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| Risk & Reward: Product |
Safe and Sound
John Ferry
11/01/2007
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Who Buys Stability Notes?
At the moment, the market for hedge fund–linked stability notes
is specialized and still relatively small. Only professional investors are
getting involved, with most trading taking place in Europe and Asia. While a
very sophisticated private investor could enter the market, he would need a top
financial legal team in place to make sure the documentation on what constitutes
a trigger event is watertight. Over time, the products will no doubt become more
widespread, and perhaps more standardized. In the meantime, those interested in
stability notes in general could buy them linked to more common underlying
exposures other than hedge funds, such as equities. "If you look at stability
notes in general, and not just to hedge funds, that’s where we start to see
high-net-worth interest," Suhonen says.
Investors are buying stability notes linked to equity indexes, commodity indexes and credit indexes. An equity note, for example, would be put
together in the same way as a hedge fund–linked stability note, but the
possibility of making a loss would depend on the performance of an equity index,
such as the S&P 500. Once more, the loss would be worked out as a multiple
of the difference between the trigger level and the actual fall—thanks again to
the leverage effect that comes with the products.
When weighing the merits of stability notes, it is important to remember that although these vehicles are linked to the performance —or more
accurately lack of performance—of an underlying, apparently risky asset,
investors usually view them as money market alternatives, or so-called yield
enhancement products: The investor is providing insurance against a low
probability event and is rewarded accordingly.
This summer’s subprime mortgage fiasco also impacted some hedge funds. Among other failures, two Bear
Stearns’ hedge funds faltered, and others began to look shaky as losses in
credit markets started to move beyond subprime mortgage securities. A few weeks
later, Goldman Sachs said it and other investors would inject $3 billion into
one of the bank’s quantitative funds that had "suffered significantly," although
it described the move as an investment opportunity.
Those with money tied up in credit funds became spooked during
this period, and it did not take long for some professional investors to start
predicting impending disaster for the hedge fund industry. Jeremy Grantham, the
oft-quoted chairman of Boston-based Grantham, Mayo, Van Otterloo & Co., an
investment firm that manages more than $150 billion, told Bloomberg at the end
of July that credit market declines could force as many as half of all hedge
funds to close in the next five years.
That is a singularly pessimistic view, but more fallout could well be on the
horizon. Under such circumstances, investors are unlikely to be interested in
entering stability note deals linked to hedge funds that could be exposed to
complex credit products.
John Ferry is an Edinburgh, Scotland–based financial writer and a
senior correspondent for Worth.
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