# Understanding Hedge Fund Linked Principal-Protected Securities

Principal-protected securities can be attractive investments in the current market environment where investors are concerned about the loss of principal in higher-yielding investments, yet frustrated at the low returns Treasuries or other high-quality instruments offer. Protected securities assure the return of principal at maturity without limiting the upside potential of the investment. As a result, they allow investors to participate in the expected yield of hedge funds with minimal risk of losing principal.

**Principal Protection**

Without purchasing a put to provide the
protection, there are two hedging methodologies employed to protect
principal in protected securities transactions: static portfolio
hedging and dynamic portfolio hedging. In a static portfolio hedge,
the portfolio is fully and explicitly hedged with risk-free assets
at the inception of the transaction while in a dynamic portfolio
hedge, the portfolio is not explicitly hedged at inception but
rather, it is hedged (partially or fully, as needed) throughout the
life of the transaction depending on the performance of the
underlying. These transactions are often accompanied by an explicit
principal guarantee from a third party to mitigate hedge execution
risk. There are several financial institutions that offer
guarantees on hedge fund-linked protected securities transactions
subject to dynamic portfolio hedging. Such guarantors
include
**CDC Financial
Products**,
**JPMorgan**,
**Royal Bank of
Canada**,
**Zurich
Capital Markets**
and
**AIG**.

In the current interest rate environment, static portfolio hedging is too expensive to produce an attractive level of risk-adjusted return because Treasuries are so expensive. As a result, dynamic portfolio hedging has become more popular for protecting principal. Protected securities linked to hedge funds typically carry maturities of six12 years.

**Dynamic Portfolio Hedging & Portfolio Insurance**

One form of dynamic hedge was developed by
**Fischer Black**
and
**Robert Jones**
when they were at
**Goldman
Sachs**
in 1986 called Constant Proportion
Portfolio Insurance. CPPI is the most popular and broadly applied
form of the portfolio insurance model and, to the best of our
knowledge, all recent hedge fund linked protected securities
transactions have been structured using the CPPI model. Its main
advantages are that it does not involve investment in options, is
suitable for portfolios consisting of all types of marketable
securities and is relatively simple to understand and implement. In
the CPPI framework, the maximum amount of capital allocable to
hedge fund assets can be expressed as follows:

Hedge Fund Assets=(Gearing Factor)x(Portfolio NAVBond Floor)=(Gearing Factor)x(Trading Equity)

where:

*
*Bond Floor*
at any time during the investment horizon is
the

present value of the protected principal discounted at the

risk-free rate and represents the amount of riskless assets

required, if purchased, to pay the principal of the
protected

securities at maturity.

*
*Portfolio
NAV*
is the net asset value of the
portfolio (hedge

fund assets plus the defeasance, or riskless, assets less

borrowings).

*
*Trading
Equity*
is the amount by which the
*Portfolio NAV*

exceeds the
*Bond
Floor*. In other words, the
*Trading Equity*

represents the surplus of the
*Portfolio
NAV*
over the amount

of funds required to ensure that defeasance assets, equal to

the
*Bond Floor,*
can be purchased if
necessary*.*

*
*Gearing
Factor*
is a multiplier greater than one
and is kept

constant during the investment horizon. It is an implied

source of leverage to the portfolio.

After a hedge fund is selected, a gearing factor is generally set between three and five for hedge fund assets depending on the prevailing return on the defeasance assets and the risk tolerance level of the portfolio. As the gearing factor increases, the potential return on the portfolio may increase but at a higher risk of preserving capital. Thereafter, the portfolio is actively managed in accordance with the investment guidelines of the portfolio. For example, if the trading equity increases, investment in the hedge fund assets may be increased through borrowing from an external source. The trading equity may grow due to an appreciation in the portfolio value; a rise in the interest rate, which will have the effect of reducing the bond floor; or a combination of both. If the trading equity decreases, the hedge fund assets are liquidated in an amount required by the CPPI allocation formula and the proceeds are invested in the defeasance assets. The trading equity may decrease due to depreciation in the portfolio value; a decline in the interest rate, which will have the effect of increasing the bond floor; or a combination of both. In the event that 100% of the portfolio is allocated to the defeasance assets at any time during the investment horizon, the asset allocation process likely would cease.

**Asset Allocation, An Example**

The example in Exhibit 1 shows the changing allocation of assets due to changes in the portfolio's net-asset value. This example assumes that 100% of the capital raised from the issuance of the protected securities is allocated initially to hedge fund assets, the gearing factor is constant at 4.5 throughout the investment horizon and the portfolio may leverage, through an external source, up to 50% of the principal amount of the protected securities.

**Time T1: Use Of Full Leverage**

If the portfolio's NAV increases from 100% to 104% of the principal, the allocation to hedge fund assets can increase from 100% to 167% (37% x 4.5) of the principal, in accordance with the CPPI formula. However, the allocation to hedge fund assets will be limited to 154% of the principal (104% + 100% x 0.5) because the portfolio is allowed to leverage only up to 50% of the principal. This scenario illustrates the maximum permitted leverage and the allocation of all available capital to hedge fund assets.

**Time T2: Reduction Of Leverage**

The portfolio's NAV then decreases from 104% to 98% of the principal, the allocation to hedge fund assets must be reduced from 154% to 131% of the principal. This permits leverage of only 33% of the principal, which means some of the hedge fund assets are sold.

**Time T3: Elimination Of Leverage**

A further fall to 90% of the principal, will cause the allocation to the hedge funds to drop from 131% to 86%. As a result, no leverage can be used because the portfolio's NAV (90%) is greater than the maximum allocation (86%) to the hedge fund assets. The remaining 4% of the principal is allocated to the defeasance assets (not shown in Exhibit 1). This scenario shows not only complete deleveraging of the portfolio, but also a simultaneous allocation to defeasance assets due to a significant decline in the NAV.

**Time T4: Use Of Partial Leverage**

If the NAV recovers from 90% to 95%, the allocation to hedge fund assets can be increased from 86% to 99% of the principal. The appreciation of the NAV enables an increase in the allocation to the hedge fund assets by 8% of the principal. This is accomplished by releveraging the portfolio by 4% and reallocating the 4% in the defeasance assets to the hedge fund assets. This scenario shows a partial releveraging of the portfolio and a reallocation to the hedge fund assets through a deallocation of the defeasance assets.

__ __

**Certain Risk Factors**

Protected securities transactions are frequently structured with a guarantee of the payment of principal at maturity from a financial institution. As such, these securities carry the rating of the financial institution providing the guarantee. The financial institution, in turn, requires the portfolio manager to manage the portfolio in accordance with the provisions of the CPPI formula. Therefore, investors in protected securities transactions are exposed to certain risks regarding the return of principal and the return on the securities. The nature of the risk depends on the structure of the transaction, the portfolio manager, the protection provider and the characteristics of the hedge fund assets. Protected securities may also be subject to significant early redemption penalties.

*This week's Learning Curve was
written by**Brian
Lancaster**, managing director
and head of structured products research (left),
and**Jeff
Prince**, associate focusing on
CDOs, at**Wachovia
Securities**.*