Hedge funds are a form of alternative investment that is growing rapidly. But this diverse group uses a variety of strategies with very different risk/return profiles, which can be confusing for investors. Laurent Le Saint explains the pros and the cons.
Alternative investment – a generic definition for an asset class that aims to generate absolute returns – commonly means investment into hedge funds, the collective investment funds designed to implement non-traditional portfolio management techniques. Assets currently managed in hedge funds total around $900bn and are growing at about 20% a year.
A traditional mutual fund will be considered to be a good performer if it loses less money than its benchmark in a bear market environment (positive relative performance). By contrast, a hedge fund aims for a positive absolute performance in most markets and at least to protect capital in adverse market conditions.
The regulatory environment for hedge funds allows them to go short, use leverage and trade various instruments. This makes it possible for them to neutralise the impact of market fluctuations, or to take advantage of both bull and bear trends in various markets.
Characteristics of hedge funds
This flexibility, however, also offers little protection to investors. Hedge funds are generally domiciled in offshore tax havens or registered onshore as qualified investor schemes, with few constraints in terms of investment restrictions, reporting obligations or liquidity requirements.
As a consequence, hedge funds are opaque – offering little information about market exposure, leverage or the instruments traded – and offer poor liquidity. Net asset values are typically published on a monthly basis only, while liquidity is restricted to monthly dealings at best. Equally, most funds are managed by very small asset management companies and therefore do not benefit from the protection that often comes with investment in large, established companies.
Benefits of diversification
The alternative investment industry is made up of various strategies and management styles, with very different risk/return characteristics: tactical trading (managed futures and global macro), relative value (fixed income, convertible bond or statistical arbitrage), event-driven (risk arbitrage, distressed securities) and long-short equities (with various directional bias and sector or geographic focus).
Portfolio diversification allows hedge funds to mitigate systemic and specific risks. Market conditions may be more or less favourable to an investment strategy and create performance cycles. Diversifying across a range of investment strategies maximises the return expected from a portfolio of hedge funds and minimises the risk associated with each strategy. Alternatively, diversifying across hedge fund managers reduces the risk associated with one of them underperforming against a peer group.
Structured products
Structured products linked to hedge funds have developed since the late 1990s. Most major investment banks entered the business and have played a key role in the rapid growth in assets under management.
Regardless of their underlying asset, structured products aim to transform the risk/return balance of an asset: reducing the risk while giving up some of the returns (capital protected structures), or increasing the risk in order to increase expected returns (leverage structures). They are particularly well suited to hedge fund portfolios as the absolute return characteristics of alternative investments make the cost of protection or leverage fairly attractive.
Structured products may be packaged in many different ways (option-based structures, portfolio insurance, combinations), and be linked to many different types of alternative investment vehicles (funds of funds, managed accounts, hedge fund indices). In the last couple of years, leverage transactions and hedge fund indices have developed rapidly.
Investable hedge fund indices
The success of the major equity indices like the S&P 500 is linked to the fact that they are largely traded in the form of future contracts, index-linked options or tracker funds.
But while boutique data providers have been publishing hedge fund indices for more than a decade, until last year, such indices were mainly used as an analytical tool, or as a benchmark for alternative investment portfolios and strategies. Investors were not able to trade the indices through tracker funds or forward contracts.
The poor liquidity of most hedge funds and capacity issues (the best hedge funds close to new investments after a short offering period) have made it particularly difficult to create investment products around hedge fund indices.
Heterogeneous investment styles also make it difficult to classify hedge funds into clear-cut investment strategies; managers that participate in the same strategy may run very different levels of leverage, market directionality, credit exposure, sector bias or geographical bias.
Since 2002, many established index providers – such as MSCI, Dow Jones, S&P and FTSE – have entered the hedge fund index business and have teamed up with investment banks or managed account platforms to create tradable instruments. The challenge has been to find the best compromise between liquidity, investment capacity and market representativeness.
Following the launch of MSCI’s first hedge fund indices and a comprehensive classification methodology in 2002, the “investable” version of its index was launched in July 2003 (see box). MSCI partnered with Lyxor Asset Management to provide the underlying platform of managed accounts and raised $2.5bn of assets worldwide in under a year.
Positioning of hedge fund indices
The availability of tradable indices has allowed alternative investments to develop into an independent asset class and to gain greater respectability within the institutional investment community. They also enable investors that are not familiar with hedge funds to gain exposure to the asset class without the need to select individual managers, while benefiting from the sort of liquidity they are used to. Private banking networks have already been quick to market them to medium-sized clients and the mass retail market may well be the next target, using either guaranteed products or tracker vehicles. Retail-banking networks are still looking for a way to explain the asset class to their customers, but the index solution could be the answer.
Trends in leverage transactions
Leverage has traditionally been the business of private bankers, lending cash to super high net worth individuals and taking hedge funds as collateral. Since the late 1990s, investment banks have progressively entered the leverage arena. With their tool kit of over-the-counter (OTC) options, warrants, leveraged certificates and forwards, they also brought a new approach to the leverage business: leverage on hedge funds became a specialist derivatives business. Now, it is all about avoiding credit risk on the investor and treating leverage as a pure market transaction.
At the same time, leverage ratios – and risk – have significantly increased. While the standard collateralised loan in Geneva was typically provided on a 1.5x to 2x basis ($0.50 to $1.00 is lent for every dollar of capital committed by the investor), it is now very common for experienced hedge fund investors to look for 3x to 4x leverage. Due diligence on hedge funds, as well as dynamic risk management of the underlying portfolio, is now an integral part of the transaction.
Recently, more and more funds of funds have launched a leveraged class of flagship products. Custodian banks were traditional leverage providers for funds of funds – but for bridge financing purposes only, with credit facilities usually capped between 25% and 50% of the funds’ net asset value. Now, funds of funds have started to look at borrowing 100% or more of their capital.
Limited recourse
But why has leverage become so popular? With interest rates at record lows, it is very cheap to borrow money. At the same time, investors have become more optimistic about markets in general and hedge fund performance in particular, making the breakeven of leverage transactions looks very acceptable.
Leverage has also become a way to deploy capital more intensively and efficiently – particularly with limited recourse, a feature that makes the deal very attractive to investors. This limits recourse to the hedge fund portfolio only, protecting the investors other assets from a claim by the leverage provider.
A such, cash extraction strategies clearly illustrate what leverage can offer. Assume an investor whose capital is primarily invested in hedge funds. He finds a new business in which he wants to invest, but borrowing for buying a company that will generate cash flows (if any) only after an incubation of several years is a risky transaction. The other solution is to liquidate his assets, which is an unattractive prospect. Instead, he can transfer his hedge fund portfolio into a collateral account with an investment bank, agree on a lending value (lower than the initial portfolio value) and receive this value in cash. The bank will take its interest rate from the hedge fund performance (no cash flow to be paid by the investor) and would only sell hedge funds if the value of the collateral decreases too much. If the performance is so bad that the collateral value becomes lower than the loan made to the client, the portfolio is liquidated but the investor is not called for additional margin.
Forms of leverage (packaging)
Some transactions have been structured in the form of collateralised fund obligations (CFOs). A portfolio of hedge funds is placed into a special purpose vehicle (SPV) and the liability part of the balance sheet is tranched into equity and senior debt parts. The senior receives an interest rate with a spread over Libor. The equity receives the hedge fund performance, after the SPV has paid the interest rate to the senior. This looks very much like the senior lending cash to the equity with hedge funds as collateral. If the performance is so bad that the hedge fund portfolio value is lower than the nominal of the senior debt, then the senior debt holders receive less than their initial capital (hence being rewarded with the spread over Libor).
But CFOs are complex transactions with high arranger fees; as such, they are a fairly inefficient and costly means to achieve leverage. Two more efficient alternatives are fund-linked products, where the owner of the underlying portfolio is the leverage provider, and collateralised loan transactions, where the investor keeps his ownership on the hedge fund portfolio.
Fund-linked products are typically structured in the form of options. Options can be “delta-one” in order to synthetically replicate a traditional loan, or be true derivatives. A delta-one option is simply an in-the-money call option, where the premium corresponds to the equity (the capital committed by the investor) and the strike price corresponds to the loan. The strike price increases over time with accrued interests. At maturity, the option buyer receives the value of the underlying hedge fund portfolio minus the strike (ie, the loan and accrued interests). In order to hedge the call, the option writer simply buys the underlying hedge fund portfolio and sells it back at maturity. During the investment period, if the value of the underlying portfolio decreases down to certain trigger levels, the option writer would de-leverage the product through resetting the strike price and the nominal exposure (which corresponds to selling hedge funds and redeeming a part of the loan). The de-leverage/re-leverage mechanism can also be embedded in an underlying fund of funds, as well as the interest payments, instead of having them in the option pay-off.
Options can be traded in the form of OTC transactions or can be securitised and sold in the form of warrants or leveraged certificates. The advantage of the security is that it can be split into several accounts or transferred easily.
Collateralised leverage transactions are suitable for investors looking to keep their ownership over the hedge fund portfolio. They are more complex to implement than options, as they require more documentation. But it is possible to organise a standardised set up, providing investors with a full package including the custody facility, the pledged account and the leverage facility. The objective is to be able to deliver a leverage facility for a high gearing, but still provide the limited recourse feature.
A third option is to deliver the product in the form of funds (investment companies or trusts) with embedded leverage. The investor buys the fund, which borrows from the bank and invests the leveraged asset in the portfolio of hedge funds. Leverage is provided to the fund either by a fund linked product or a collateralised leverage transaction.
Laurent Le Saint is head of structured alternative investments
The msci® hedge invest fund
The hedge funds that make up the index are all listed investment companies incorporated by Lyxor. Each investment company is a segregated entity managed by an established hedge fund manager, according to a management mandate granted by Lyxor.
This set-up has several advantages:
- Transparency: the mandate given to the hedge fund manager details the investment policy, which allows analysts to classify the hedge fund based on the exact portfolio and trading characteristics, rather than on performance data or declaration from the hedge fund manager.
- Strict valuation process: the valuation process is controlled by Lyxor and its administrators according to a methodology that is the same for all hedge funds using the same strategy. All managed accounts publish weekly net asset values, corresponding to real mark-to-market prices
- High liquidity: the managed accounts allow weekly dealings at net asset value, subject to one-week notice. The size of the platform (Lyxor manages $20bn in hedge fund products) allows it to absorb the liquidity without it being a handicap for the underlying hedge fund managers.
- Investment capacity: Lyxor negotiates capacity with its hedge fund managers, in order to ensure that each managed account will be able to absorb significant amounts of assets.
The above characteristics are key to success, but are not sufficient to make the index a “true” index. Liquidity and capacity features must compromise with a rule-based, representative methodology that makes the index a benchmark of the asset class (and not another fund of funds packaged as an index).
- Neutral and objective: inclusion of funds in the index must be on the basis of objective set of rules and guidelines. The index construction process must be fully disclosed in the index methodology.
- Diversified: the index must represent all the liquid strategies available in the industry and include enough fund managers in order to represent most investment styles.
- Representative: the index must be weighted in order to be representative of the global allocation of assets in the industry.
The MSCI Hedge Invest Index started with 64 funds in the allocation, representing 11 different investment processes. Since the re-balancing of May 2004, the index comprises 88 funds with 13 investment processes.
