Capital guaranteed hedge funds seem to offer the best of both worlds, safety of capital and returns well in excess of prevailing bond yields. A closer look at how they work
Capital guaranteed hedge funds are a perfect example of how investor needs and regulatory restrictions give birth to a financial innovation. The first few capital guaranteed products were launched to allow institutions such as pensions and trusts to find a way around restrictions on investing in hedge funds. Once the products were structured as medium-term notes with participation in the upside of the underlying hedge fund, both regulator and tax considerations were overcome. Along the way came bells and whistles such as profit lock-ins and guaranteed coupon payments. Retail investors jumped onto the bandwagon as it seemed the safest way to invest in a sector that continues to be loosely regulated.
How do guarantees work?
Capital guaranteed products are usually structured as medium-term notes issued by a bank with a maturity of anywhere from three to seven years. The level of capital guaranteed might vary from 90 per cent to 100 per cent at maturity. Some notes have a guaranteed minimum return that can either be structured as coupon payments or payable at maturity. Apart from this is the participation rate, that is, how much of the returns of the underlying hedge fund will the note participate in. It usually is a figure below 100 per cent, say 90 per cent. What puzzles most investors is why are large and conservative institutions such as banks taking on the risks of an unregulated and supposedly risky product such as a hedge fund. Are they truly taking on risks and providing a service? Of course, there are various fees, commissions, trailer fees and spreads that are packaged into the capital guaranteed product. A bank has the option to sell off the risk to another institution willing to buy it, or alternatively retain the risk on its balance sheet and hedge it in-house. To understand this, a look at how capital guarantee structures evolved is called for.
Vanilla guarantees
The first generation guaranteed products were relatively straightforward transactions. So much so that technically any investor could structure a 'home-made' guarantee. The issuer of the note allocated a portion of the initial capital into high quality zero-coupon bonds with a maturity matching the note's maturity. For example, the issuer will invest in a three-year note which will mature at a face value of US$1,000 is worth US$864 at a yield of five per cent. After investing in this note, the balance of US$136 goes into the underlying hedge fund. If the hedge fund returns 100 per cent over the three-year period, the maturity value of the note will be US$1,000 plus the US$272 generated by the hedge fund, or an overall return of 27.2 per cent.
The biggest drawback of this structure is the poor level of participation. In our example, the investor gained only 27.2 per cent out of a possible 100 per cent. And this is not counting the hefty fees that accompany such products. As interest rates fell over the past few years, the amount needed to buy zero-coupons kept climbing, eating away at the participation levels and making this structure unattractive.
Option structure
Facing the need to increase participation in the underlying fund, intermediaries came up with a solution based on options. Like before, the issuer invests partially in a high-quality zero-coupon with a maturity matching the note. The balance, instead of going into the fund directly, is used to purchase a call option on the underlying fund. A call option gives the buyer a right to buy the underlying fund at the exercise price, which is the current NAV of the fund at the time of the issue. For this right, the buyer pays a premium, say 15 per cent.
Continuing our above example, using the balance US$136 towards the 15 per cent premium will give the issuer access to 90 per cent of the underlying funds performance or equivalent to investing US$900 in the fund. If the fund returns 100 per cent, the value of the call option goes up by US$900. The investor, therefore, gets a total of US$1,900 on maturity. The participation rate has suddenly jumped from 27.2 per cent earlier to 90 per cent. Since the call option is an over-the-counter instrument structured by the bank writing it, the bank bears the risk of a loss on the call written. Those banks with a proprietary desk buy units in the underlying fund daily using complex delta hedging strategies to cover their risk. Others prefer to transfer the risk to insurance companies who have the size and cash flows to take up such risks. However, this structure can be applied only to funds with a daily NAV and liquidity. Most hedge funds report monthly NAVs and have quarterly or yearly redemptions. The premium on call options might make many structures unviable, because higher the volatility in the hedge fund, higher the call premium.
Dynamic hedging
Dynamic hedging, as the name implies, relies on shifting capital between the zero-coupon bond and the underlying hedge fund according to performance of the hedge fund. The issuer constantly monitors the value of the hedge fund investment versus the minimum amount required to be invested into zero-coupons to provide the guarantee, at prevailing yields. One way to do this is to follow a formulaic approach with pre-set rules and performance limits. However, the disadvantage is that if the fund performs poorly during the initial months and the value of the hedge fund investment breaches the minimum required to guarantee, the issuer is forced to shift 100 per cent into the zero-coupons. Irrespective of the subsequent performance of the hedge fund, the investor is 'stopped out' and is left holding zero-coupon notes till maturity. Thus was born the second variant - constant proportion portfolio insurance, also known as CPPI.
Here, the issuer determines the 'floor' value or the amount required to be invested into zero coupon to maintain the guarantee. This can be plotted as a curve which rises to maturity value of 100 per cent as the time passes. Above this floor is the 'cushion' or the difference between the floor and current value of the hedge fund. This cushion or a multiple of this cushion, depending on aggressiveness or leverage can be applied towards the underlying fund and the balance invested into zero coupons. On monthly rebalancing date, if the value of the hedge fund rises, the cushion increases and money is moved out of zero coupons into the fund. However, if the fund loses money, the cushion keeps reducing and money gets invested into the zero coupon, reducing exposure to the hedge fund. CPPI is in effect a dynamic and trend-following strategy.
CPPI undoubtedly addresses a key concern of investors, that is, the risk of being stopped out because of a large initial drawdown in the hedge fund. Also the methodology is simple and transparent. Unlike option based structures, CPPI can be applied to funds that have monthly liquidity too. However, it would be erroneous to conclude that CPPI is the holy grail of guarantee structuring. My next column will look at the pros and cons of investing in capital guaranteed products.
INSURING YOUR PORTFOLIO
Portfolio insurance models such as CPPI are designed to give the investor the ability to limit downside risk while allowing some participation in upside markets.
CPPI is a portfolio insurance technique that exposes a constant multiple of a cushion over an investor's floor or 'insured' value to the performance of the risky asset
The investor starts by setting a floor equal to the lowest acceptable value of the portfolio
The investor will revise the exposures as the portfolio value changes and as the cushion approaches zero, exposure approaches zero too.
CPPI was introduced by Perold in 1986 for fixed-income instruments and Black and Jones in 1987 for equity instruments.
Anand Subramaniam
© businesstoday 2005
