Investors finding value in structured products based on hedge funds

Investors who want to diversify into the hedge fund universe but have constraints on how they do it, can find a solution through structured products. These vehicles offer a way to access hedge funds that may be off limits to direct investment.

A hedge fund structured product can appeal to investors with little appetite for risk or who face legal, tax or compliance constraints. They can also provide investors with a regular income.

Eric Personne, head of fund derivatives in EMEA at Merrill Lynch, says there are really three products available. One is the traditional CPPI (constant portfolio protection insurance) or options of CPPI on fund of hedge funds. This, he says, was popular but is now diminishing in attractiveness.

Middle East and Asian investors, mainly in Hong Kong, are attracted to leveraged baskets with no capital guarantee. Personne says these investors have the cash to invest and the appetite for these structures.

More exotic options are also now gaining ground. Continental Europeans, investors from the Middle East and a limited, albeit growing, number of US investors are interested in these products.

Personne believes there are many reasons why investors buy structured products. To him, however, there is an overriding reason. "A very important service you buy from the investment bank is due diligence and risk management capacity. Not all investors have this ability or the capacity."

Second is the wrapper. This depends on the country or type of investor. The wrapper is the way for the investor to invest efficiently. For example the warrant, he points out, could improve the investor's tax or regulatory treatment. It could also be a way to meet internal investment constraints.

The most important factor influencing an investor's decision, however, should be the fact that the investment bank offers a product that gets the best possible performance from a fund of funds. "The real story is that you offer something that makes sense to the investor."

As an example, an investor may see a fund with a good Sharpe ratio but not want to invest directly into the fund. To capture this good performance, the investment bank would create a structured product that means the investor can invest directly into the ratio.

Merrill Lynch is looking at transferring some ideas that are more commonly associated with equities to hedge funds. For example, callable products that are very common in equity but not used as yet with hedge funds. The bank also sees value in creating its own proprietary internal fund of hedge funds and then creating products around this basket to match specific client investment needs.

Richard Thomas, a partner in Ogier Group and based in Jersey, has been helping banks create structured deals for some years. He says his law firm has helped create a number of structured products, including 130/30 and guarantee vehicles.

Structured notes "fit more logically into the portfolio" of some institutional investors. Thomas sees the appetite for structured products driven by the constraints imposed on the institutional investor by trustees or their approach to risk. Some may not want to be exposed to hedge funds directly but "if the investment is through a structured product, the level of unmanaged risk is much lower. The investor trades a higher return for a lower risk rate," says Thomas.

Over the medium term Thomas expects the use of structured products to increase. "I can't see why these structures should go away. Some have a longer life than others, some appeal to the short-term investor market." He thinks investors will continue to use these vehicles to manage and limit risk (perceived or actual) when looking to invest into hedge funds.

Marc Russell-Jones, managing director of alternative investment services at Bank of New York Mellon, expects market illiquidity to influence investor selection of structured products in future. He says they will want to understand more completely the liquidity of the structures they buy.

Investor appetite, he says, will be for liquid funds that are leveraged. "It is a little too early to tell in the current environment. The dust is still settling as exposed investors exit and new ones come to market. But we are seeing a huge amount of caution and due diligence carried out on underlying structures, particularly where people apply leverage to illiquid products. The liquidity crisis means that credit, not good performance, is driving demand. There is more emphasis placed on the underlying structure of the instrument and the liquidity criteria. Highly illiquid with leverage is not a good place to be."

In general he expects to see more client-driven structures.

Wrap with caution

John Godden, managing partner IGS Alternative Investment, thinks managers should be cautious when allowing their funds to be wrapped in structured products. "It is a good way to raise stable assets, but managers need to understand the regime and how the issue redemptions work," says Godden. He believes the appetite for structured products as a way for institutional investors to gain exposure to hedge funds may be waning. "A lot of European pension funds invest directly now. UK pension funds directly allocate to fund of hedge funds vehicles. I rarely see appetite for structured products."

Andy Halford, head of structured products at Kleinwort Benson, explains that to some investors hedge funds can appear to be a difficult and inaccessible investment option.

"People see them as being an unfriendly offshore option that is inaccessible and where the liquidity isn't that good. So we are working on whether it is possible to give them a product with guaranteed levels of liquidity as this would make it easier for them to invest in," he says.

According to Halford, while some alternative asset classes can be illiquid if a structured product is issued by a bank then it can provide liquidity for that product.

The most popular products at present, says private bank Kleinwort Benson, are those created to attract capital gains rather than income tax. By putting a wrapper around a fund, the investor pays capital gains tax rather than income tax which would typically apply to offshore funds. In the UK this gives a significant tax advantage: the difference between an 18% tax rate for capital gains compared with a 40% income tax rate.

"There is also an issue of safety where hedge funds are largely unregulated offshore investments and it's quite possible for somebody to run off with your money. But if you have a structured product that's issued by a large bank you have the knowledge that that isn't going to happen."

Most investors now accept hedge funds have a place in their portfolio, says Halford, but some find it difficult to hold a direct exposure, so the next step is to establish how to hold it in the most efficient manner.

"The advantage of using a structured product is that it can do things like improve access to asset classes, also it can help with tax treatment and you can play around with risk-reward ratios and capital protection ratios. A disadvantage is that very often with these structured products they are fairly long-term investments, usually over three years," he says.

One of the most common forms of hedge fund-linked product is a note with a capital guarantee. This allows an investor to capitalise on the potential of a hedge fund while at the same time guaranteeing capital.

Frank Gerhard, director of the fund-linked derivatives strategy team at Barclays Capital, explains that structured products are often linked to hedge funds to alter the level of returns that a fund produces. "Sometimes an investor might like a particular fund but the absolute returns it offers can be too low. So we can provide a product that will give them greater leverage and provide more aggressive returns," he explains.

Investors also use hedge fund-linked products to give them protection on the downside says Gerhard. "They want all the benefits of any returns the hedge fund makes but they want to know that their capital is protected if things don't go so well."

Fund-linked products are becoming more exotic and more varied in what they can do. Gerhard says there have been attempts to use them to make hedge funds Shariah compliant. "There have been attempts to do this with these products, but we don't think it is really possible to use them to make a hedge fund Shariah compliant. Shariah compliance has to be actually built into a hedge fund. Instead we've created a platform for hedge funds."

Gerhard also sees a growing demand from investors. "Fund-linked derivatives can help with this giving an investor access to funds with a range of exposures," says Gerhard.

According to Gerhard there are several advantages for hedge fund managers in using structured products. "If an investor goes to their hedge fund manager wanting, for example, exposure to a particular topic, it isn't always possible for a manager to set up a fund just to meet the needs of one investor. Creating a new fund can be cumbersome. It makes more sense to wrap the fund in a structured product and create a bespoke basket for that one investor," he says.

Structured products are beneficial for investors, believes Gerhard, because they allow them a greater degree of customisation. "These products allow investors to achieve certain returns that they couldn't achieve otherwise. They can also allow investors a greater degree of accessibility as some products allow them to access a range of underlying institutional funds," he says.

Gerhard does not believe using structured products as a long-term investment is a disadvantage. "These products usually require an investor to invest for over three years. But this isn't really a disadvantage because hedge funds in general are a longer-term investment. Hedge fund managers don't want investors to invest for a few months and then pull out," explains Gerhard.

Hedge funds can also use structured products to their advantage. "Sometimes we have hedge fund managers approach us. A client may have requested something and they come to us to try and find a solution. And sometimes we will approach a fund manager if we see a particular market trend developing."

At present Gerhard says the biggest users of these products come from Asia, followed by Europe with the US far behind. This he expects to change with more interest coming from the US.

Jean-Eric Pacini, head of structured products at BNP Paribas in London, agrees the most popular types of fund-linked products are those offering capital protection. "If you look at the history of fund-linked structured products, it started with the beginners in the hedge fund industry looking for protection of their capital. As time passed people started to realise that a diverse fund had lower volatility so capital protection became less important.

"Over the last few months we have seen a greater degree of volatility in the markets, and people are tending to go for more concentrated strategies which means that capital protection is back in favour," says Pacini.

Another key aspect is leveraging. "The more volatile a fund is the less leverage you have, and the less volatile it is the more leverage you have," Pacini explains. "This benefits clients because structuring around leverage is cheaper than capital protection."

A growing trend among institutional investors is for products linked to indicators of a fund's performance. "Structuring products on performance indicators like alpha is popular. We find a performance indicator that has some meaning to the investor, and then we take the historical performance of those indicators into account," he says.

Like Gerhard he says fund-linked products and structured products in general are popular in Europe but are not so widely used in the US. "Structured products aren't that popular in the US because it is a demand-driven market, so products don't tend to be offered unless there is a demand for them. In Europe there has always been a demand for structured products," says Pacini.

Benefits all round

He believes the use of fund-linked structured products can benefit both investor and fund manager. "We have investors come to us wanting capital protection or alpha, for example, and we try and find the best solution for them. Sometimes there are fund managers who have clients with similar requests. It benefits the investor because they get what they want and for the fund manager, they can either agree to the investor's request or there is no deal. So the client gets what they want and the fund manager gets a client."

Fund-linked structured products help to broaden the reach of investors, says Pacini, giving them a greater degree of customisation than they normally could get by investing directly into a hedge fund. "We go on roadshows with fund of fund managers. They talk to clients about their funds and we talk about the structures we can put around those funds. It's a win-win situation."

Pacini believes there are very few disadvantages to these structured products. "As long as you buy an underlying fund that you like and the structure is right there are no disadvantages. The challenge is making sure that the client is fully aware of what they are doing and how the product works."

Before selecting a fund for a structured product wrapper, BNP Paribas closely scrutinises the underlying funds. "Our due diligence process is very thorough. We take issues like reliability and transparency into account. After that process is complete we look at issues like liquidity and volatility."

Pacini sees few reasons why the use of structured products linked to hedge funds should not continue to increase, providing a growing variety of options for investors.


"Rather than saying what structured products are most popular, today you should say 'what's least unpopular'," postulates Brett Wander, senior managing director and head of the active fixed-income unit at State Street Global Advisors, Boston.

He says the entire structured products area has been negatively hit by the subprime crisis. "In my 20 years in the business I've never seen a market as bad as it is today," says Wander.

"Spreads are at all-time highs" with "very illiquid markets". The effect on hedge fund managers and traditional long-only managers has been severe. "It isn't possible to overstate how bad the market has been," Wander continues.

According to Wander there are a few hedge funds launched to take advantage of the conditions and buy debt cheaply.

Brian Tinny, head of active fixed-income area at State Street Global Advisors, says some funds are putting distressed pools of capital back in the market and "there are signs of life in better quality subprime names."

"February and March were terrible, but now we see a little bit of recovery and more liquidity," says Wander. However, "by no sense have things normalised, most investment managers are still in risk-reduction modes."

The dealers with the inability to reduce their balance sheets as they sell off inventory have been helped out by the US Federal Reserve and its willingness to lend money, according to Tinny.

"The improvement will be gradual, with a lot of volatility, over the next six to nine months," says Wander. If the Fed keeps putting liquidity in the marketplace that will help too."

According to both Wander and Tinny, the variety of government bailout programmes that are before Congress, with Republicans and Democrats offering different bills, has created uncertainty as the market looks for help. Both the timing and amount of help is unknown.

Wander says there is more liquidity in the derivatives market itself than in the market for structured products. "The securities are highly illiquid; there's not a lot of trading," he says.

There are many hedge funds using leverage with structured products and most of them have collapsed, concludes Wander.

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