Merrill Lynch has begun to structure guaranteed products with single hedge funds as the underlying risk. Although Deutsche Bank has structured similar products, most firms do not offer these types of capital guaranteed structures because it is necessary to actively hedge the underlying exposure on a frequent basis. This is because single funds do not have the same diversity as fund of hedge funds.
Steven Phan, director of equity markets at Merrill in London, said the firm started offering these products alongside its principal-protected fund of hedge funds products, because investors have been asking for instruments that have more upside potential. Single fund products are less diversified and therefore are potentially riskier but also offer greater potential returns. In addition, they give investors more upside because there are fewer fee layers, Phan explained.
The products are structured using either constant proportion portfolio insurance (CPPI) or via options, Phan said. The underlying funds are managed accounts, which allow Merrill Lynch to more actively hedge the underlying risk because they are more transparent. Phan said the firm could potentially structure these products using any type of fund as long as the fund manager is willing to disclose information to Merrill about trading strategies. In addition, it requires a performance track record. Phan said Merrill has used both internal and external managers, but he declined to elaborate on the allocation between the two groups. The latest fund on which it structured a capital guaranteed product was a long/short futures fund, he said.
