The Risk-averse Investment Tool

With between 15% and 20% of all hedge fund assets coming from structured product providers, the alternative investment market is fast catching on to the benefits of attracting such institutional clients. Up until now, most of these assets have been directed at funds of hedge funds (FoHFs), but single-manager funds are beginning to jump on the bandwagon too. Yet despite the allure of ‘sticky’ money, some hedge funds remain dubious of such clients.

The structured hedge funds sector is growing fast, with almost every investment bank dedicating a separate unit to ‘structured investments’ - or more specifically ‘structured alternative investments’. With the market increasingly moving towards alpha products, structured product providers are keen to increase exposure to hedge funds, explains Declan Canavan, managing director of JP Morgan’s structured alternative investment unit.

Investment Alternative

Structured products provide investors with an alternative to direct investment in a given asset class and are proving popular with institutions and private investors who are risk averse or are not permitted to directly access certain asset classes due to regulatory constraints. “Capital protection sells well when there is uncertainty around an underlying,” says Laurence Kaplan, director of the structured products group at RBC Capital Markets in New York. Structured products can also maintain high levels of leverage, thus altering the fund’s expected returns.

While there is no one way of creating a structured product, issuers usually issue a ‘note’ that links a zero coupon bond (a security that does not pay current interest and is normally purchased at discounted prices with investment returns payable at maturity or upon call) to an asset class - in this case hedge funds or FoHFs - in order to gain from the upside participation of the underlying investment. They tend to offer 100% capital protection if held to maturity, which can range anywhere from two to 10 years, but in return for this protection, investors’ exposure to the growth of the underlying is capped (typically between 70% and 80%). The issuing investment bank usually acts as the counterparty, absorbing the note’s default risk.

Meeting Demand

Société Générale, BNP Paribas, and Barclays Capital are among the biggest structured product issuers in Europe, while the three major structured product providers in the North American market are Merrill Lynch, Citibank and Morgan Stanley. These issuers will structure notes linked to external hedge funds and FoHFs, and distribute them as pre-packaged investment products to proprietary clients.

While typically the remit of large investments banks, traditional hedge fund managers are starting to mimic investment banks by developing their own hedge fund-linked notes.

Man Investments raised US$540 million and US$560 million from the issue of two principal-protected, cash-intensive, hedge fund-linked products last year. Available through private placement, the products offered 60% exposure to FoHFs and 40% to managed futures, while guaranteeing a 100% return at maturity.

A structured hedge fund, apart from its capital protection feature, which fits in well with the risk averse profile of many institutional investors - namely pension funds - also offers investors access to investment products they would otherwise not be privy to. According to Canavan, German investors are not allowed to invest in US hedge funds, so the structured products provide alternative access to foreign hedge funds in that market.

Even with regulations permitting direct investment into onshore FoHFs, German investors still prefer to access the asset class via structured products. According to Bundesverband Deutscher Investment-Gesellschaften (BVI), Germany’s mutual fund association, total inflows into FoHFs amounted to US$913 million in 2004, the year the regulator allowed direct investment into onshore FoHFs. This is compared with structured notes linked to hedge funds, which reached volumes to the tune of US$16 billion over the same period.

One of the reasons German investors tend to go down the structured products route rather than invest directly into FoHFs is due to tax benefits. According to the regulator, the German Financial Supervisory Authority, if you hold a certificate (structured note) for longer than 12 months, you pay no tax on profits, while direct investment into FoHFs means the investor is taxed on the interest and dividends earned on the underlying funds.

Unlike in the US, where structured products are confined to the high-net-worth and institutional space due to stringent regulation, structured products can be distributed to retail investors in certain European countries, giving hedge fund managers access to new client groups. Last year, US$11 billion of all new investments in the UK retail space came from structured products, while in France structured products raised US$15 billion between 2003 and 2004. And with the Ucits III regulations now allowing hedge fund indices to be used as eligible underlyings in a fund destined for cross-border distribution, the retail alternative market is clearly burgeoning.

According to Canavan, whose unit structures products linked to funds managed by the likes of GLG, BlueCrest, Cheyne and Golden Tree, there is a possibility that JPMorgan will begin distributing products to retail investors through its third-party distribution network.

Sticky Money

Aside from accessing a broader distribution space, structured products offer hedge fund managers an efficient way of raising capital, Canavan explains. Due to the long maturity periods and the threat of early redemption fees typical of most structured products, “We offer sticky money for the hedge funds,” he says.

When selecting potential hedge funds as underlyings, Canavan says the funds must have a three-year record, monthly NAVs and at least US$500 million assets under management. At present, at least 20% to 30 % of all FoHFs will allocate part of their asset-raising capacity to structured products. FoHFs have always been more open to raising assets via structured products compared to single-manager hedge funds. But according to Canavan, this trend is starting to change. Between 5% and 10% of all single-manager funds now accept assets from structured products, he asserts.

But as the universe widens and hedge funds become more welcoming to structured product assets, issuers are faced with capacity constraints and limited access to high volatility products. According to Canavan, JPMorgan has just launched a structured product linked to BlueCrest’s CTA fund. The capacity awarded to JPMorgan is constrained to US$250 million. “Capacity constraints are a problem,” says Canavan. Considering all the time and marketing that goes into raising assets, the capacity constraint limits the profitability of the exercise.

For the time being, structured product providers tend to structure products around low-volatility hedge funds. Because the issuing bank assumes the structured product’s counterparty risk, it has to be satisfied that the fund is not excessively risky. According to Canavan, JPMorgan “warns” participating hedge funds that it will pull out of the fund if it deviates too far from internal risk controls.

But according to some hedge funds, liquidity issues sometimes put a  strain on the marriage between hedge funds and structured products. “While structured products provide us with our bread and butter, they are also like double edged swords as they tend to be the first to pull out of a fund when it is performing badly,” explains one London-based hedge fund manager who wanted to remain anonymous. “They [structured product investors] are also the first ones to redeem their investments when the fund is performing well,” the source added.

Due to the credit risk, an investment bank is less likely to ride out a fund’s poor performance spell, preferring to pull out altogether instead. And when the fund is performing extremely well, some structured product investors will decide to redeem the note ahead of maturity, believing the fund has achieved its maximum potential. And not all structured products apply early redemption fees, while others only make them mandatory in the first year or two of the product’s life, which tends to be in line with the underlying fund’s lock-up period.

“If clients think the fund is performing poorly, they will pull out,” Canavan agrees. “But the fact that we outline a ‘formula’ that the hedge fund has to abide by in order to fend off the threat of early redemption means there should be no surprises for the fund manager.” Furthermore, low-volatility funds do not tend to trade as frequently as high-volatility funds, so there is less room for surprises. But convincing hedge funds to take on the risk of early redemption for such large sums in the first place is problematic. Canavan concurs it is a systemic risk for the structured products business overall.

This article first appeared in Issue 34 of HFMWeek.