Besides, hedge funds operate under light or no regulatory oversight. Thorough due diligence and diversification are the only ways to mitigate these risks and that is precisely why the fund of funds business has boomed over the last decade or so.
However, with the mushrooming of hedge funds and funds of funds investors were finding it difficult to choose the right hedge funds even before the LTCM shock in 1998. The debacle of LTCM proved a catalyst for the structured products linked to hedge funds. Structured products have further benefited from their ability to meet regulatory requirements in many – especially European – regimes.
Capital protected hedge fund investment is not a new concept. As far back as mid-198os investors were offered simple versions of what has now become one of the fastest growing segments of the structured equity-linked note business. These embryonic investment products were linked to CTAs – a liquid underlying – and were based on a simple zero plus long CTA positions. The last five years have witnessed a major boom in this area with many a key innovation: the underlyings are now mainly funds of hedge funds (relatively illiquid) and structures range from the very simple calls & synthetic puts to more complex path dependent dynamic strategies. Also, the technology extension is no longer restricted to capital protection. Investors are increasingly using fund derivatives to tailor risk/return profiles not achievable through cash markets alone. Credit and currency overlays are being increasingly brought into play. Leveraging a position in a fund of funds is easier and cheaper through fund derivatives than through conventional bank borrowing arrangements. Even though the variety of fund-linked derivatives is vast indeed, a vast majority fall into one of the four following categories;
A call option on a fund of hedge funds is akin to a call on a basket of stocks with two key differences:
Call options are primarily embedded in a zero plus call structure giving investors principal protection and a certain participation in the upside of the underlying fund of funds at maturity.. The participation rate is a function of volatility, tenor and interest rates. The key features of the option-based structure are:
The classic threshold is a stop-loss arrangement whereby a capital protected investment linked to a diversified fund of funds reverts to a fixed income security if the Net Asset Value (NAV) of the underlying fund of funds falls through a predefined threshold at any point in time. The structure is akin to a barrier option.
Unlike the option-based structures, the threshold structure provides 100% participation in the up-side of the fund at maturity provided no trigger event has occurred. Also, from the fund manager’s perspective, the threshold structure is attractive because, as long as there is no termination event, the assets under management are fixed and close to 100% of the notional.
Figure 1 depicts the risk of loss to the writer of the guarantee. Clearly, both the cost of the guarantee and the likelihood of early termination can be significantly reduced if the guarantor can control the variability of the fund’s NAV. Many proprietary ways have been developed by the key banks in this business to do precisely that. Modified threshold minimises investor exposure to jump driven early termination through path dependent payoff accumulation.
While the modified threshold structure addresses many of the issues that beset the classic threshold, many investors find the possibility of early termination as well as the loss of performance that inevitably results from a volatility controlled underlying fund of funds as unacceptable. A more acceptable variation on the classic threshold structure is the so-called variable threshold structure – a concept borrowed from the portfolio insurance technique, hence CPPI.
Essentially, the variable threshold structure is a classic threshold structure written on a dynamically adjusted underlying (Figure 2). The de-leveraging has the effect of smoothing the evolution of NAV over time thereby reducing the probability of a jump driven early termination. The proportion of assets allocated to the underlying fund of funds is simply a function of the distance (D) at time t between the current NAV and a reference curve:
Where NAVTrigger is the point on the reference curve at time t. The reference curve itself can be fixed or variable.
The dynamic nature of the underlying in this structure lends itself to a variety of interesting variations. One of the popular features is the incorporation of contingent leverage which has the effect of enhancing returns while not exaggerating the losses.
The phenomenal growth in structured alternative investment products has been driven by a variety factors. The chief among these are:
As pointed out above, most investors, both institutional and retail, lack an in-depth understanding of hedge funds as an asset class.
For such investors, structured products provide a gateway to this alternative asset class. Also, for investors that consider hedge funds inherently risky, structured products provide a way of mitigating the risks at a reasonable cost while allowing them to participate in the returns of an alternative asset class. In several tax and regulatory regimes structured products are the only feasible way of gaining exposure to hedge funds.