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| Risk & Reward: Product |
Safe and Sound
John Ferry
11/01/2007
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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. |
Amounts of Leverage
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.
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