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By Stephane Liot, Global Head of Fund-linked structures at Banque Nationale de Paris (BNP). This article appeared in the November 1998 issue of Hedge Fund News┐.

Innovations in financial products have opened up the hedge fund market to new categories of investors looking for capital protection as well as participation in hedge fund returns. The breakthrough in capital protected products linked to alternative investments was achieved in the past two years when a few banks began offering capital protected structures using option-based methodologies similar to those used in notes linked to equities and equity indices. Investors who had previously been deterred by the possibility of losing all their invested capital have been increasingly interested in these new products, particularly in continental Europe, Japan and, to a lesser extent, in the Middle East. Offered mostly through private banking networks, these products offer real downside protection to investors and, in most circumstances, a longer term source of capital for managers of hedge funds and funds of funds than is typically available.

The old forms of capital guaranteed products

The first structured products linked to alternative investment funds were created in the 1980s. These rudimentary structures amounted to purchasing zero-coupon government bonds to guarantee the capital invested for about two-thirds to three quarters of the invested amount and investing the remainder with CTAs or hedge fund managers. The low historic return of these structures comes from the fact that they do not offer any leverage: only a fraction of the capital is exposed to the high targeted returns of alternative investments. The substantial fees charged by banks for products without any real added value have not helped make them popular with investors.

A variation of these structures that is still frequently offered introduces a Letter of Credit and an agent who acts as asset allocator. The LC guarantees principal while the asset allocator shifts capital between bonds and hedge funds depending on the performance of the underlying fund. As the fund does well, the asset allocator tends to invest more in it. As it does poorly, he shifts money into bonds, with the aim of making sure that at maturity the product will be worth at least as much as the amount invested at inception plus fees. The main disadvantage for investors entering into such arrangements is that even a short period of negative returns in the reference hedge fund leads to an automatic de-leveraging of the amount actively managed. A sharp drawdown may lead to a 100% allocation to bonds, effectively terminating the product. Investors, meanwhile, must wait until the maturity of the structure to be paid back the invested capital. These structures have limited utility both because of the lack of transparency of their leveraging and de-leveraging provisions and because the fees charged by the bank issuing the Letter of Credit and the asset manager have brought down returns in the structures that were lucky enough to avoid early termination due to reaching their stop-loss triggers.

The new option-based structures

The development of option pricing methodology has led to the creation of structured products with embedded options analogous to options on equities and indices that are very widely used and understood by both institutional and private investors. Just as a note can be created with a redemption price linked to the rise of the S&P, for example, a note can be structured with a redemption price linked to the rise of the Net Asset Value per share of a hedge fund, a futures fund or a fund of funds. These structured transactions have typically been private, so it is not possible to know the exact amount of money raised through them, but typical deals have been between $30 million and $50 million with a few transactions reported at more than $200 million. The banks active in this market make money on the edge they build in the pricing of the embedded options, in the syndication of the structured notes and on the secondary market they usually provide to investors.

Such structures can be implemented as call options, capital guaranteed notes, or in the form of closed-end funds with embedded guarantees. In the latter cases, they combine zero-coupon bonds and a call option on the performance of a fund. Even if most of the capital is invested in bonds, the use of options provides the leverage needed to make the return of the note on the upside resemble that of the underlying fund. In its plain-vanilla form, a typical capital guaranteed note will have a redemption price calculated with a formula of the following form:

100% + P * Performance.

P is the participation rate, also called gearing, in the rise of the hedge fund. Its value depends mostly on the maturity of the structured note and the characteristics of the underlying hedge fund. A 5-year structured note linked to a fund of hedge funds will typically deliver a participation around 85%. Hence, a 120% rise of the underlying fund after 5 years (17.1% annualized) will result in a redemption price at 202% (100% + 85% ┐ 120%) of nominal and an annualized return of 15.1%. The participation obtained on hedge fund linked products has been substantially higher than that on equity-linked notes with otherwise similar characteristics because long-term stock index options have much higher implied volatility than that of the hedge funds.

To value options on baskets of funds, the banks which offer them have developed proprietary pricing models that take into account (among other parameters) the past performance and volatility of the funds, their correlation to equity, currency and interest rate markets and the level of diversification of their positions and trading systems. The banks face a difficult task in hedging the risks implicit in these positions. Since there is no inter-bank market for fund-linked options and no common pricing models, a position has to be kept until maturity, regardless of the future behavior of the underlying fund. Unlike with the L/C based structures, the buyer of the structured note knows from the beginning what his or her participation rate will be.

Some structures offered to European investors have made use of out-of-the money options to provide a dramatic leverage if the fund exceeds a declared threshold of performance. Such options are particularly appropriate where the underlying hedge fund has a high targeted return and a standard deviation at the high end of the market. They introduce the risk, however, that the investor will not benefit at all from a merely moderate performance by the fund. As an example, if the strike price of the option is set 27.6% out of the money (equivalent to 5% per year), the participation in the rise of the underlying fund beyond that threshold will be around 150% on the same typical 5-year structure discussed above. The same 120% rise after 5 years that generates 15.1% when the option is struck at the money will bring a redemption price of 238.6% (100% + 150% ┐ (120% - 27.6%)), i.e. a 19.0% annualized return on the structured bond. This is much higher than the return of the fund.

A few structures based on put options instead of call options have also been marketed. Since it is impossible to sell short shares in hedge funds, put-writing banks tend to require complete disclosure of the positions held in the underlying hedge fund, sometimes even before the positions are actually put in place. Establishing such a structure on an existing hedge fund might require a change of investment policy that would hurt the returns of other investors in the fund. The complexity of the legal documentation for such structures also deters many investors.

An active role for the issuer

The issuer, typically a bank, which sells a fund-linked structure delta-hedges its exposure as though it had sold any other option-based structure. This hedging takes the form of investments by the bank in the reference fund. The bank funds these investments out of its own capital. Thus, the purchaser of the option indirectly benefits from the good rating of the bank since the funding cost of the hedge is one of the parameters that affects the price of the option. The bank typically initiates a trade with an investment that is three to four times higher than the premium of the option it receives from its customer. The delta of the option changes during the life of the product as a function of the time remaining before maturity and the change in value of the fund. The bank will accordingly readjust its investment, adding more capital when the Net Asset Value is going up and decreasing it when the NAV is going down. The need to adjust the position frequently is the main difficulty that option writers on hedge funds face. Unlike equities or bonds in which there is a quasi-continuous market with great liquidity, hedge funds typically restrict their investors to monthly adjustments. To make things worse for option writers, the most popular hedge funds with investors are often those that have the most stringent liquidity conditions (quarterly or worse). The delay necessary to obtain an audited valuation of some hedge funds adds to the complexity of the problems faced by the banks. In the case of structures offering a redemption price linked to the performance of a fund of funds, the problem can be magnified by the longer time it takes administrators to collect the values of each hedge fund comprising the fund of funds. Some special arrangements on reporting can be established between the bank and the fund manager in order to improve the visibility of the funds performance: a fund with a monthly liquidity may provide the bank with weekly estimates or reduce to a few days the normal one month period for notice of subscriptions or redemptions. During periods of high volatility such as during August 1998, fund managers can keep the bank informed daily on what they know about the changing value of their positions.

The issuer of the note does take on the risk of a precipitous meltdown of a fund. Such a circumstance as we have seen recently may be caused by government actions or the use of leverage in an illiquid market or a market that suddenly becomes illiquid. In these unusual circumstances, the volatility of a fund may be at the very far end of the bell curve. There may be no time for the issuer to adjust its position before the fund plunges into a decline that cannot be subsequently recovered. It is therefore critical for the issuer to examine all the potential circumstances that may impact the results of the underlying funds or funds of funds.


Some investors, considering the record returns available in the last few years have rejected capital protection as an unnecessary expense. Recent volatility in fund returns, taken together with the ongoing crisis in emerging markets and its long term implications for the world markets will cause many to reevaluate their position, particularly in regard to the latest generation of these instruments providing leverage through options.u

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