DUBAI -- One of the great strengths of funds of hedge funds is that they can be structured to meet very specific investor requirements.
Products can be built to provide hedge fund investors with the security of principal protection while still maintaining the benefit of attractive performance possibilities. They can also be designed to include profit lock-in features or a coupon (floating or fixed) and various amounts and variations of leverage can be used to increase the ultimate investment exposure to the underlying hedge fund managers.
Principal Protection
Principal protection is designed to ensure investors the return of their initial capital, typically 100 percent, but it can be more or less depending on the terms of the product. The capital guarantee provides a layer of comfort to investors in the event that the underlying strategies do not perform as anticipated.
The traditional guarantee involves splitting the initial net asset value into two components: The guarantee element and the trading portion. The guarantee element typically ensures a 100 percent return of the initial net asset value at maturity of the fund and usually does so through the purchase, at inception, of zero coupon instruments, such as zero-coupon treasury bonds, that have the same maturity date as the fund. The remainder of the initial net asset value becomes the trading capital. Investors therefore benefit from both the trading returns achieved and the underlying guarantee of the initial capital invested.
To offset the impact of purchasing the zero coupon bond, the product uses "notional funding" to gear up its investment exposure. Some financial instruments, like options and derivatives, only require a small portion of the initial investment to secure a position. This is known as trading on margin. Short-selling, borrowing a security or instrument and selling it in the hope of buying back at a later date, also creates investment capital. These strategies allow the fund of hedge funds to create notional capital with a fraction of that capital.
Trading on margin was originally limited to managed futures strategies, but has been refined over time to include the addition of various hedge fund styles and strategies. However, it requires a special relationship between the fund of hedge fund provider and the underlying hedge fund manager to bring this benefit to clients.
More Complex Guarantees
A modern variation on this product includes an option structure, where an investment bank writes an option on a basket of underlying hedge funds and provides the investor with a fixed participation at maturity.
Another guaranteed product structure is constant proportional portfolio insurance, or CPPI. This structure is very popular with investment banks, because it is the least capital intensive of any of the available structures.
Another capital guaranteed structure that the market has recently opened up to is collateralized fund obligations, or CFOs, which provide investors with the possibility of investing in rated "tranches" of exposure to hedge funds. These products essentially sell floating and fixed rate debt instruments based on a bundle of hedge funds. The instruments are rated by a credit agency on the basis of the potential loss of the portfolio and the integrity of the investment adviser as well as the managers of the underlying strategies.
The capital raised by the sale of these bonds is then invested in the underlying bundle of hedge funds, giving investors the security of a rated debt instrument and the performance characteristics of a fund of hedge fund portfolio.
Skill and Infrastructure
These structures require a high level of structuring expertise in order to meet different fiscal, legal, liquidity, risk transfer and financing requirements. This expertise includes skills in consulting and assessment, financial engineering, legal structuring, product management, financing, liquidity management and performance analysis. A structured product provider will also need to have the infrastructure and capacity to adapt to the constantly changing fiscal, legal, accounting and investment environment, both globally and locally, and provide ongoing product management services. Rigor, insight and experience are fundamental to the structuring and management of successful alternative investment products and solutions.
As a result, only the largest alternative investment managers have the necessary infrastructure to deliver this kind of structured investment product.
Benefits to the Investor
For investors, the key value of financial engineering and structured products is the access that they provide to new and dynamic hedge fund investment strategies without the associated fear of downside risk as long as they stay invested for the full length of the products' lifetime.
(Antoine Massad is head of Middle East and Asia at Man Investments. He is based in Dubai.)
Antoine Massad
© Arab News 2004
