John Ferry
11/01/2007
The implosion of Amaranth Advisors in September 2006 was a stark reminder of the risks inherent in investing in the unregulated hedge fund industry. The fund, which managed more than $9 billion in assets, collapsed after losing roughly $6 billion in a single week. Yet, to date, Amaranth remains somewhat unique (not taking into account the eventual fallout of the subprime fiasco). This type of rapid implosion happens rarely with large funds. What’s more, the potential upside of investing in hedge funds and other alternative investments remains so high that many private investors are happy to take on the relatively small risk of collapse.
However, the big international banks that service hedge funds face a different reality. They provide investors with leveraged exposure to hedge funds, and they also sell products that offer a capital guarantee: Any money you invest you are at least guaranteed to get back—including hedge fund exposure. As investor demand for such exposure has increased, the amount of hedge fund risk that banks are sitting on has also expanded.
Anxious to get this risk off their books, the banks have come up with a product called a hedge fund–linked stability note—also known as a market default obligation—which they use as a vehicle for passing on some of their hedge fund risks. Banks designed these notes to enable investors to bet against the possibility of a hedge fund implosion. "This is a market that’s growing quite strongly because the amount of risk on banks’ books that is linked to hedge funds is pretty large right now," says John Godden, chief executive of IGS Group, a London-based hedge fund consultancy.
Hedge fund–linked stability notes let banks protect themselves against losses from hedge funds via their customers, who, in effect, sell the banks insurance against potential hedge fund losses. Though this scheme may sound convoluted, it’s actually fairly simple: The investor and the bank enter a deal in which the investor receives a steady income stream, which will be a certain number above short-term interest rates. Under the terms of the agreement, the bank will continue to pay this return until things turn bad—generally when the value of the hedge fund falls by more than a given amount. "In buying a stability note, you are saying that your return will be a steady stream of, say, Libor [a short-term money market rate of return] plus between 1 and 2.5 percent, and you will earn that return unless a very dramatic event happens in the market," says Antti Suhonen, head of fund-linked derivatives structuring at Barclays Capital in London. "The downside is that if a very dramatic move happens in the net asset value (NAV) of the fund or in the value of the underlying index that the stability note is written on, then the investment and the principal of that investment, as well as the return, are at risk."
These vehicles are linked to the performance—or more accurately lack of performance—of an underlying, risky asset. |
How dramatic that reduction in value will be depends on the amount of leverage wrapped up in the hedge fund risk that the bank is selling. Suhonen says banks typically provide investors with hedge fund exposure that is 5 to 10 times leveraged. The more leverage the stability note covers, the more risky the investment. For example, an investor and a bank enter a deal in which the former puts up $10 million. For this, the investor gets, perhaps on a quarterly basis, payments of 2 percent above short-term interest rates for the next two years. At the end of that two years, the investor gets his $10 million back, unless the NAV of a particular hedge fund—or more typically, a group of hedge funds—falls by more than 15 percent on specific observation days during that time. When this happens, it is called a trigger event, because it triggers the stability note to kick into action. If and when that happens, the investor’s principal investment—the $10 million—starts to soak up losses.
In another scenario, say the underlying hedge fund exposure is leveraged 10 times and the trigger is a 15 percent fall in value, with the NAV measured at the end of each month. If the NAV of the underlying fund has fallen by 16 percent on one of these observation days, then the loss would be 10 times the difference between the trigger level and the actual fall—in this case, 16 minus 15, multiplied by the 10 times leverage—which ends up 10 percent. If, however, on a particular observation day the NAV number is down 20 percent, then the loss is much higher, at 50 percent (20 minus 15, multiplied by the 10 times leverage). The trade would wind up at this point and the investor would have to live with that loss.
For the investor, such a return looks just like a bond investment. He puts up some principal and, in return, gets regular coupon payments that are somewhere above "safe" market rates. Rather than taking on the risk of a company defaulting on its debt payments, however, he takes on the risk that a fund (or funds) will fall in value by a certain amount. The probability of the note triggering is relatively small—despite their notoriety, cases such as Amaranth or Long Term Capital Management are rare—which is why the returns are not particularly impressive.
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.
Credit Woes Hit Hedge Fund Market
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.