There are all sorts of reasons why an investor might want to place a structure around a hedge fund. It can reduce the minimum investment level. It means you are not investing in an unauthorised collective investment scheme: as an institution, that can help you get around balance-sheet or investment-charter restrictions; as an individual, it may help to limit tax exposure or make the allocation eligible for tax-efficient wrappers.
And then there is capital protection. That is what most investors feel they are paying for when they structure products on other underlyings. But does it make sense with hedge funds – which are supposed to be risk-management tools? Unless you want to buy a single fund, or a single strategy that is more volatile than most (like global macro) or characterized by fat tails (like fixed income arbitrage), why pay for another layer of hedging on top?
“If you think about a diversified fund of hedge funds that is explicitly designed to deliver absolute returns with low volatility and low correlation with the broader markets, it may well seem strange,” concedes Ravi Bulchandani, head of alternatives at Barclays Wealth. “You’re doubling-up on something that the fund manager is already trying to do.”
Coming between the manager’s alpha and the client has implications for the structure long before it is sold on by wealth managers.
“A key consideration in the fund-linked business is that funds are unlike equity indices,” as Barclays Capital’s head of fund-linked structuring Antti Suhonen puts it.
“You are interacting with the fund manager and potentially impacting the underlying fund, so you need to have a very active and open dialogue with the manager throughout the process,” he explains.
Hedge fund giant Man Investments maintains its own extensive team to structure products on its funds, working with banks like Barclays.
“The mandate of my team with regard to Man’s investment managers is to negotiate guidelines in such a way that the managers are not materially restricted in their asset management,” says René Herren, the firm’s head of product structuring. “That means very hard negotiations with the banks, which often want to impose restrictions to get maximum diversification and underlying liquidity. This is often underestimated by clients, but you really don’t want to transform an active product into a static product.”
With CPPI (constant proportion portfolio insurance) structures, the impact on the underlying fund manager can be particularly painful, as the “active management” set by the cushion and multiplier can introduce significant volatility into inflows and outflows.
HOPELESS CASE STUDY?
With a simple bond-plus-call option structure, the initial cushion in excess of what is invested in the zero-coupon bond gets put into the option on the “risky asset”, once and for all. With CPPI, leverage is introduced via a multiplier: if, as is commonly the case, the maximum one-day loss for the underlying is set at 20 per cent (one-fifth), the multiplier is set at five.
So if an investor has a portfolio worth E100, and sets a guaranteed floor of E90 and a multiplier of five, he starts with 5 x E10 (the portfolio value minus the floor) in his hedge fund allocation, and the rest (E50) in his bond. A month later, rebalancing the asset allocation, the hedge fund has returned 5 per cent, sending the overall portfolio value up to E102.50 (E50 in the bond plus + 5 x E10.50 in the hedge fund). The “cushion” has grown from E10 to E12.50, and therefore the hedge fund allocation goes up to E62.50, leaving E40 in the bond.
But imagine that next month, the hedge fund goes down 4 per cent: the overall portfolio value falls to E90.04 (E40 in the bond plus 5 x E10.08) - the “cushion” has shrunk to E0.04 and the client can only afford to keep E2 in the hedge fund when rebalancing. He has bought high, sold low, and in this instance, redeemed almost 97 per cent from the hedge fund manager.
“This can be particularly difficult in the early stages of the CPPI structure, when you are driving that fine line between staying in it and getting knocked into the capital protection,” says Mr Bulchandani of the above example.
This may not be a problem when the risky asset is a liquid equity index. A hedge fund – with monthly liquidity or less – is a different matter. That is where exhaustive due diligence on the nature of the underlying is vitally important – the “active and open dialogue” that Mr Suhonen refers to.
"That’s the way it should be – but of course, it’s a lot easier for the banks if no-one looks at the structures in detail,” says Mr Herren at Man Investments – whose products are heavily-skewed towards the CTA style epitomized by its AHL Diversified programme, which can be very volatile, but are also extremely liquid.
