A growing appetite for capital protected products and alternative investments are two of the most significant trends influencing pan-European investment product structuring at both retail and institutional level and both are, to a large extent, dependent on derivatives.
Capital Protection Techniques
Capital protected products are not new. There are two basic types of protection: static portfolio hedging and dynamic portfolio hedging, often combined with a third-party bank guarantee of principal (Understanding Hedge-Fund Linked Principal-Protected Securities DW, 6/1).
With static portfolio hedging, the investor's capital is used to purchase a basket of riskless assets. The remaining capital either funds an active investment strategy or it can be used to fund the premium of a cash settled over-the-counter derivative in which the payout is linked to the performance of underlying assets.
There are some advantages of the OTC over the straight investment model. Subject to pricing, the OTC can deliver 100% exposure to the performance of the underlying assets over a defined period. For an actively managed strategy to achieve the same result would require the fund to either borrow against the security of the trading pool or fund management group or to pursue a dynamic asset allocation strategy.
Dynamic portfolio hedging involves an ongoing systematic allocation between baskets of riskless and risky assets. This aims to maximize exposure to a portfolio's risky assets while ensuring that a predetermined level of capital is protected. It thereby facilitates a higher participation in the underlying risky assets than would be allowed by traditional static structures.
Dynamic asset allocation can be carried out by asset managers at fund level or can be replicated in synthetic form in an over-the-counter derivative. If in OTC form, the dynamic asset allocation algorithm is set out in the ISDA confirmation and the payout is determined by reference to it. This has the same benefits over traditional static hedging that are noted above. But, it also maintains a minimum equity exposure, offers full currency protection, results in a verifiable and transparent pay-off and does not require an external investment vehicle. Care needs to be taken to ensure that the ISDA documentation and the circumstances of the OTC transaction itself do not result in the relationship with the OTC counterparty being recharacterized as investment management or the arrangements themselves being characterized as creating a collective investment scheme.
Principal protection mechanisms are now embedded in a wide range of investment products--medium-term notes (bond plus embedded long/short options) issued by special-purpose vehicles, mutual funds, life insurance policies and savings accounts. The development of OTC capital protection techniques has effectively allowed issuers not involved in asset management to offer returns linked to the asset management activities of third parties. For example, Italian banks issuing notes to their retail investor base that link returns to the performance of a basket of UCITS (Undertakings for Collective Investments in Transferable Securities) funds managed by established third-party active European fund managers. UCITS status means the funds can be sold without restriction on a pan-European basis.
Guaranteed Vs. Capital Protected
It is important to distinguish between capital guaranteed and capital protected products. European regulators rightly note the marketing power of the word guaranteed in selling products to retail investors. Regulators have tended to interpret guaranteed as implying the existence of a legally enforceable third-party guarantee, rather than simply a capital protection strategy or block insurance. Needless to say, the price of the use of the word guaranteed to investors will be the guarantee fees and increased establishment costs that go with putting in place an external third-party guarantee.
Capital Protection & UCITS III
Capital protection mechanics embedded in investment funds seeking to benefit from UCITS status have always required close analysis to ensure that UCITS compliance criteria are met. For example, it has been necessary to ensure, when a dynamic asset allocation strategy is pursued, that the baskets of riskless and risky assets meet appropriate diversification criteria and that the fund's shares are capable of being redeemed at the option of the investor on an ongoing basis. Prior to UCITS III, where capital protected returns were delivered through a combination of riskless assets and an OTC derivative, some jurisdictions, such as Luxembourg, took the view that provided there was adequate disclosure in the relevant prospectus the use of the OTC derivative was "efficient portfolio management" and so permitted by the European Union directive.
In many ways the amended UCITS Directive, which came into effect on Feb. 13 last year, but will not be fully implemented across Europe until Feb. 13 next year, (UCITS III) has liberalized the use of derivatives in UCITS funds. It now expressly allows the use of derivatives for investment purposes.
However, UCITS III has also introduced a counterparty risk exposure limit of 10% for each derivatives counterparty.
The rules do not provide a definition of this counterparty risk, but a reasonable interpretation in the context of capital protected funds, would be to measure it as the mark-to-market value of the derivative as a percentage of the net asset value of the fund. This value will fluctuate as the value of the derivative looks closer to being in the money or if the value of the riskless portfolio deteriorates. Given current interest rates, the value of the derivative at inception may breach the 10% limit. This presents a problem, since splitting the derivative into several contracts with entirely separate counterparties is unlikely to be economic and would make unwinds messy. Credit support strategies (involving cash payments to and from fund cash accounts collateral documented using standard ISDA credit support annexes) could be used to avoid inadvertent breaches of the 10% limit and may become a standard feature of these products, provided E.U. regulators allow them.
Alternative Investments
The market for alternative investments, such as hedge funds, private equity and real estate, is expected to double over the next four years. There are often, however, reasons why direct investments are either prohibited or undesirable so investors turn to capital-protected structured products.
The result is that increasingly capital-protected structures are incorporating payouts linked to alternative investments. This raises challenges when these structures use the OTC route given that the assets governing the payouts are less liquid then traditional asset classes, such as quoted securities or retail mutual funds. In fact, given the relative lack of transparency of private equity investments as an asset class, the closed nature of subscriptions and the comparative underdevelopment of any regular secondary market in private equity interests, the equity derivatives business is some way off writing OTCs with payouts linked to this asset class.
By comparison, hedge funds and funds of hedge funds are more suitable for inclusion in OTC payout baskets. Hedge fund trading strategies tend to be linked to more conventional securities which makes it easier to generate mark-to-market valuations on hedge fund portfolios. There are still significant issues around the restrictions on hedging of the derivatives counterparty's payout obligations. This is largely concerned with ensuring that the OTC counterparty can trade the underlying hedge funds at net asset value (i.e. without subscription, switching and redemption costs).
Combining capital protection techniques with exposure to alternative investment strategies is proving a winning formula in the current marketplace and this looks set to continue for so long as controlled exposure to alternative assets remains attractive.
This week's Learning Curve was written by Matthew Judd, partner at Clifford Chance
in London.
