Structured products: the ripple effect

Structured product providers are becoming an increasingly important hedge fund investor group. But some regulators are concerned they may be exacerbating liquidity risk mismatches. By Christopher Jeffery

The structured hedge fund business has grown rapidly since the first major deals were struck in the mid-1990s in Japan. The market services retail, private banking and limited institutional appetite for enhanced returns over traditional equity and bond holdings, while also offering portfolio diversification and, in many cases, capital guarantees. Most major dealers now offer structured hedge fund investment products or hedges to distributors via their derivatives teams. And the market is currently valued at between $30 billion and $50 billion.

But this growth has attracted the attention of regulators, which have launched a series of investigations into the opaque world of hedge funds during the past year. Some supervisors are worried that the increasing number of institutional investors holding stakes in hedge funds could cause liquidity imbalances between the redemptions offered by hedge funds and their underlying positions. This, they say, could further exacerbate market disruptions.

The UK Financial Services Authority (FSA) unveiled its concerns about the structured hedge funds market in a June report, Hedge funds: A discussion of risk and regulatory engagement. The UK supervisor says it is concerned about the increasing number of 'side letters' that hedge funds offer to some large institutional investors, which give them shorter redemption terms. It says these preferential liquidity provisions may be out of kilter with the liquidity of the underlying positions.

"It is possible that structured product providers may automatically seek to redeem a portion, or all of their investment in the underlying fund if its performance is negative. They may do this in order to accurately hedge an option or comply with an asset allocation algorithm of a constant proportion portfolio insurance type product," the report says. "This potential instability of the capital base and likely withdrawal of liquidity when it is most needed may exacerbate the effects of poor performance and require more forced selling."

Rebecca Jones, capital markets sector team manager at the FSA and co-author of the report, says hedge fund managers generally try to match the liquidity they are offering their investors to the liquidity of their underlying investments. "There does seem to be quite a strong correlation there, which is comforting from our perspective," she says. "But there are starting to be some slight caveats to that point."

Concern

The most notable concern is that funds of funds (most structured products are based on funds of hedge funds) are offering significantly greater liquidity to their investors than are provided by the underlying hedge funds. The biggest fund-of-funds managers include Man, Financial Risk Management, Gam, Permal and Pioneer, although there are hundreds worldwide with significant hedge fund portfolios.

A related fear is that a number of direct institutional investors are also being provided with enhanced liquidity. "On top of all of that, any structured product related either to the fund of funds or a structured product directly on the underlying fund might have even greater liquidity, and this could trigger this disorderly selling effect," adds Jones.

The FSA accepts it has only had a limited view of the hedge funds market-place, although this picture should be somewhat clearer once it starts monitoring 25 large UK-registered hedge fund managers – as yet unnamed, but likely to be the large UK mutual funds such as Gartmore and Threadneedle that have set up hedge funds units – from November. "We haven't got a quantitative survey of the entire industry at this point that would enable us to give an absolute categorical figure on potential liquidity mismatches," says Jones. "But we do see an increasing number of structured products and increasing investment by funds of funds."

However, Richard Ho, managing director and head of fund-linked derivatives at Barclays Capital in London, argues that the structured products business "acts as a layer of additional due diligence" for the hedge fund industry. "Most experienced structured product providers will be very careful in matching the liquidity," he says. Retail structured hedge fund products typically require the most liquidity, with redemptions often permitted weekly. He adds that most of these deals are offered to Asian clients, and are based on the main hedge fund indexes, such as HFR, Standard & Poor's, FTSE and MSCI, which tend to be run on a managed account basis, where the hedge fund managers provide the trading strategy but do not directly control the assets. This means the structured products provider does not need the hedge fund's approval to liquidate any positions.

He concedes, however, that many hedge funds are increasingly investing in more illiquid assets in their search for alpha at exactly the same time as institutional investors are ramping up their exposures to alternative investments. But he argues that most structured product providers are careful to limit their exposure to funds with redemptions periods greater than one month.

Commenting on the interaction between structured product providers and fund managers, Julia Wilks, London-based head of fund derivatives marketing at BNP Paribas, compares it with the equity derivatives business. "You don't ring S&P and say, 'I'm writing an equity option on your index'," says Wilks. "But if I'm writing an option on a fund of hedge funds, I will ring the manager. Their first question should be: 'what will be the impact for me?'"

Structurers also typically explain the de-leveraging triggers linked to the delta hedging required with a hedge fund option, she adds. "Once you start moving into the more exotic structures, you can have some fairly dramatic delta moves," says Wilks. "So it is very important when you are putting something together that you structure the product to ensure the fund can cope with subscriptions and redemptions."

The FSA's asset management sector team manager and co-author of the June report, Andrew Shrimpton – who will become the regulator's first hedge fund tsar on October 31 – says the FSA and other leading regulators watched the disconnect in the correlation market caused by the downgrades of General Motors and Ford in May with great interest.

"There were some funds that had very poor monthly returns and that did lead to some redemptions," says Shrimpton. "Now, it seems that the market was able to cope with that episode, but it was a real-life example where you had an illiquid investment such as credit default swaps and funds having to meet redemptions on the other side. People were quite concerned about how it would play out. As it happens, the funds had enough liquidity to meet those redemptions, the losses weren't so great and the funds managed to improve performance quickly enough afterwards to ensure it was not a problem that got out of control."

A hedge fund structurer at a leading European bank told Risk that some funds such as London-based GLG and Madrid-based Vega were angered that they were hit with so many redemptions after the downgrade of Ford and General Motors (GM). The structurer says this was because funds of hedge funds were redeeming their most liquid investments first, prompting GLG and Vega to rethink their liquidity terms.

Barclays' Ho says he is also aware of hedge funds that have restructured their terms for dealing after April and May. "By and large, they have done that to match the underlying liquidity with the redemption liquidity," he says.

Reduction

But all the structured product providers Risk spoke with say they have seen a reduction in the amount of redemption liquidity being offered by the hedge fund community. "We have noticed for the past 18 months that managers have attracted enough capacity and are making it tougher and tougher to gain access," says Eric Van Laer, a director in Credit Suisse First Boston's fund-linked group.

"They have been doing this for some time and it is fair to say this was not sparked by a market event," adds David Smith, London-based chief investment director at Gam, who says this has occurred as a result of hedge funds moving out of traditional strategies such as long/short equity in search of yield in more illiquid markets.

What is clear is that some of the basic risk management protections in place at well-managed hedge funds came into effect and worked, most notably so-called 'gateway provisions' that permit funds to roll-over redemption requests when they exceed a pre-specified limit – conceptually like a stop-loss provision on an equity exchange. "Some of the managers that were caught up by GM and Ford were relying on the gateway provisions they had, where, if they had to redeem more than 10% of the fund, they could pull the gate down and there couldn't be redemptions for another period," says the FSA's Shrimpton. "So it did start to show some of the protections that were coming in with this issue. And they did appear to work."

But the FSA's Jones is sceptical about whether hedge funds would use some of their risk management provisions. "One has to wonder if there would be some reluctance from fund managers to actually make use of those protections they do have, as there is potential reputational damage in having to deny investors their money back at a specific point in time," says Jones. "While the protection certainly exists legally for many hedge fund managers, I wonder sometimes how much they would be used in practice."

The reputation versus legal enforceability argument, however, can be played by both camps. Although structured product providers all work hard to ensure they have the most favourable redemption terms available, they say there are limitations associated with side letters. "The number one rule about a side letter is to ensure it is enforceable," says BNP Paribas' Wilks. "I always get a director of the fund to sign the letter, but if the articles of the fund are hard coded with a particular liquidity, notwithstanding the prospectus or any actions by the directors, the articles will prevail. There have been disputes over side letters and it goes back to: was the person providing the side letter empowered to do it? And was the company empowered to do it?"

And Barclays' Ho says the importance of side letters is already waning. "For us, as structured product providers, they are worth very little, simply because they come with reputational risk," he says. "You don't want to be seen exercising these preferential terms and the remaining investors are worse off." He also questions the legal enforceability of such letters and describes this area of law as "relatively untested". More fundamentally, Ho says even if an institution has the ability to force the sale of the underlying assets, it might not be the best exit strategy if it resulted in a free-fall in market prices. "So even if theoretically you have liquidity, in practice you could potentially cause more harm than good."