The lucrative business of writing protection on hedge funds and fund of funds is under threat because traditional fund managers are getting jittery about banks using mathematical models to determine when to move cash in and out of the managers' funds. Fund managers who have branched out into hedge funds and fund of funds are concerned the models, known as constant proportion portfolio insurance, create the appearance of market timing, short-term trading that disrupts the running of the fund. This is not illegal in the U.K., but the Financial Services Authority may impose fines or require compensation to be paid if it believes investors have lost out because of market timing.
Schroder Investment Management and Invesco are among the managers wary of the protected products and their compliance teams are setting strict guidelines for products linked to their funds. The asset management industry as a whole is sensitive to market timing problems following high-profile investigations in the U.S. and Europe into retail mutual funds this year.
The problem arises when managers offer a share class to banks which can be traded more frequently than those held by individual investors. Banks with exposure to the underlying funds can better manage risks they take on, by moving in and out of the underlying quickly when other investors might only be able to trade at monthly or three-monthly breaks. Fund managers who offer banks higher frequency trading in their funds compared to ordinary investors may be more susceptible to market timing, saidAndrew Irvine, previously head of structured products at Investec Financial Products and now setting up his own structuring boutique in London.
"The bank should not do anything that is different to what any other investor can do," agreed Tim Hailes, assistant general counsel at JPMorgan in London and co-chair of the International Swaps and Derivatives Association equity derivatives working group on hedge funds. Hailes said ISDA will look to include guidelines on adjustment provisions for CPPI fund products in its supplement to the 2002 equity derivatives definitions (DW, 9/17).
Reputation risk has already put some fund managers off CPPI products. Fidelity Investments announced earlier this year that it would not allow any structured products to be issued on its mutual funds, due to concerns banks' delta hedging activity was making the funds more volatile. Other fund managers, including Scottish Life International, have been put off CPPI because it is a difficult product to explain to retail investors. Structured fund products, however, have been a lucrative area for banks this year and derivatives houses prefer writing CPPI to pricing options on funds because the banks cannot hedge the fund volatility in options.
