). “We have executed trades in all of those three types of leverage,” says Fullalove. “We have leveraged funds of funds, and some single strategies.” This has included providing both leverage and protection to a variety of funds of funds shops, including diversified FoFs, those with an asset-backed lending focus, equity or fixed income overweights. Fullalove emphasises that his team has been dealing with a wide range of different kinds of funds, from mutual funds to hedge funds, and all points in between. Within the hedge funds sphere, it has included derivatives trading strategies and managed futures amongst those funds it has dealt with. Its clients include the likes of Winton and Aspect on the managed futures side, as well as Pall Mall on credit long/short.

“What we set out to achieve in the fund derivatives space, by being flexible, trying to win business from competitors, do delta one, CPPI, add leverage…I think we have succeeded in executing, especially with some of the things that have become popular in the last few years,” says Fullalove. “We’ve been able to look at those risks, and get comfortable with those risks quite quickly, in order to be able to launch products linked to them.”

He has been happy with the progress that has been made, but does not allow himself to rest on his laurels. He stresses the time and money invested in the infrastructure required to get Nomura’s fund derivatives business up and running. He sees 2007 as a year of growth in both number and types of trades, as well as the volume of assets involved. With the infrastructure in place now, he is confident that his sales teams will be able to go out into the market, confident that the ‘factory floor’ has the equipment it needs to meet client demands.

In terms of personnel, numbers have remained fairly stable over the past two years, although more people are involved in fund derivative and exotics trading, as well as working in the Hong Kong office. Nomura has also hired to increase its distribution and product range in Asia. In particular, the Japanese sales team has been enlarged to fill the obvious opportunity that exists to move product in Tokyo. Per year Nomura executes 70-80 trades in Japan, from zero in early 2005. This is thanks to the bank’s extensive distribution network (eg sales of notes and funds on a private placement basis to high net worth individuals and institutions and public distribution to retail clients) and to its recognised brand, something a non-Japanese institution would find difficult to emulate. Indeed, two hedge fund-linked products intended for public distribution were on the launch-pad in April this year, opening a new front of product development for Fullalove’s team. “That has been done before, but not many times,” he says.

Demand still strong for fund-linked derivatives

Nomura is still seeing strong demand for fund-linked derivatives. In 2006, there was less demand for leverage structures than previously, mainly due to a decline in hedge fund performance and higher interest rates. More expensive borrowing coupled with lower returns made these trades far less attractive. As hedge fund performance picked up in Q4 of 2006, this led to a corresponding return of demand for leverage.

There has also been a trend towards more strategy-specific derivatives, for example asset-backed lending and leveraged loans. “Asset-backed lending you didn’t hear about two years ago – now it’s a hedge fund strategy on its own,” says Fullalove. The rise of this strategy required Nomura to familiarise itself with the way underlying portfolios functioned, and the risks involved. There is a definite awareness at the bank that, as regulatory oversight of fund-linked products gets tougher, the onus will be on them to ensure there is proper risk management and due diligence being carried out. With more ways of managing a hedge fund emerging every year – as firms seek to exploit future money-making opportunities in inefficient markets – Nomura and its competitors will be working hard to expand their respective knowledge bases.

With this has come an enhanced degree of transparency on the part of the managers Nomura has been dealing with. Hedge funds are coming to understand the risk management demands which structuring banks have to cope with, and this has led to the banks receiving greater access to a portfolio’s details. Indeed, there have been occasions where managers have worked with Nomura to adjust the way they trade their portfolios in order to clarify the risks, and make the bank’s job easier (and the fund a more attractive underlying).

“They realise that if the NAV doesn’t come on time, or their investors don’t get the report they need, or they don’t get the answers, then the investors – be it a fund derivatives player or a direct investor – feels less and less comfortable with the fund,” says Fullalove. “If you speak to some of the funds of funds about some of the single managers they’ve switched out of, that’s why they have redeemed their positions – because they weren’t happy with the operational side of the business, and the reporting they were getting. Reporting is much more important than it was two or three years ago. People expect managers to be very professional.”

Some of the other asset classes, like commodities and property, have come into vogue since 2005, with a large number of fund launches in these areas, and corresponding interest from both retail investors and pension funds. One of the funds that Nomura established on its UCITS III platform was linked to Japanese real estate, an asset class that has rallied enormously.

“That’s the value of fund derivatives,” says Fullalove. “You can be flexible. There’s always a theme that is interesting to investors. Emerging markets with protection is a theme which people like, especially since emerging markets can be more volatile; thus, to switch out of emerging markets and into a more protected emerging markets investment can make sense, and we have been doing that.”

As a result, Nomura has adapted to new asset classes – and indeed also revised old ones like commodities in the form of the S&P DTI Funds, which as a sector are enjoying a new period in the sun – in order to meet client demands. It is not always easy for a structuring house to do this, and there is always a temptation to stick with tried and tested underlyings. It is perhaps this culture of innovation that has allowed Nomura to steal a march on the competition, being keener to win the business, and go the extra yard in terms of research and risk management in order to be able to deliver the required solution.

Two years ago Fullalove was expecting the market to start moving towards a strategy-focused hedge fund investment trend, away from diversified funds of hedge funds. “To be honest that hasn’t happened as much as we’d thought it would three years on,” says Fullalove. “The top 10 diversified funds of funds are still collecting an awful lot of money. I think the sophistication you would have imagined would have happened over three years – people overweighting long/short equity or managed futures for example – isn’t really there. That’s been something that has happened slower than we anticipated.”

Going forwards, Nomura is expecting further expansion in the number of asset classes and continuing variance in risk return profiles. This could mean that there will be a solution to suit almost every market condition. Multi-assets will be a growing area, as institutions still do not have the correct weightings in all these areas: there is no question the average portfolio is still overweight in large cap equities/cash products, and that this will have to change.

The biggest challenge

Fullalove’s biggest challenge has been to coordinate many disparate activities in order to make the established formula work. Hiring people, creating issuance platforms for notes, certificates, and warrants, as well as three fund platforms while at the same time building systems from a risk perspective and integrating those with the firm, has kept him busy. Added to this, he and fellow Co-head of the International Equity and Fund Derivatives team, Marco Mocquard, were promoted last year following the departure of Joachim Willnow, who had originally joined Nomura from Merrill Lynch in 2004 following the Japanese bank’s strategic decision to move into this area.

Fullalove and Mocquard now oversee the funds, derivatives (exotics), and flow-trading businesses simultaneously: “If you think about it, people who have created these sorts of businesses before will have concentrated on just one of these things,” says Fullalove. “To do all of these things at the same time is definitely challenging. Having to build four or five different parts of the business simultaneously, and employing different skills, that was probably the hardest thing to do. But sitting here three years later, we do have an exotic business, we do have a fund business, we have issuance platforms, we have all of those things in place.”

Capitalising on UCITS III

The challenge of dealing with regulatory change has been met by hiring a large number of lawyers. It was obvious to Fullalove from the start that the regulatory trend would be towards a climate of increasing and more specific demands. He thinks his firm has, from the off, retained more in-house legal minds than the average for this industry, and that it has been a sound strategic investment to do so.

Trying to match innovative financing solutions to new types of asset class, and pioneering some structures, requires a unit that will stay on top of current regulatory practise every day. It has been an investment that has paid off. A good example has been Nomura’s role as part of a small lobby group which has approached the European Commission on the role of hedge funds within UCITS III.

“CESR [Committee of European Securities Regulators] have still not opined on the final answer there, but it looks more positive than it did a year ago,” Fullalove says. “I do think that in one form or another – diversified fund exposure or hedge fund index exposure – [hedge funds] will be allowed in UCITS III and will be sold to retail. Outside of that, with some other listings of closed-end funds, you can already buy hedge fund exposure as a retail investor. I think that has changed, and it will continue to grow, and people will understand hedge funds more and more, and regulators seem to be pushing that way – that is something we welcome.”

UCITS III was a focus for Nomura from the beginning of its venture in this territory. It devoted dedicated business development and legal teams to growing its business, and has striven to beat many of its competitors in this area. The issue of hedge fund indices within UCITS III has, however, taken longer than expected to resolve. But Fullalove stresses that what Nomura is seeking to achieve within the directive, and what a normal asset manager would look to do, are not one and the same thing. “We’re trying to create strategies and risk return portfolios to sell to investors – we want to create new indices, new products, it’s a very different way to viewing UCITS III than a normal asset manager,” he explains.

Getting products approved, building distribution and having the right relationships with regulators, takes time. The lead time on funds, Fullalove stresses, is much, much longer than that for a note. Developing a proper understanding with the regulator is critical to success, and it is heartening to see the approval process speeding up as more Nomura products are brought to the market. This is often the experience of banks and other firms in the investment space that are doing something new: overcoming the initial regulatory suspicion takes a huge investment in time, and the hope is that this will pay off with first mover advantage, often so essential in the European financial services game, further down the roa

And has Nomura caught up on the more established banks? “We were never trying to be all things to all people,” says Fullalove. “We wanted to be very focused, and be good at what we focused on. We have focused on derivatives and structured funds, and we have won an award in the structured fund space this year. Exotics were the second business we’ve done, and that’s really been a growth phase for this year. We’ve set everything up, and we’ve seen good growth in Asia in the last three months, which should continue there and in Europe. I think we have certainly cut ourselves a niche in fund derivatives and equity derivatives in total.”

Having built its infrastructure and its client base up over the last three years, Nomura is now well-positioned to react to future changes in investment trends. Developing offerings that the market wants, that are tailored to current economic conditions, is part of the skill set required to run a successful operation in this area.

With more clients being signed up all the time, and with some solid performance numbers from its pioneering products (eg Japanese and global property), it is well positioned to build on its successful early days.