A small but growing number of structured products allow sophisticated investors to bet against a hedge fund implosion as part of efforts by investment banks to reduce their exposure to extreme events in the sector, the report says.
The products, typically called stability notes but also known as market default obligations, allow the banks to pass on risks they are taking from the rapid expansion of demand for geared or capital guaranteed products linked to hedge funds. Rather like insurance for natural disasters, investors are unlikely to lose. But be warned - if they do lose, they lose everything.
The entirely private market for stability notes is small, with estimates of its size varying from $1bn to $2bn. But with investor appetite for structured hedge fund products already in hundreds of billions of dollars and rising at 20-30 per cent a year, many specialists think banks will soon want to lay off significant chunks of the risks they are taking on hedge funds - prompting a flood of stability note issuance. According to bankers, a typical stability note linked to a five-times geared portfolio of hedge funds with reasonable liquidity might pay one percentage point over Libor.
“What has really stopped the market taking off is that each bank has committed a lot more risk budgeting to this issue so they don’t need to do it yet,” said John Godden, founder of the hedge fund consultancy IGS.
The risk is reasonably well known from the structuring of products linked to mutual funds, and is dubbed “gap risk”. At its simplest, it is the risk that a fund - typically a fund of hedge funds, but sometimes an individual name - falls by more than the equity put up by an investor between valuation points, which for hedge funds are often monthly or quarterly.
For example, on a three times geared structure where an investor puts up $10m and the bank $30m, if the hedge fund falls more than 25 per cent in a month the bank starts to face losses. If it falls exactly 25 per cent, the loss is $10m - so the investor is wiped out. But the bank redeems the remaining $30m and loses nothing.
Banks are taking on more of this risk, and several have been building up specialist teams in the past few years to satisfy the demand for guaranteed and geared hedge fund structures.
The demand comes both from wealthy individuals and institutions, with even retail markets in some countries, such as Japan, opening up to guaranteed hedge fund products. Asian investors outside Japan are generally willing to accept more volatility from products such as geared structures.
Institutions investing in hedge funds for the first time are also buying guarantees. Those more familiar with the industry are graduating to geared products to try to boost returns or limit regulatory capital requirements. Funds of hedge funds are further adding to the demand for leverage after two years of weak returns, using geared share classes or structured loans linked to their portfolios to increase their appeal to investors.
As a result, hedge funds are increasingly finding that banks setting up structured products are big clients, with a different set of demands from their ordinary investors.
“We are more interested in stability and avoiding extreme events than strictly the performance,” said Paul Coleman, director of investor solutions at Barclays Capital. “The hedge fund managers need to ask how far they should come to meet the investment banks, who want greater liquidity than the funds ideally would like to provide.”
[Hat-tip to Fintag for inspiring the headline]