It has been a catastrophic year for hedge fund investors. Many hedge funds lost vast amounts of assets as markets declined steeply while investors attempted to redeem what they could of their investments. Many funds were forced into changing liquidity measures and imposing strict gating (halting of redemptions in the fund until a specified date) procedures, which severely impaired investors' liquidity. This left many investors with unhedged portfolios and desperately seeking a way to protect themselves in the short term.
BNP Paribas responded promptly to the growing concern by marketing its Verso index, a synthetic inverse tracker of a global hedge fund portfolio, the Morningstar Hedge Fund Composite Equal Weighted index. It is designed to provide a proxy for a short global hedge fund position. Since July 2007, Verso has exhibited a -90% correlation to its hedge fund proxy. The bank, instead of creating a new underlying, structured an index that offered access to an already existing, but non-investable underlying.
Verso is intended to make a non-investable hedge fund tracker investable, says Fabien Labouret, New York-based head of BNP Paribas' global structuring group in the Americas. "The index uses a Kalman filter, which is the same technology that is used in missile guidance systems, to replicate a fund of hedge indexes and minimise tracking errors," he says. "Because many hedge funds faced liquidity problems during the fourth quarter last year, clients needed a short-term way to hedge their exposure until they received their money back, and Verso was a good way to create a realistic hedge."
"We approached both private banks and institutionals with the index," says Labouret. "Given that the hedge fund industry was in decline and the index was a way to mitigate the risks associated with hedge funds, many hedge funds managers were in fact recommending institutionals to use our index." Notional traded on the Verso index in late 2008 and early 2009 in the Americas totalled US$214 million across fund of hedge funds, family offices and institutionals. One boutique private bank bought $25 million on a timer-warrant linked to the index.
Another index created by BNP that has sold extremely well in the current environment has been the Spectrum Long/Short Excess Return, which is designed to be market neutral, and instead of using controlled correlation uses a controlled volatility mechanism, a feature that controls risk, and also serves to lower the cost of an option on the underlying. The index, which rotates across different investment styles in order to generate return, decreases or increases allocation to each equity style long/short pair according to an 8% volatility budget.
In a year where the S&P 500 TR dropped 37% and the Vix index (a measure of S&P 500 implied volatility) reached record levels (spiking at 80.06 on October 24), volatility-controlled indexes have proven solid performers and recorded positive returns. The Spectrum index returned over 3% in 2008, while another index that also uses volatility capping, the Millenium MAD US index, returned 0.1%.
"The most interesting feature of the Spectrum index is the embedded volatility cap," says Labouret. "If the volatility of the index goes above the cap then the structure deleverages and allocates some of the exposure to cash, which constrains the volatility. This risk control is highly suitable in a high-volatility regime and the low option premium, achieved by the use of a volatility cap, has been ideal to promote the index within the Federal Deposit Insurance Corporation (FDIC)-insured Certificates of Deposit (CD) wrappers."
The index has been popular among retail and institutional long-only funds alike in 2008 and 2009. A notional worth $500 million has been placed in structured products linked to the index by private banks, wealth managers and institutionals. BNP traded a CD product linked to the index with Wells Fargo with a notional of over $250 million.
"BNP Paribas is one of the most innovative and creative firms out there in terms of finding solutions to reduce risk in portfolios without having to sacrifice performance," says one US distributor.
"We are big fans of the index for many reasons. Primarily because of its low volatility and low correlation to traditional asset classes, which allow for better performing portfolios in times of market uncertainty. We also like the daily calculations to determine the optimum long/short pair and the weighting to help clients capitalise on both upward and downward trending indexes."
On the fixed income front, BNP has also been at the forefront of innovation. The BPSTAR index is designed to capture trends in US dollar market rates. Meanwhile, the bank, in response to global carry unwinding, developed the Galaxy Diversified index, which aims to improve on the traditional ranking-styled FX carry trade, employing both a volatility cap to reduce exposure during severe market moves and a volatility filter in the selection of currency pairs.
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