Q&A: Fund-linked structures fail to fly

Special report: Focus on Germany


Until last year, the German retail market could only access hedge funds through structured notes. The absence of a regulatory structure meant that hedge fund investment through mutual fund wrappers, single-manager funds and funds of hedge funds faced high tax penalties.

But in January 2004, the German Finance Ministry unshackled the hedge fund industry when it passed its Investment Modernisation and Investment Tax Acts. At a stroke, Germany became Europe's most liberalised market for direct hedge fund investment. But the predicted flood of cash into the market has yet to materialise.

According to Bundesverband Investment und Asset Management (BVI), Germany's mutual fund association, total inflows into funds of hedge funds amounted to only E706 million for the 12 funds set up during the year. This is nowhere near the targets that were set by the industry.

These figures are nothing compared to the money pouring into structured notes. The total volume of structured notes linked to hedge funds was around E12 billion last year, according to Michael Schmollgruber, manager at Hedgefondsweb, a database of hedge fund-linked certificates in Germany.

Perhaps this should be no surprise, given that the Deutsche Derivate Institut (DDI) says that that asset advisers and banking advisers usually recommend clients to invest a third of their portfolios in certificates.

At least the structured products market as a whole looks healthy. According to Derivate Forum, an industry body established by Deutsche Bank, DZ Bank, HVB, Sal Oppenheim and West LB, structured product-based assets under management for the five members increased by E7 billion in the first half of this year, and now stand at E34.7 billion. Assuming that Forum members command a 50% market share, the group estimates that total first-half volumes will be between E60 billion and E65 billion.

Q: Since Germany authorised the retail distribution of hedge funds and funds of hedge funds, have more hedge fund-linked products hit the market? Or do investors still prefer to invest in alternative asset classes through structured notes such as certificates?

A: Germany's first fund of hedge funds was launched in March 2004. So far, we have authorised 16 single hedge funds and 10 funds of hedge funds, while a few weeks ago we authorised the first German fund of hedge funds managed by a US manager – Chicago-based O'Connor Partners Investment Office. But certificates have been around for a lot longer in Germany and are therefore more popular. I think it will take one or two years before investors take to directly investing in hedge funds and funds of hedge funds.

Q: Are there any tax advantages that come with certificates? Or is there a regulatory reason why they are more popular than fund-linked products in Germany?

A: Unlike funds, certificates are not licensed by BaFin, so they are not supervised by the regulator. Basically, certificates are tradable and offered in the form of securities. But issuers offering certificates in Germany or within the European Union must publish a prospectus that has to be approved by the relevant financial regulator of each member state.

Certificates also offer tax advantages. If you hold a certificate without a capital guarantee feature for longer than 12 months, you pay no tax on the profits. This applies to funds of hedge funds too, but you do have to pay tax on the interest and dividends earned on the single hedge funds (underlying hedge funds) that offer dividends. With certificates, you can easily also access asset classes such as commodities, which is something that would take time to develop and approve if used within a fund structure.

Q: Certificates have been criticised for their lack of transparency and high costs. How important is it to educate investors about these issues?

A: It is important to point out that certificates are not guaranteed by the bank, leaving an investor with nothing if an issuer was to default on its payout obligations. This risk does not exist with mutual funds. Before the implementation of the new EU Prospectus Directive (the redrawing of prospectuses for financial investments in the interest of transparency), issuers preferred to gain exposure to hedge funds and funds of hedge funds through certificates rather than float a (fund of) hedge funds. But the new Securities Prospectus Act enforced in July this year requires more disclosure, even for certificates.

Certificate issuers must now use their prospectuses to explain clearly what type of product they are offering and how it functions. The prospectus must also list all fees and explain what they are for. But for more complex certificates, such as those linked to a basket of stocks or swaps, explaining and listing all the different costs involved becomes somewhat difficult. Again, this complexity is not apparent in a hedge fund or mutual fund prospectus. Mutual funds have very high levels of transparency. So I would say further education and familiarity surrounding fund-linked structures is needed.

Q: Although Germany has created an onshore market for hedge funds, the regulator's refusal to allow managers to use credit facilities and duplicate tax reports has attracted criticism. Can you comment on that?

A: According to the Investment Act, leverage is not allowed in funds of hedge funds. However, credit facilities are not always used for leverage. They are sometimes used for customer payouts.

In April, the Ministry of Finance introduced a consultation paper regarding this investment law. It is asking the industry to submit its comments about the possibility of introducing credit facilities for funds of hedge funds (that use credit facilities to pay out customers). So perhaps there could be a change. We have to await the results of the consultation process.

Q: Now that hedge funds and funds of hedge funds are available to the "man on the street", how do you ensure that mis-selling is avoided?

A: There are currently nine people working in our hedge funds team. To make sure there is no mis-selling, BaFin's team of inspectors look at how a fund carries out risk management, risk control and the calculation of its net asset value. We also spend time with fund managers in their offices and ensure that they use top prime brokers with a lot of experience of strong risk ratings. Most prime brokers are based in the UK and are therefore regulated by the Financial Services Authority, with which BaFin has a close relationship. Good supervision of prime brokers is essential.

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