Ensuring transparency and liquidity

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. “Man has always tried to build seriously large buffers into its structured products before they are forced to de-gear, whether that is for leveraged products or for guaranteed products. Some well-known competitors have leveraged their structures to the maximum, and are now seeing significant redemptions, not due to clients leaving their funds but through de-leveraging within structures. There were plenty of cases where banks came to us with structures and we just had to say, ‘No, that doesn’t make sense’. We believe there is real value for the client in having an independent structuring team that can advise the client and negotiate with the banks, because even sophisticated private clients probably won’t have the experience to do that.” In house only There is a similar philosophy at SGAM, where the structuring team will only work with in-house funds and SGAM Banque. A dedicated risk management team determines risk limits on each product in collaboration with managers, and sometimes even creates funds of funds specifically for structuring. “We have free access to positions and investment processes, so we can optimise the leverage with full transparency,” says head of structuring Thierry Mirabel. “That’s a key advantage for clients.” Transparency is important to understand underlying liquidity, but also the related matter of return distributions. As the example above illustrates, the best risk assets for CPPI structures are low-volatility. In the hedge fund world, that means arbitrage strategies. But it is precisely those strategies that exhibit leptokurtic return distributions, which increase structured products’ gap risk - the chance of the value falling below the floor. This risk is usually insured by the structurer buying an out-of-the-money put option, which makes up the lion’s share of the cost of a CPPI structure. Interestingly, structurers will buy these put options from institutional investors – but also from hedge fund arbitrageurs, who are natural sellers of puts. In theory, this is a virtuous circle: if the hedge funds who are selling puts get hit by a tail event, that makes the structured product’s put in-the-money. But again, a thorough understanding of the underlying strategies is imperative because the structurer needs to know that the risks being insured are the same as the risks being run in the product – it is a cost issue, as much as anything else. “Buying protection against hedge fund crashes from hedge funds is similar to using credit derivatives, in that you always need to assess the correlation between the entity that you are buying protection on and your hedge counterparty,” as Mr Suhonen says. “If the fortunes of those two are closely related then the protection is probably not worth very much.” So do hedge funds preclude the “open architecture” approach normally so beloved of the banks? At Barclays Capital, Mr Suhonen says that almost all their structures are on third-party funds. And at Barclays Wealth, Mr Bulchandani says there is nothing wrong with open architecture hedge fund structuring “as long as you are satisfied with the robustness of the processes on both sides of the structure”, and observes that Chinese walls between fund management and structuring teams mean that information flow is not necessarily better when products are put together under one roof. Another way around the problem of using third-party hedge funds is to use managed account platforms – as SG Hambros has for its bond-plus-call structures (at the moment it is working with Lyxor’s platform, but it is also in discussions with HFR, Crédit Agricole and Innocap Investment Management). “Hedging an option on the performance of a non-transparent basket of hedge funds is very expensive and can completely kill the expected return of the note,” says group head of advisory and investment solutions Alexandre Zimmermann. “Managed account platforms massively improve liquidity and transparency, so in January we launched a series of actively-managed funds of hedge funds with capital protection, and the costs are not only not detrimental to the return but very cheap, enabling us to offer leveraged exposure within the capital-protection envelope.” Of course, this opens up a whole other debate about how much of the return from the hedge fund “asset class” comes from a systematic liquidity premium, or other sources that are vulnerable to constraints imposed by managed account investment. But transparency and liquidity must remain vital commodities within hedge fund structured products: as the cost of leverage goes up (and at least half the point of structuring on a low-vol fund of hedge funds is to gear it up), and market volatility sends the general cost of hedging up too, optimizing those hedges becomes ever more crucial to make products competitive for clients – but also to persuade banks to open up their stretched balance sheets to fund them in the first place.