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Structures to tame hedge funds

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Pension professionals are expending considerable amounts of energy on alternative investments, and particularly that category labelled ‘hedge funds’, at a time when the traditional asset mixes of equity, bonds and property are failing to deliver the required level of return and are becoming increasingly correlated. However, even if hedge funds prove to be the perfect non-correlated, alpha-generating, low-risk asset class for which they are all searching, will they be able to invest in such assets?
There is significant evidence that institutions have warmed to hedge fund investment (see figure 1), but it is apparent that significant and varied barriers still exist. 1, the issues are predominantly focused on the nature and integrity of the asset class, but it is also the case, as will become increasingly apparent, that existing regulatory frameworks in many European territories severely restrict the use of hedge funds.
The level of interest registered in each country broadly correlates with the flexibility of local regulations on allowing investment in hedge funds. The notable exception is Italy, where the appetite is immense but the limitations are great and generally only Italian-approved funds can be used. These must be in the form of a special investment vehicle (SGR), which is notoriously difficult to get approved. Only one or two hedge fund SGRs have been approved to date.
Many of the negative aspects historically associated with hedge funds are blocking investment by institutions or approval as a mainstream asset class by regulators. Figure 2 gives an insight into the relative importance of the various issues.
Many of these issues are being resolved by the industry itself. Fees are arguably reaching a more justifiable level and there is a determination to foster greater openness. Fees of 1.5% a year, plus a performance fee of up to 20% above a high watermark equal to the cash rate can be seen as fair remuneration/incentive for a manager providing consistent alpha. What is more difficult to accept is that knowledge of the assets being used and of the net asset value is irregular – quarterly in extreme cases.
Others problems, such as liquidity, regulatory framework and absolute risk control, can only be solved through the involvement of a third party in the form of a bank or insurer issuing a structured product linked to the hedge fund assets.
Structured products create a firebreak between the assets – hedge funds in this case – and the investor. This can prove crucial in determining the nature of the asset from a regulatory or tax
perspective. An asset, often a medium-term note (MTN) or a swap, is purchased from the structured product provider (a bank, for example). The economic value of the asset is determined by reference to a basket of hedge funds or hedge fund index. However, the physical owner of the underlying hedge funds is the bank, to neutralise the risk it has under its liability through the structured product, not the investing institution.
Such an arrangement provides the opportunity to tailor the economic exposure to the underlying hedge funds and reshape the asset into a form acceptable under local regulation and relatively tax-efficient.
The bank can itself make a market in the underlying fund/fund of funds, offering bond-style liquidity to purchasers of the hedge fund-linked MTN. The ultimate limitation is the bank’s own capacity to hold long or short positions against the funds over the period between liquidity dates on the funds themselves.

An alternative, and more robust, approach is for the bank to use the purchasing power derived from pooling many investors to negotiate weekly liquidity, properly with sub-weekly notice periods, with hedge fund managers. This allows it to build up a deep liquidity that will be available when needed.
A cynical view of the quest for improved liquidity – and indeed greater transparency – from hedge funds is that this requires a significant compromise on quality. This has been demonstrated to be inaccurate. A recent study showed that managers offering better liquidity and transparency within any given strategy are more likely to outperform than those that do not.
A key focus of both investors and regulators is the risk associated with hedge fund investment and the control and understanding of that risk. Structured products can reduce or remove both operational and economic risks.
The structured product provider will generally subsume the full impact of any valuation, fraud and credit risk against the fund. Removal of exposure to downside risk through the protection of the investor’s principal is also a widely used feature.
The dominant structures used to provide principal protection to date are threshold products, also known as CPPI or dynamic funds. These track the underlying hedge funds on a value basis against the zero curve and re-allocate between the hedge funds and the zero bonds accordingly. While this provides capital protection cheaply, investors can never predict the level of participation they will enjoy in the underlying asset.
A handful of banks can also write options in hedge funds, enabling the pension fund to buy a note with a zero-plus-call structure . This provides a full capital guarantee plus a predetermined rate of participation rate in the underlying hedge funds.
As the wide use of hedge funds is still a relatively new proposition for regulators to digest, the environment is dynamic – with some countries distinctly more flexible than others. The closer to ‘normal’ long-only investment that a product can be seen to be the greater the likelihood of regulatory acceptance.
Fund-linked MTNs will gain almost automatic acceptance in some countries. Others, Italy for instance, require the underlying funds to fit the regulatory framework. This presents a barrier for the multitude of funds domiciled in the Cayman Islands, British Virgin Islands or Bermuda.
Some structured product providers have created their own fund of fund ‘platforms’ in a domicile within Europe on which hedge funds can be placed. This enables them to create notes, and indeed retail funds, that conform fully to European professional investor fund rules and will ultimately gain acceptance as UCITS.
Such platforms need to demonstrate to the regulatory authorities that they provide high levels of risk management. The following features are effective in this regard:
q diversity across both managers and strategies;
q 100% managed accounts;
q daily transparency between hedge funds and the fund of funds platform;
q limitation on the use of leverage;
q structural design to eliminate cross-contamination between hedge funds.
Despite removal/control/limitation of virtually every erroneous aspect of risk associated with hedge funds, the regulatory difficulty of allowing the use of short positions, fundamental to hedge funds, remains. The primary comfort that regulators are increasingly looking towards is that of overall principal protection thus satisfying the moral interpretation of the investor protection driven legislation.
Further features used to ‘normalise’ assets, such as annual coupons for a note, are being incorporated, with greater respect for the economic link to the underlying such as a coupon ‘spread’ linked to the achievement of the hedge funds over the year.
The final hurdle on the course towards full acceptability of hedge funds as a mainstream investment for pension funds, be that directly or through structured products, appears to be the capacity limitations of such funds.
Many strategies rely upon stealth to exploit their arbitrage and fund size can be limited to as little as e150m. This could present a limitation to the extent to which pension can use this asset class, although modern markets have a healthy habit of throwing up new arbitrage opportunites as fast as old ones are closed. Although other strategies – equity long/short, for instance – have few such limitations, it is difficult to build non-correlated, low-risk, high-alpha strategies without using the full range of strategies.
Once again, structured products provide some comfort. As they are capable of providing exposure to the full (or even geared) economic upside of a hedge funds, delta investing results in less than full notional being invested on average therefore multiplying the market through a gearing effect on the investor side.
John Godden is director of solution sales at Barclays Capital in London

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