Although structured products linked to hedge funds enjoyed a few years’ of popularity between 2004 and 2006, the financial crisis and low interest rates have largely put paid to that.
Capital guaranteed products linked to hedge funds are relatively straightforward to set up and traditionally comprise a zero-coupon bond plus a fixed investment in the underlying fund of the difference between par price and the zero coupon value. But mark-to-market risk from holding the zero-coupon bond, combined with the slide in interest rates, squeezed the participation cushions available for investment in the underlying hedge funds.
The industry also produced zero-coupon-type products called knock-out structures, which offered full capital protection with increased participation in the upside of the hedge fund, while avoiding interest rate exposure. However, they exposed the protection provider to the underlying hedge fund risk, and several products faced knock-out trigger events which damaged their image.
Search for liquidity
“Structured products based on a zero coupon bond and option on CPPI (Constant Proportion Portfolio Insurance)became less attractive as interest rates are now extremely low,” says Nicolas Gaumont-Prat, co-manager of TFS Structured Products, which is part of Swiss inter-dealer broker Tradition. “A clear consequence of the financial crisis is that clients are more and more concerned about liquidity and transparency, and as such – although very large hedge funds are coming back into favour – in general they have not been a preferred option as underlyings for structured products in 2009.
“In wealth management, especially in Switzerland, lots of investors were invested with Madoff and are now very cautious about hedge funds,” he adds. “We have therefore seen more interest in other asset classes such as equities, commodities, fixed income or currencies. In particular, FX baskets – like Bric (Brasil, Russia, India and China) currency baskets – have been widely used for targeting emerging markets.”
Before the crisis, low interest rates encouraged providers to take advantage of cheap leverage, particularly in structures that aimed to enhance the returns from low-volatility hedge funds. But as hedge fund managers of all types experienced great difficulties, providers quickly pulled back from offering products where liquidity was scarce.
“Hedge fund underlyings pose a double problem,” explains Mr Gaumont-Prat. “Demand for such products is not great, but on the other side there are now strong risk management constraints within trading desks that make structures linked to hedge funds more difficult to hedge. There are however funds sitting within managed accounts with investment banks offering more transparency and liquidity but some hedge funds do not accept the constraints of managed accounts because by doing so they would disclose their strategies.”
A lack of transparency about hedge fund valuations and difficulty getting money out of funds did nothing to improve confidence, and a few frauds also tainted the whole industry.
“There has not been a great deal of demand for hedge fund linked products, because fund of funds have not delivered the returns they advertised, ie they have shown a high correlation to the equity markets, albeit with a lower beta, but this was not what investors were sold,” says Alex Robinson, a director at Barclays Capital. “There are the occasional trades but not the volume of flow compared with commodity or equity linked products.”
“Most new structured product launches in recent months have been in the fixed interest space, with just a few per cent using hedge funds as the underlying compared with perhaps 10-15 per cent historically,” says Nicolas Cagi Nicolau, global head of structured products solutions at Société Générale Private Banking. “Private clients can be heavily affected by inflation so they have welcomed products to hedge the rest of their portfolios, and inflation linked products have therefore been quite popular in the last three to four months. Very classically, these are fixed coupon products over five to seven years, with the coupon in the last three years fixed to inflation, usually defined by a local market.”
Links to mutual funds are becoming more common however. “These will be funds that have consistently performed well – mostly traditional fund managers,” says Mr Gaumont-Prat. “We’ve seen a lot of back to basics with a shift to mutual funds that either increased their assets under management by achieving a decent performance, or have a strong and transparent strategy in place.”
Traditional funds
The fund styles used vary widely but most involve traditional active equity funds, particularly emerging markets funds and European shares funds, while use of an absolute return fund would be unusual. “We have never used mutual funds and certainly not hedge funds in structured products as underlying assets,” says Patrick Grauwels, head of institutional asset management at KBC. “In our capital protected funds we have continued to use baskets of shares or as we recently did a basket of corporate bonds.” In CPPI products, KBC continues to use mutual funds, but they invest straightforwardly in bonds or equities within the bank’s traditional regional diversification.
