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Structured hedge fund products
Fabien Labouret, Structured Alternative Investments Asia, and Yukihiro Nishimura, Structured Alternative Investments-Marketing Japan

October 2003

The hedge fund industry and alternative investments in general, are often described as one of the only dynamic and uncorrelated asset classes able to generate consistent returns even in vicious volatile and bear markets. In contrast with other traditional funds, they are commonly accepted, a fact with which few would argue. With such reputation, gained by showing a consistent positive track record over a long period, the industry has expanded over the past years in a context of fewer investment restrictions being imposed by investors on money managers.

Unfortunately, but perhaps to the delight of the detractors of hedge funds, August 1998 has illustrated to some extent the vulnerability of certain strategies and fund set-ups in distressed and wired markets. However, for investors and adepts alike, the year 2002 has been even more critical for this industry, simultaneously emphasising vulnerabilities and making questionable the functioning of some of these funds.

Even though issues relating to transparency, vehicle structures and regulatory supervision have been raised for some time now (managers in unregulated markets, off-shore investment vehicles, etc) the main concerns have shifted towards irregular and sometimes non-existent NAV calculations. In the context of an overabundant supply of hedge funds, some with reputations tarnished by recent noteworthy and often well-publicised negative events and even outright debacles, the liquidity of some of these funds (in which it is always easy to invest, but much harder to exit), as well as the reliability and accuracy of the valuations, are increasingly being questioned. In particular, the practice of managers performing valuations of their own portfolios' underlying assets is drawing much criticism, due to the nature of the strategies and the liquidity of the assets involved, sometimes with barely sufficient control of independent third parties, and often limited to only an annual year-end audit.

In a context of a very low interest-rate environment, volatile bear markets and for the majority of alternative investment funds the worst year since 1994 - a year where they observed many of their peers disappearing - structured alternative investment products offering leverage or principal protection present themselves as an interesting alternative, and more so as an appropriate solution for making more secure investments in hedge funds.

In Japan, for example, such structures were initially used to hedge out foreign exchange exposures (JPY investment into USD- or EUR-denominated funds) and to offer intermediate coupon distribution to investors (floating, fixed, digital, performance coupons). The first principal-protected fund structure evolved in the mid-80s and was designed to meet a growing demand from the retail sector to invest in hedge funds or multi-manager products. Due to the risk/return characteristics of hedge funds and their lack of transparency and liquidity, as well as the outright lack of hedge fund investment experience of investors, principal protection features were developed and embedded into the structures to alleviate these issues.

In contrast with current structures, the first generation of principal-protected products was rather simple, and represented a straightforward and almost one-off proposition for the principal protection provider: the purchase of a zero-coupon bond plus a fixed investment in the underlying fund of the difference between par price and the zero coupon value. Mark-to-market (i.e. interest-rate) risk generated by the holding of a zero-coupon bond, combined with the significant decrease in interest rates, led to the collapse of the participation cushion available for investment into the underlying hedge fund, and therefore decreased the interest in such structures. In Japan especially, except if one were to consider very long-term maturities, the near-zero interest-rate environment have made these kinds of structures irrelevant as the participation cushion would be virtually nil for products of a decent duration.

For a while, one alternative to zero-coupon-type products were the so-called knock-out or stop-loss type of structures. The advantage of such structures was that they were able to offer, over a reasonable time-span, full principal protection with an increased participation ratio to the upside of the hedge fund, while avoiding interest rate exposure. Since knock-out-type structures, as opposed to zero-coupon-type products, exposed the principal protection provider to market risk (i.e. underlying hedge fund risk), they required increased due-diligence processing and risk monitoring - but also contributed to the development of structuring capabilities. Even if knock-out structures were still able to offer full principal protection at maturity with an enhanced participation rate - thanks to leverage provided by the structuring entity - the actual occurrence of quite a few knock-out trigger events has made these structures lose credibility over time.

Structuring capabilities of investment banks have evolved dramatically over the past years, thanks to focused investments, deeper involvement and a better knowledge and understanding of the overall hedge fund environment. In the meantime, apart from the old debate about the cost of structuring, versus the necessity of adding principal-protection features to hedge funds' investments, another debate has emerged about the efficiency of the structures. Surprisingly, the latest and most commonly-used techniques in this business are not newly-created hedging techniques. The real innovation lies in the risk approach and in the application of existing techniques to this very particular asset class. Current hedging techniques are mainly based on two different but long-standing techniques, portfolio insurance protection through dynamic allocation, and option-based structures.

Both hedging structures can provide investors with an efficient principal protection at maturity date, but with different characteristics.

As for dynamic allocation, the principal protection is granted by the structuring entity, either at maturity date (CPPI) or at any time (TIPP), through the implementation, throughout the life of the structure, of pre-determined dynamic rebalancing operations between two different asset classes: (i) trading assets (i.e. hedge funds' shares) and (ii) liquid assets (money market instruments and cash or cash equivalent). Hedging mechanisms and parameters are defined at product inception, and re-allocation is performed at regular intervals and in a non-discretionary manner. The multiplier that is used to determine the portion to be allocated to each of the two asset classes is determined as a function of volatility, liquidity, and transparency of the underlying fund and is fixed until maturity. From inception date to maturity date, the structuring entity will then be responsible for monitoring the capital preservation value (i.e. the present value of the protected principal or the "floor") and implementing accordingly dynamic allocation, allowing for efficient principal protection. Additional features may include re-setting such as a ratcheting-up of the floor to lock in some of the upside for the investor when the underlying fund performs well.

Even though dynamic allocation structures offer many advantages such as the absence of mark-to-market sensitivity to interest rate (no long position in a zero-coupon bond), and the fact that these structures, owing to the leverage provided by the structuring entity, may even outperform the underlying fund's performance, detractors will always argue that this mechanism as opposed to option-like structures, is sensitive to the "J" curve effect of the fund because of its path-dependent nature. There are in fact innovative solutions to prevent such negative impact - to hedge, if necessary, interest rate impact on the allocation to trading assets. Moreover, the nature of the underlying assets (single funds, multi-strategy funds, funds of funds), and especially their liquidity characteristics, make dynamic allocation techniques more appropriate than option-like hedging structures.

The latter, because of the hedging requirements (i.e. delta hedge), is in fact more suitable to assets offering better liquidity and funds on which the option seller can impose certain constraints, thus allowing proper management of the standard deviation risk. This is the reason why these structures often come with trigger events related to fund volatility. On the other hand, the obvious benefit of option-like structures is to offer, against payment of an upfront premium, a principal-protected structure with a straightforward payoff. In contrast with dynamic allocation structures, the participation rate can be determined at inception and remains static regardless of the intermediate performance of the underlying fund.

Apart from structured products such as the ones described thus far, aimed at capital preservation, current market conditions and especially the low interest-rate environment, are shifting interest towards different types of structures, designed to take advantage of their relatively cheap leverage. Lately there has been a growing investor appetite for structures that maximise the benefit of investing in low-volatility hedge funds thus enhancing the potential return through the use of leverage, fixed or adjusted. Collateralised fund obligation-type structures (CFOs), and also leveraged products, structured as warrants, swaps or collateralised loans have been developed to achieve this target.

To sum up, structured products linked to alternative investment shall be regarded as tailor-made products, adapted to market conditions and wrapped into a single legal package. They are designed to deal with the very unique constraints of hedge funds, and at the same time, to meet the specific requirements of investors and distributors as well as hedge fund managers. In this regard, it is in the investors' interest that the risk/return profile be adjusted in order to protect and/or maximise the investment return at product inception. At the same time, the product is structured for distributors, offering easy marketing of a single product and incorporating reasonable distribution fees. As for the fund managers, who are obviously concerned about the underlying fund return, the interest lies in the assets under management and therefore the management fees.

Structured alternative investments products offer an efficient way to deal with these three different groups (investors, distributors and managers) addressing each group's unique concerns while focusing on their shared target of obtaining return: investment return for the investor, protected and/or maximised by risk/return profile adjustment; distribution fees for the distributor, maximised by the nature of the product; management fees for the manager, maximised by leverage and fixed-investment duration.

The debate shall therefore not only be focused on the nominal level of the structuring fees, which shall be justified by the nature of the product and the underlying fund, but on the structure transparency and the value added in terms of efficiency and the capacity to deliver a decent return in line with investors' expectations. Moreover, structured alternative investment products offer the opportunity to access a very unique asset class while solving legal and regulatory issues (swaps, bonds or unit trust investments versus offshore fund share investments), while offering leverage, capital preservation or a tailor-made pay-off, while dealing with sensitive issues such as fraud risk and concerns about valuation. Above all, even though the goal of structured products will remain the securing of investment and the enhancement of the fund's potential for returns, everyone should bear in mind that the engine of the structure will always remain in the underlying funds.


If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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