Fund-Linked Derivatives

Accessing focused alpha

Originally published in the February 2007 issue

The market for alternative investments has undergone several waves of development. The same holds true for the market for fund-linked derivatives, which first became popular in the late 1990s, expanded significantly since 2000 and more recently has started showing the first signs of commoditisation. From principal protected or leveraged products to portable alpha or, more recently, alpha extraction products and exotic options linked to actively managed investment vehicles, fund-linked structures are becoming increasingly mainstream. They evolved from highly bespoke instruments used by the avant garde of high net worth investors and a few sophisticated institutional clients to a regular investment tool embraced by small to medium size banks and insurance companies. These instruments have now successfully been applied to enrich the range of retail products available, where local regulations permit the use of derivatives on alternative investments.

Recently, competition has increased between funds of funds and co-mingled multi-strategy funds. Multi-strategy funds have been lauded by some as efficient successors to funds of funds. Proponents argue that they deliver a similar risk-return profile while avoiding a layer of fees. And while some market pundits were already ringing the death bells for the multi-manager fund of funds in the first half of 2006, there has been a revival of the virtues of diversification in the context of ring-fenced multi-manager products in the wake of Amaranth (which provided a real life example of the apparent downside of co-mingled single manager products).

In 2006, in a context of increasing competitiveness, funds of funds faced the need to prove their role in the market, while pure multi-strategy funds faced investor reservations given their highly concentrated exposure to one manager, one infrastructure and one risk management approach.

Between these extremes, a range of hybrid solutions emerged. Products derived from single manager ring-fenced solutions, i.e. six to eight strategies set up in individual funds managed by one entity, specialist fund of funds, i.e. credit or commodity trading advisors (CTAs), and funds of managed accounts, with appropriate ring fencing, e.g. equity long/short funds, have all been successful.

Risks of alternative investments

The multi-layered character of risks in the alternative investment industry has resulted in regulators across regions expressing some concern in the way that investment banks and other entities deal with hedge funds. The typical sources of risk an investor faces when investing in hedge funds include:

* Reputational risk

* Operational and liquidity risk

* Qualitative market risk

* Quantitative market risk

Reputational risk in this specific context could be considered as the risks encompassing the idiosyncratic risks of alternative investments which have not been appropriately addressed in a given context.

Operational risk address the fact that fund vehicles are exposed to various infrastructure-related issues which need to be assessed in a due diligence process that precedes any transaction on a new manager or fund vehicle. First, the legal set-up, governance and regulatory oversight of the vehicle must be considered. Second, the robustness of the valuation and custody of the assets in the fund have to be examined. To emphasise the importance of this point, it is important to note that mis-valuations and fraud related risk have contributed to most of the well-publicised hedge fund failures. Third, the liquidity profile of the investment funds need to be gauged, as in most cases they are significantly worse than that of most other asset classes. At the liquid end of the spectrum, mutual funds offer daily liquidity, whilst at the other end of the scale, hedge funds and funds of funds typically provide liquidity only on a monthly or quarterly basis with liquidity periods ranging from 30 to 90 days.

Qualitative market risk mainly refers to issues related to event risks and other specific market risks, which do not necessarily show up in historical analysis of performance figures. These risks are typically only accessible through some degree of transparency on invested instruments. Where this transparency does not necessarily need to encompass the individual instruments themselves, it might actually suffice to assess specific aggregates or results of scenario analysis as provided by risk aggregating industry tools like RiskMetrics or Bear Measurisk. These issues arrive mainly from the customary asymmetric distribution of information between the investment manager driving the portfolio management process and the investor attempting to conduct some degree of risk management based on the information made available.

Quantitative market risk again is more in line with the typical market risk management procedures around the analysis of historical performance and risk measures derived from historical performance. Obviously, there are some strategies for which the analysis of historical performance yields reasonably meaningful results, such as equity long/short and CTA strategies. Here, the historical analysis only needs to be accompanied by a reasonably small amount of qualitative information such as leverage and net exposure. Whereas for credit-driven strategies or some macro strategies and definitely the majority of multi-strategy funds, a substantial amount of qualitative information is needed to put the quantitative analysis in perspective.

Balancing risk and return potential

The creation of new derivatives products is particularly important in a market where tactical investment in structured products linked to concentrated hedge fund baskets is still hampered by slow turn-around times and cumbersome negotiations over risk mitigants and infrastructure. The specific management of risks in the context of due diligence, agreement of investment guidelines, potential termination events and the implementation of dedicated investment vehicles in the form of managed accounts often set-up for one specific product, has significantly complicated the provision of commoditised structures derived from alternative investments. Often the process of structuring a specific instrument can stretch over months and, as a consequence, the demand might significantly weaken or even disappear over the time it takes to fully implement the trade infrastructure. The agreement of investment guidelines is a minor task compared to the negotiation of legal contracts facilitating, for example, over-the-counter derivative trading by the vehicle, or the set-up of data feeds. This often limits quite severely the set of available funds for concentrated baskets. As a consequence, investors are often significantly limited to work with a small number of relationships that have already been set up by a specific investment bank.

In order to provide investors with an innovative way to gain exposure to hedge funds, Barclays Capital teamed up with HFR, an independent fund platform provider, to create an attractive and commoditised solution to offer concentrated exposure to hedge funds.

The product offers clients call options on bespoke baskets of hedge funds on an independent platform. Clients can build a basket of between 5 and 10 hedge funds, from those listed on the HFR Manager Select platform. The platform currently lists over 300 hedge funds across a range of strategies.

The selection of funds and combination into baskets is left to investors and their advisors. They are only limited by specific maximum weights per fund. Funds are classified into risk groups which are defined within the context of the platform, e.g. funds whose market risk is well characterised by volatility. This category is typically dominated by equity driven strategies and CTAs. On the other hand, we find categories defined by their dependence on liquidity risk like credit-driven strategies or funds subject to specific risk factors like emerging markets. Allocations to these risk groups imply the maximum possible weight per fund. Turn around time of pricing requests can be short and the pricing is competitive given the homogeneous set up of funds on the platform and the ready availability of quantitative risk management data across the platform. Operational risks are addressed by the framework of the HFR platform and the on-going risk monitoring performed by HFR.

This product provides institutional and high net worth investors with a new way of gaining exposure to specific hedge funds, allowing them to build a concentrated basket or express a view on a particular strategy. The options are available in Euros, US Dollars, Pounds Sterling, Yen and Swiss Francs with a minimum dealingthreshold of $500,000 and initially have maturities from three to five years. This product was designed to reduce the impact of many of the risks to investors while enabling them to tailor their exposure. The risk management features include:

* Reducing the conflict of interest scenarios by separating the role of platform service provider, HFR, from the role of structured product provider, Barclays Capital.

* Managing specific risks by leveraging off the risk management framework set-up by HFR and imposing a defined diversification framework of maximum exposures to funds included in the portfolios.

* Efficient execution, making available generic term sheets and providing a set of concise rules describing attainable portfolios and thereby speeding up the approval process.

This market innovation is in the tradition of the transparent pricing on tradable options on the HFRXGL Index, which Barclays Capital launched in September 2005, creating a new industry benchmark. This latest initiative based on the Manager Select platform is a natural continuation of these efforts to add transparency, liquidity and investor choice in the alternative investment market by extending the availability of option products to more focused strategies in line with the shifts in investor demand.


In 2000, Barclays Capital set-up its fund-linked derivatives (FLD) business. Initially, the business focused on structured products linked to traditional mutual funds, but soon became active in diversified funds of hedge funds, as well as specialist funds in niche markets such as high yield, credit and emerging markets debt.
Since 2003, Barclays Capital has been offering actively managed investments linked to a full range of underlying markets and strategies in pass-through, principal protected and leveraged form. The team has built a significant fund-linked options business over the years, and in 2005 pioneered a transparent two-way market for options on hedge fund indices. The FLD business started in Europe, but the Asian markets have been a significant source of flows since 2002 as has North America since 2004, Today, the FLD business is run globally from London, servicing real money nvestors, distributors and asset managers world-wide with experienced sales professionals based in over a dozen financial centres.
Barclays Capital was awarded Fund-Linked House of the Year two years running by Derivatives Week in 2006 and 2005 and also named Hedge Funds House of the Year by Structured Products magazine in November 2006.
The HFR Group is based in Chicago, Since its formation in 1993, HFR has grown to become one of the global leaders in the provision of hedge fund data, research, indexation and asset management services. The HFR Group companies include Hedge Fund Research, Inc., and HFR Asset Management LLC, an investment adviser regulated by the SEC. Hedge Fund Research produces The HFR Database, considered to be a leading source of hedge fund performance and information, and distributes the HFRI and HFRX indices, benchmarks of the hedge fund industry.
The HFR Manager Select platform provides access to over 100 hedge funds and potential investment in additionally over 200 funds. Funds are selected by HFR’s due diligence team utilizing HFR’s extensive proprietary database. Safety of Assets is achieved in a ‘closed system’ which separates asset custody and control from the trading manager. Risk management is undertaken through daily independent pricing and enforcement of manager trading guidelines to put in place risk control and style purity. Transparency is achieved through daily performance reporting based on position-level investment information..