Despite the fourth-quarter uptick in the equity markets, investors have largely endured a difficult year. Stocks traded in a narrow band and the debt markets saw falling yields in the face of rising short-term interest rates. As a result, many concerned treasurers, portfolio managers and other investors began searching for increased returns in a variety of alternative investments. One of the hottest investment areas to emerge this year was hedge fund-linked and mutual fund-linked derivatives and structured products.
Wall Street firms ramped up staffing in these areas and acquired interests in hedge funds; investments in the first wave of hedge-fund index-linked products this year topped $10 billion and the International Swaps and Derivatives Association began preparing standardized documentation to meet growing global demand. This Learning Curve provides a general overview of what have been the most popular types of fund-linked products: total return swaps, call options and structured notes.
Total Return Swaps
In a typical fund-linked total return swap, an investor enters a contract with a dealer in which the investor receives the appreciation and pays the depreciation on a synthetic investment in an underlying fund or index. For example, an investor may want to invest $100 in XYZ Fund, $60 of which the investor will provide, and $40 of which will be funded by the dealer at a LIBOR-based rate. The $100 investment will be indexed to changes in the net asset value (NAV) of the underlying fund. Increases in the NAV over a quarterly period will be paid to the investor, while decreases will be paid to the dealer. Typically, the dealer will subscribe for interests in the underlying fund to hedge its exposure under the total return swap.
While the net gain/loss in the NAV is typically paid quarterly, the NAV is usually marked to market each day to determine variation margin. Depending on the credit profile of the investor, intra-quarter exposure may be collateralized on a daily basis, usually through posting cash or Treasury bonds. In addition, dealers will often require the ability to terminate the swap upon the occurrence of certain significant events, such as an amendment to the redemption procedures or investment strategies of the underlying fund. The dealer may also cancel the swap if certain financial or leverage ratios of the underlying fund are breached, if the dealer is unable to receive periodic NAV statements or if a particularly important individual at the underlying fund dies, leaves or is incapacitated, this is known as a key man provision.
As with most fund-linked structured products, liquidity in the underlying fund is critical. Investors of course will need to know how and when they can eliminate their exposure to the fund by terminating the agreement, but dealers will also need liquidity to appropriately manage their hedge exposure. One of the drawbacks of hedge fund-linked products, as opposed to mutual fund-linked products, is the often quarterly or semi-annual restriction on redemptions, which may be in addition to lengthy notice periods.
Investors will generally opt for a total return swap in lieu of a direct investment in a fund for several reasons. One is cost-efficiency. A dealer may be able to invest in several underlying investment funds or indices and reduce the various administrative fees and expenses a single investor would incur. The dealer would then pay a weighted return to the investor through the total return swap. In addition, a dealer can provide investors with a highly leveraged position in a fund.
Another common fund-linked investment is a call option on interests in a fund or index. In its most basic form, an investor will purchase a cash-settled call option from a dealer in which the in-the-money amount of the call option, if any, will be based on an increase in the NAV of the underlying fund over the strike price of the call. As with most call options, if the closing NAV is less than the strike price, then the option simply expires and the investor forfeits the premium. Maturities on these types of call options may extend to five to seven years and allow investors to defer taxes on any unrealized gains in the underlying fund until the option is exercised.
One example of a fund-linked option is an accreting strike call option. With this product, the premium is equal to the strike price and is usually financed in part by the dealer, thereby providing the investor with leveraged fund exposure. During the term of the trade, the strike price increases (or accretes) at LIBOR plus a spread. If during the term of the trade the value of the fund investment relative to the accreting strike price falls below a negotiated threshold, the dealer may terminate all or a portion of the call option. In some cases, the investor will have the option to increase the strike price (e.g., through an additional payment or delivery of additional margin) until the threshold is reached. Upon settlement, the dealer will liquidate its hedge investment in the fund and pay to the investor the proceeds exceeding the amount financed by the investor.
Structured notes linked to the performance of funds or indices typically come in two varieties: principal-protected and principal-at-risk. In a commonly seen principal-protected note structure, the investor purchases a fixed-rate note with an embedded cash-settled call option on an underlying fund or index. At maturity, the investor will receive a return of principal and, if the option is in-the-money, an amount based on the increased NAV of the fund. The premium for the call option embedded in the note is generally paid by the investor through a reduced coupon on the note.
A principal-at-risk note, however, has a different payoff profile. With this type of note, the investor risks losing both the premium paid for the call option embedded in the note and all or part of the principal depending on the characteristics of the particular note. In return for this risk, the investor receives enhanced upside exposure on the underlying fund or index. Like a principal-protected note, a principal-at-risk note typically pays a semi-annual coupon, but the payoff at maturity is directly linked to the performance of the underlying fund or index. Returns are usually based on averages of the annual, quarterly or monthly returns of the underlying fund or index over the term of the note. Investors may choose to purchase principal-at-risk notes rather than direct investments in funds or indices for a variety of tax or accounting reasons.
This week's Learning Curve was written byMatthew Kerfoot, v.p. atCredit Suisse First Boston.