Providing a safety net
As a means of getting the institutional market of insurance companies and pensions funds to embrace hedge funds, fund distributors have developed structured products that attempt to address some basic issues – the need to generate positive returns in an uncertain market environment and to generate income to maintain pension funding requirements.
The attraction of the structured product concept for pensions funds is the ability to control the minimum and maximum return in the form of the original investment and any income or growth it produces. And funds of hedge funds have proved popular as a means of low-risk exposure to hedge strategies, particularly for institutions, where the complexity of tax and legal issues involved in individual funds can be an obstacle.
The structured products market is fragmented, in that many different types of product exist. It is possible to say, however, that the market for investments that attempt to combine capital safety with market exposure is one of the great growth areas for fund marketing. In an environment where investors have a diminished confidence in a fund manager’s ability to produce positive returns unaided, the hedge fund industry has been able to demonstrate the benefits of alternative strategies. For the banks, this has become a hugely profitable area of business. While there is no official data, banks like BNP Paribas and Société Générale have seen a tremendous growth in their structuring businesses.
Structures tend to fall into two distinct types, either a fixed income with growth element with the return of capital dependent on performance of a set market, or a minimum return with growth element tied to the performance of a relevant stock market or markets. Structured products do have a mixed reputation, especially at the more active end of spectrum, where some of the higher income products have failed to return investors’ capital in full. This is indeed one of the risks inherent in the products, but is something an institutional investor should be well aware of at the outset. Equally, the matching of assets within these structures needs to be the most appropriate for the investor’s needs. In the current environment, the relatively low yield on bond markets and the potential for sharp equity market movement is an issue when structuring long-term products.
The time horizon of the investment, the participation rate, the current level of interest rates and the level of income required are the crucial elements in the structuring of the product. The longer the term, the easier it will be to secure capital guarantees. Many products, particularly in the retail area, run for three to five years. But for pension funds and insurance companies, there are many different products available with different terms. An investor has to look at the length of the product, the participation to the underlying fund/funds performance, the capital guarantee percentage and coupon payments (if any). One can only compare products with similar characteristics. For instance, a 10-year product should have a higher coupon or a higher guaranteed capital percentage than a five-year product.
The trade-off between protection and market participation is the key to the success or otherwise of these products. It is possible in theory to make a positive return from the investment even during a period when the stock market has fallen. An example from Nvesta Research shows a three-year plan that became due for payment in April 2002, linked to the performance of the FTSE 100. The product paid out 26% growth as promised. It also returned 82% of the original amount invested, giving an overall return of 8%. So the investor made money despite the fact that the FTSE fell 18% over the same period.
Most capital-guaranteed investments are launched for a specified period and then closed to new investors, with further tranches offered according to demand. Some are listed funds that can be traded on a stock market. The guarantee offered by these products is traditionally achieved by investing part of the money in money markets or zero-coupon bonds, which grow passively over the investment term to cover the capital amount, a simple low-risk means of delivering a return of capital. The active part of the product can take a variety of forms, with the common factor being the use of equity derivatives.
The methods of providing a return of capital have evolved and the products offering degrees of growth and higher income are naturally the area of greatest innovation. Robert Benson, director of Structuredretailproducts.com says: “The flexibility of the underlying instruments and innovation of product providers have produced a continual evolution in product design to meet changing investor appetites. This rate of innovation cannot be matched by any other investment market and will undoubtedly continue to sustain market growth.”
One of the most suitable structured products for pension funds, in that it takes away some of the investment manager decision-making, is the guaranteed return linked to a fund of hedge funds. Some of the more popular structures are based on strategies run by hedge fund specialists such as Man Group and RMF. In March this year, Swiss boutique CMA Management Advisors structured a 15-year, E135 million note with a 2.4% annual coupon, linked to the Berklay Global Fund , a multi-strategy fund of hedge funds. The note was issued and guaranteed SocGenand was sold to European insurance institutions.
CMA has launched a number of smaller structures since the 15-year product, mainly shorter-term capital guaranteed notes. Partner in the firm, Sabby Mionis, says, “The 15-year maturity was significant as it confirmed the insurance sector’s longer-term commitment to alternatives as an asset class. This trend is set to continue as insurers and pension funds, in the face of short-term liabilities, will increasingly demand strategies that can combine fixed income with capital protection.”
What are the key considerations for a pension fund investing in a structured product? Mionis suggests a pension fund should consider how long term it wishes its investment to be, whether it needs regular income from the capital, and if it needs to remove the risk of loss of capital (bearing in mind that this has a cost).
“The pension fund in essence needs to match the structured product with its investment needs. In addition it needs to consider carefully the provider of the structured product and the investment adviser who will manage the fund of funds linked to its structured product. Specialist skills are needed to manage fund of funds linked to structured products.”