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Hedge-Fund Linked Notes Gain Popularity In Equities

Depressed equity markets fueled a surge in popularity for equity-linked hedge fund products and absolute return strategies, highlighting the year in synthetic equity developments. Capital guaranteed funds, some with lookback options, were also popular as investors turned bearish and world economies, particularly in the U.S., teetered toward recession.

Products structured on hedge funds have been the flavor of the year. "It's something we've seen a lot of, there have been a lot of trades done on them and it will be a big part of the business next year, too," said Jon Sandelman, head of equity financial products at Banc of America Securities in New York. He said the woeful underperformance of traditional money managers led investors to turn to hedge funds, both as a synthetic underlying and of course in the cash market. Stéphane Liot, global head of fund derivatives at BNP Paribas in Paris, agreed with Sandelman's reasoning and estimated that the guaranteed-fund of hedge funds market has doubled to around USD6 billion in the last year. Several banks, including HSBC, Credit Lyonnais, Dresdner Kleinwort Wasserstein, KBC Financial Products and Deutsche Bank, established a department as a response to the demand (DW, 1/21, 3/11, 3/25, 7/15, 9/23).

Johan Groothaert, managing director and head of equity structured products and alternative investments at Deutsche Bank in London, said higher volatility, especially after the terror attacks, coupled with low interest rates also led to a rise in so-called constant proportion portfolio insurance strategies, or CPPI. In this strategy the firm moves investment out of the hedge funds and into risk-free assets if the fund starts to lose value. Groothaert noted that the combination of low rates and low vol would severely limit investors' participation in traditional equity-linked notes structured with equity options, but by using the CPPI strategy and maintaining a risk-free pool of assets, managed structured notes can have increased participation and upside potential.

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