Backlash against hedge fund-linked structured products

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.

“There is no single pattern in how wealth managers are using structured products,” explains Eric Debray, co-manager of TFS Structured Products.

“Some portfolio managers are considering structured products as an asset class, others consider them as additional investment vehicles regardless of their asset allocation. One private bank could consider that structured products should represent 10 per cent of their asset allocation, when another could consider that whenever they are looking for a new investment – shares, ETFs, bonds – they should always check whether a bespoke structured note could provide them with a better risk/return solution.”

In emerging markets, investors are particularly keen to gain exposure with the benefit of a capital guarantee and providers such as TFS have worked on structures based on a volatility cap where high participation levels can be achieved despite low interest rates.

“Clients are using structured products to invest in emerging markets as this is a less aggressive way to enter the market, and they are probably accepting a structure with 10 per cent downside and two times the upside,” says Jeffrey Goldenberg, managing director at Goldman Sachs Asset Management. “In developed markets, they may be happy to be more long, with two or three times leverage and a bit of a buffer.”

Return of equities

A desire to participate in rising markets and greater appetite for yield have led to a growing raft of equity-linked launches, a segment that traditionally represented more than 50 per cent of the structured product market but dwindled to almost zero at the end of last year. UK-linked investors are also attracted to structured products to benefit from the relatively lower capital gains tax environment compared with income tax.

“There has been a strong recovery in demand since April with equities again representing 50 per cent of our inflows, driven by our thoughts on the macro-economic scenario and the arguments we’ve found to take advantage of the recovery,” adds SocGen’s Mr Cagi-Nicolau. “At this moment we can see clients investing in directional bets. This started mainly on the indices in April, but since then there have been some products based on specific baskets of equities. These have been mainly stocks in developed markets but a very recent trend in the last two to three weeks has been demand for baskets of emerging market equities, particularly Indian and Chinese stocks.”

Alex Robinson at Barclays Capital agrees: “At the start of the year, structured products were based on indices rather than individual stocks and analysis was top down rather than bottom up. Recently there have been some moves from large to mid-cap indices, plays such as the Russell index versus the S&P for example, but the big thrust has been to keep it simple. There is now a gradual move from developed market stocks to emerging markets, and at some stage single stocks will come back in vogue.”

One niche regaining interest is products structured around a basket of dividend-paying stocks because yields on equities are high, higher even than long duration corporate bonds. “This is not simply a matter of chasing yield and hoping the stocks perform well at the same time as supplying dividends,” says Ben Pace, chief investment officer of Deutsche Bank Private Wealth Management.

“These normally involve 10-15 stocks, well diversified across industries, and the trick is to avoid too heavy a weighting within financials and utilities, although this might entail giving up a little yield.”

There is less interest in small caps, Mr Pace notes. “After an economic trough these normally turn up, but the US recovery is largely being driven by inventory restocking and the weak dollar is helping export companies, and it is of course the big caps that are usually more heavily involved in exporting.”

There has also been a significant trend to use structured products to optimise entry points. This can be a simple mechanism that allows the investor to observe during a predefined period the monthly closing price of the underlying. At maturity, the investor will benefit from the increase of the underlying from the lowest level seen during the observation period.

Products linked to commodities, mainly oil and gas, have also been in demand, particularly products that have successfully solved the contango problem. At Deutsche Bank Private Wealth Management, a popular investment in the commodities space is a structured product that on a systematic basis takes advantage of commodities’ tendency to mean revert. This has been a successful strategy for six years, but recently the strategy has been adapted to add a special allocation to gold because the mean reversion technique was consistently selling the metal.

Demand for FX-linked products is patchy because, although currencies tend to trade in reliable ranges, visibility is still poor, but products with short maturities of one week to three months have been gaining traction.