An Overview of Hedge Funds and Structured Products

An Overview of Hedge Funds and Structured
Products: Issues in Leverage and Risk
Adrian Blundell-Wignall
With their high share of trading turnover, hedge funds play a critical role in
providing liquidity for mis-priced assets, particularly when large volumes
are traded in thin markets – thereby reducing volatility. This activity is
particularly important, given the rapid growth in volume of new-generation
structured products issued by investment banks.
Hedge fund leverage estimated via an induction technique suggests a
leverage ratio that must be above 3 (versus total AUM of USD 1.4 trillion).
Gearing is required to boost returns where low risk and low return styles
are implemented. Investment banks are well capitalised against hedge fund
exposure.
“Structured products” are one of the fastest growing areas in the financial
services industry, and may already be over half of the notional size of the
hedge fund industry (AUM plus leverage). These products, constructed by
investment banks, are extremely complex using synthetic option replication
techniques, and offering a variety of guarantees in returns. They are sold to
retail, private banking and institutional clients. Hedge funds help reduce
volatility risk for investment banks in supplying these products.
Structured products are passive in nature (unlike hedge fund active styles),
focusing on providing returns for different risk profiles of clients. These
products have not been tested when major anomalies in volatility arise. They
are highly exposed to downward price gaps in the „risky‟ assets used in their
construction. Considering the potential for such a crisis scenario, two major
policy conclusions emerge: The importance of (1) stress testing of
investment banks‟ balance sheets; and, (2) given the large retail market
segment, consumer education and protection.
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An Overview of Hedge Funds and Structured
Products: Issues in Leverage and Risk
Adrian Blundell-Wignall*
Executive summary
*

The size of the hedge fund sector, using IOSCO sources and
results from responses to an OECD Questionnaire on Hedge
Funds, is around USD 1.4 trillion in assets under management
(AUM). While this does not seem that large compared to total
global AUM, the hedge fund share of trading turnover (augmented
by leverage and investment style) is much greater than its share of
global AUM.

On the issue of volatility, this paper shows that hedge funds play a
critical role in providing liquidity for mis-priced assets – arbitrage
opportunities – particularly when large volumes are traded in thin
markets. This is a volatility reducing activity. This activity is
particularly important, given the rapid growth in volume on newgeneration structured products issued by investment banks.

Hedge fund return performance, costs and style data can be
combined to back out an implied number for global hedge fund
leverage (in the absence of any hard data). The leverage ratio has
to be well above 3 to come even close to consistency with the
performance return numbers – leverage of over USD 5 trillion is
implied.

This leverage does not imply undue risk. This is because gearing is
Adrian Blundell-Wignall is Deputy Director in the OECD Directorate for
Financial and Enterprise Affairs. The opinions expressed and arguments employed
herein do not necessarily reflect the official views of the Organisation or of the
governments of its member countries.
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Financial Market Trends, N°92, Vol. 2007/1
required to boost returns on AUM for investors in hedge fund
activities which, by their very nature, are low risk – because hedge
funds to a large extent engage in market-neutral arbitrage activities
that do not depend on the direction of the market.

Investment banks have strong capital adequacy, in particular with
respect to their hedge credit fund exposures – some estimates of
which are provided below.

Ironically, the fastest growing area of new financial products that
utilise highly-complex derivative products exclusively lies mostly
within the regulated sector. This is the market for “structured
products” that are produced by investment banks and sold to retail,
private bank and institutional clients. The strong volume growth in
this area, particularly in Europe and Australasia, creates ex-ante
derivative pricing pressure, and hedge funds frequently take the
other side of the trades (reducing ex-post volatility).

The size of this market is very roughly estimated to be around
USD 3.8 trillion, already over half of the notional size of the hedge
fund industry (AUM plus leverage), and growing quickly in the
last two years.

Structured products are passive in nature (unlike hedge fund active
styles), and focus on providing returns (for different risk profiles
of clients) with some element of capital guarantee. Constant
proportion portfolio insurance (CPPI) is one of the popular newgeneration techniques. These products have not been tested when
major anomalies in volatility arise. They are highly exposed to
downward price gaps in the „risky‟ assets used in their
construction.

The potential for a crisis scenario in the event of such anomalies in
volatility, with multiple investment banks having to close
positions (due to „knock-on‟ effects) is considered. Hedge fund
and other counterparty‟s ability to meet calls in this situation
would affect the size of the balance sheet risk for investment
banks.

This raises two main policy issues. (1) The balance sheet risks to
investment banks offering guaranteed products: stress testing for
worst case scenarios and ensuring capital adequacy for them is
important to reduce concerns about financial stability; and (2) given
the large retail market segment, consumer education and protection.
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I.
What is a hedge fund?
Hedge Funds have grown quickly over the past ten years,
and are important part of the financial landscape. They are
difficult to define as entities, because the line between what
hedge funds do that other institutions do not is blurred –
proprietary traders in investment banks, private equity funds,
and fund managers all use extensive leverage and derivatives
to trade markets or to shift risks.
Lightly-regulated
active investment
style using
derivatives
The definition of a hedge fund used here is as follows:
lightly-regulated managers of private capital that use an active
investment approach to play arbitrage opportunities that arise
when mis-pricing of financial instruments emerge. Extensive
use of leverage and derivatives is a common feature of hedge
funds.
The main differences between a hedge fund and a private
equity fund are: (a) the private equity fund looks to use
leverage to buy companies to obtain full management control
for purposes of changing its structure operations, whereas a
hedge fund trades assets without looking for full control; (b)
the hedge fund covers a multitude of styles, only one small part
of which might involve buying shares to force management to
make value enhancing changes (activist); and (c) hedge funds
often (but not always) have a shorter investment horizon than
private equity firms.
They play a key role
in providing liquidity
II.
Overall, hedge funds fill a broad role in providing liquidity
in markets where pricing anomalies have occurred, often due to
lack of breadth. In the main this is a volatility reducing activity
that is an essential part of the efficient working of financial
markets and financial stability.
Hedge fund industry size: AUM versus turnover
Size of USD 1.4
trillion AUM
At the start of 2007, estimates suggest that hedge funds
have over USD 1.4 trillion assets under management
(considerably less than the USD 18 trillion in mutual funds;
see Table 1). Some high-end estimates have it higher at closer
to USD 2 trillion. The bulk of hedge fund activity is in the
United States, followed by the United Kingdom and EU (ex
UK), with Australasia next.
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Table 1. Hedge funds’ assets under management (AUM)
Country
Mid 2006 Estimates
$bn
USA
870
UK
320
EU
118.4
Australia
47
Non-Japan Asia
34.05
Switzerland
23.1
Canada
11
Japan
7
TOTAL
1430.55
Source: IOSCO; and OECD Questionnaire on Hedge Funds.
Augmented by
leverage
Of course the „fire-power‟ of hedge funds is greatly
augmented beyond this by leverage, though the amount of
this is uncertain due to lack of reporting and the difficulty of
assessing the implicit gearing of derivatives.
Table 2. Shares of hedge fund trading in the US market
Shares of Hedge Fund Trading in US Markets
%
30
60
33
45
47
33
25
Cash equities
Credit Derivatives (plain vanilla)
Credit Derivatives (structured)
Emerging Mkt Bonds
Distressed debt
Leveraged loan trading
High Yield bond trading
Source: Greenwich Associates, as reported in The Financial Times.
And have a large
impact on market
turnover
Leverage, when combined with a rapid and focused
trading style, allows hedge funds to have a much bigger
impact on market turnover than the AUM figures would
suggest. In Table 2 data from Greenwich Associates suggests
that hedge funds account for between 30% and 60% of
market turnover, depending on the financial instrument
concerned. This of course is very large indeed, and illustrates
why understanding financial market behaviour today without
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An Overview of Hedge Funds and Structured Products
including explicit analysis of hedge funds is quite
impossible.
Two concerns often raised with respect to hedge funds
are: (a) that they create volatility in markets due to their
large role in turnover, and (b) that the leverage they
undertake may raise financial stability issues, where defaults
with counterparties occur – an issue given some credence by
the late 1990s failure of LTCM, that required a major private
bank-led work out to resolve.
III.
Hedge funds reduce volatility
Volatility-reducing
role
The analysis in this paper suggests that hedge funds play a
very positive role in financial markets by providing liquidity to
thin markets where mis-priced financial instruments are to be
found. This type of activity reduces volatility rather than
increasing it.
Particularly given
the growth of
structured products
Indeed with the rapid growth of structured products in
recent years, particularly in Europe and Asia, hedge funds
have been quite critical in containing the volatility that might
otherwise have arisen. Structured products are largely driven
by investment banks, and have resulted in the proliferation of
new and highly-complex derivative products (discussed
below).
Figure 1 shows the VIX index of market volatility, the
junk bond versus AAA spread and the TED spread (the
offshore Eurodollar 3-month rate versus the 3-month
Treasury). Volatility has fallen, and spreads have narrowed.
Hedge funds are put
sellers in the carry
trade
In large part, spread narrowing in the past few years has
been a process that has been driven by hedge fund or „carry‟
trades. These carry trades are usually implemented with
derivatives. A spread emerges where risk premia in two
financial instruments differ. These are taken advantage of by
selling puts. These pay the seller a premium in income
(positive „carry‟) and work as long as the spreads do not blow
out as a consequence of some credit event. The buyers of puts
(the other side of the trade), have negative carry (they pay a
premium to the seller) and so continually lose money as
markets rally and spreads narrow. Buyers rely for profit on an
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adverse credit event to occur to put them „in the money‟. The
longer this does not happen the greater is the incentive of
buyers of puts to stop further losses by quitting the trade. As
this occurs the spreads have to narrow further (because buyers
of puts need to be induced by further price action). In the
absence of exogenous risk events, volatility continues to fall
and spreads narrow.
Structured products
are natural buyers
of puts
Passive buyers of puts, including investment banks buying
for capital guarantee purposes in structured products, benefit
from spread narrowing in pricing their products for retail,
private banking and institutional clients – encouraging the
growth of this market.
Figure 1. Falling volatility narrowing spreads
Market volatility, corporate spreads and the TED Spread
60
%
%
VIX
Corp Sprd(RHS)
TED Sprd(RHS)
9
8
50
1987
40
7
Tech Bust
S&L/LBO Crises
Asia/LTCM
6
5
30
4
20
3
2
10
1
0
Feb-86
0
Feb-89
Feb-92
Feb-95
Feb-98
Feb-01
Feb-04
Feb-07
Source: Thomson Financial Datastream.
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IV.
Hedge fund performance, fees and costs
Table 3 shows hedge fund composite performance
reported in Thomson Financial Datastream versus the MSCI
global equity index. These returns are net of MERs
(management expense ratios, arising from trading), incurred
as costs to make the returns, and fund manager costs.
Hedge fund
performance has been
declining
Three things stand out: (1) hedge funds have managed to
outperform the global index on average, but not every year;
(2) hedge fund performance is correlated with global
performance, but does much better relatively when equity
markets are weak or falling (good diversifying
characteristics); (3) both total and relative performance have
declined in the 2000‟s.
Table 3. Hedge fund performance
Year
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Av 1991-99
Av 2000-06
Equities
World Index
16.0
-7.7
23.1
4.1
14.4
10.9
11.3
19.6
30.5
-16.4
-17.6
-18.5
34.8
15.5
11.2
21.3
13.6
4.3
Hedge Fund
MSCI Universe
32.2
21.2
30.9
2.6
25.7
18.0
18.3
7.9
26.4
15.0
7.6
2.5
15.4
6.9
8.1
11.3
20.4
9.5
Ret Diff
16.2
28.9
7.8
-1.5
11.3
7.1
7.0
-11.7
-4.2
31.3
25.2
20.9
-19.4
-8.6
-3.0
-10.0
6.8
5.2
Source: Thomson Financial Datastream, Hedge Fund MSCI universe.
Hedge funds have to
spend a lot to make a
lot
Hedge funds‟ massive share of turnover means that they
pay a lot to investment banks for their activities (execution
costs), and the funds have to pay their fund managers very
well. MERs are very high for hedge funds, compared to
mutual funds (due to turnover). Broking estimates suggest
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that about 25% of the pre-MER-traded returns are absorbed
by fees paid to hedge fund managers, and around 20% are
absorbed by execution costs to prime broker dealers, i.e.
about 45% in all. So for the 11.3% return in 2006, hedge
funds would have earned 11.3/(1-0.45)=20.5% before
MERs.
Which pushes towards
more leverage
The point here is that to generate double digit returns to
investors, hedge funds would have to try to earn raw preMER returns of 20% or so, and this further pushes pressure
towards more leverage (to gear up the return from investing
in low risk and return spread trades).
V. Hedge fund styles
Long-short styles
dominate
A summary of the different styles of hedge funds and
the proportion of the market they occupy is shown in Table
4, based on Hedge Fund Industry Research data. An
indication of the broad activity involved in the style is
shown on the right hand side. Most of these strategies are
long-short in nature: all of the equity hedge (e.g. long a
stock and long a put to hedge its fall); most of event driven
(e.g. buy the target M&A company and sell the buyer); all of
relative value arbitrage (e.g. buy the London listing and sell
the Sydney listing if an arbitrage spread premium opens);
and all of sector, convertible arbitrage and equity market
neutral. The macro (e.g. long only) and other (e.g. corporate
governance activist, structured products, etc.) categories
include directional riskier plays.
Low-risk spread
trades require
leverage to make
returns
The dominant nature of this long-short or spread trading
activity explains why hedge funds do so well in market
downturns (i.e. it is not directional). But it also explains why
leverage needs to be relatively high: investing in a strong
stock market generates strong returns, while investing in a
low-risk spread in a long-short strategy does not. So the
trade has to be levered up a number of times in order for the
spread trades to generate competitive returns (while keeping
the benefit of avoiding directional risk in the market).
This understanding of how the various styles work,
together with the return and MER cost information, can be
used to get some idea of overall hedge fund leverage.
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Table 4. Hedge fund styles
Style
%
Equity Hedge
Event Driven
Relative Value Arbitrage
Macro hedge
Sector
Distressed securities
Emerging markets
Equity non-hedge
Convertible arbitrage
Equity market neutral
Other
TOTAL
Equities activities
Long short activities
29
14
13
11
5
4
4
4
3
3
10
100
61.0
72.5
Nature of Strategy
Stock+deriv strategies
M&A, spin offs, bankrupcy re-org
Listing same security in 2 diff mkts
Directional plays
Long one versus another
heavy dicount work outs
Equity and debt
Activist raids
Buy convertible sell stock
Long one stock short another
Note: The equities activities are very approximate and (apart for obvious categories) assumes ½ of
event driven, ½ of relative value arbitrage, ½ macro, ½ of emerging markets, ½ of convertible
arbitrage, and none of other is equity related. Long-short (apart from obvious categories) assumes
75% of event driven, ½ of other, and none of macro, distressed securities and emerging markets is of
the long-short variety.
Source: Hedge Fund Industry Research Report Q3 2006.
VI.
Implied hedge fund leverage
Data on hedge fund
leverage is difficult to
find, and more work
needs to be done in
this area
It is difficult to find data on hedge fund leverage, and
more work needs to be done in this area. Illustrative
calculations based on the nature of returns and the type of
hedge fund activity can be used to infer some idea of the
amount of leverage involved. These calculations show that
hedge funds are likely to be somewhat less levered than
banks and broker-dealers. This is as it should be, since
banks come within the purview of regulation and
supervision, and benefit from lender-of-last-resort facilities
– they can take on more risk.
A simple calculation to
imply leverage
The calculation is shown in Table 5. The fund styles are
combined around the nature of returns: (a) low returns for
fixed income arbitrage, about USD 97 billion in AUM – and
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Financial Market Trends, N°92, Vol. 2007/1
here we assume a 1% return (somewhere between the very
low TED spread of around 0.5 ppt and the high 2 ppt spread
on junk bonds versus AAA shown in Figure ); (b) medium
returns for equity type spreads of about 4%, reflecting the
average equity risk premium, with about USD 919 billion in
AUM; and (c) high returns for outright equity type long
positions, with about USD 415 billion AUM – the 20%
return for this grouping shown in the table is roughly equal
to the MSCI return for 2006 shown in Table 3.
The implied leverage then is simple enough to calculate.
Fixed income arbitrage managers would need to have geared
their portfolios 19 times to generate the 20% pre-MER
return earned in 2006 (in order to give the observed 11% to
investors). This implies gearing of USD 1 835 billion, in
addition to the USD 97 billion in AUM. Other long-short
styles would have had to gear only 4 times to generate 20%,
implying USD 3 676 billion in gearing. Finally, the long
only funds would not have had to gear at all to generate the
20% return in 2006.
Table 5. Implied hedge fund leverage calculation
Fixed Income Arb.
Other long short
Long Only
Total
AUM
$bn
96.6
919.1
414.9
1430.6
Req Ret
%
20
20
20
Observed
Return %
1
4
20
Req Asset For
20% ret on AUM
$bn
1931.2
4595.6
414.9
6941.7
Implied
Leverage
Gearing $bn Ratio on AUM
x
1834.7
19
3676.5
4
0.0
0
5511.2
3.9
Source: OECD.
USD 5.5 trillion hedge
fund leverage number
Together these 3 groupings imply an overall leverage
ratio of only 3.9 times, or a total leverage of USD 5.5 trillion
compared to the USD 1.3 trillion of funds under
management. The bulk of this USD 5.5 trillion will come
through implicit leverage in derivatives (see below).
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VII.
Counterparty risk with prime brokers
Table 6 uses publicly available information on prime
broker counterparty exposures, using (published) company
report balance sheet data. The 10 largest prime brokers in
the area of counterparty risk were chosen, and these cover,
on our best estimate, about 80% of the total. Margin lending
is not broken out of other credit activities in the publicly
available reports. Counterparties are typically other banks
and hedge funds.
Table 6. 10 Prime brokers: published credit exposure to counterparty risk
As of December 2006
UBS
Credit Suisse
Deutsche
Goldman
Morgan Stanley
JP Morgan
Lehman
Merrill
Citigroup
Bear Stearns
TOTAL
Grossed Mkt Tot.
(Top 10 =80%)
Loaned
Securities
$bn
52
48
31
22
150
9
18
43
60
11
444
Ratio
to
Tier 1 Capital
1.56
1.65
0.95
0.66
4.07
0.11
0.96
1.09
0.66
0.89
1.09
Reverse
Repos
$bn
333
140
183
82
175
122
117
178
121
39
1491
Ratio
to
Tier 1 Capital
10.01
4.87
5.66
2.45
4.74
1.51
6.33
4.47
1.33
3.03
3.65
Derivatives
PRV
$bn
269
45
99
68
55
56
23
32
50
12
708
Ratio
to
Tier 1 Capital
8.10
1.57
3.08
2.02
1.50
0.69
1.22
0.80
0.55
0.91
1.74
Margin Loans
NYSE Total
$bn
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
275
Total Credit
Exposure
$bn
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
2926
Tier 1
Capital
$bn
33
29
32
34
37
81
19
40
91
13
408
555
1.09
1864
4.57
885
1.74
367
3672
510
Source: Prime broker published balance sheet accounts; Thomson Financial and OECD estimates.
There are four key areas where prime brokers generate
credit exposure in their financing relationships (counterparty
risk). These are:
Sources of credit
exposure in counterparty risk
1.
Securities lending: the bank lends securities to
hedge funds and others, and gets cash or other
securities as collateral (found on the liabilities side
of the balance sheet as cash received as collateral for
securities lent). Hedge funds, for example, borrow
stock in order to short securities. Other banks also
borrow stock.
2.
Reverse repurchase agreements: the bank buys
securities from a hedge fund etc. which in turn
commits to buy them back (found on the asset side
of the balance sheet) – the hedge fund gets a credit,
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but counterparty risk arises in the event that the
customer cannot fulfil its obligations. This is an
important mechanism of hedge fund borrowing.
3.
Derivatives: derivative contracts with hedge funds
create counterparty risk (found on the asset side of the
balance sheet), which is measured as their positive
replacement value (PRV). This is equal to the cost to
the bank of replacing all the transactions with a fair
value in the bank‟s favour, if all the relevant
counterparties of the group were to default at the same
time. This is a margin account concept, and massively
understates the notional value of derivatives contracts
(potential command over securities).
4.
Margin loans: the bank advances a loan to a hedge
fund (asset side) and gets a security from the hedge
fund as collateral (usually cash and securities). As
mentioned above, this important activity is not
separately disclosed by prime brokers. However, we
have total margin lending by members of the NYSE,
which is shown in the table.
The bottom line of the table grosses up the numbers
for industry totals, by assuming that 80% is covered by the
top 10 firms. For the margin lending we assume 75% is
covered by member of the NYSE.
But capital adequacy is
very high in general
The main point to note is that counterparty exposure
differs considerably between the prime brokers, with higher
risk-taking firms (to generate higher returns) showing high
exposures relative to tier 1 capital, and more conservative
firms showing much lower ratios. The total exposure of the
top 10 firms is about USD 2.9 trillion, and total Tier 1
capital is around USD 408 billion. The capital adequacy
ratio vis-a-vis these activities is about 14%, which is very
high. Furthermore, it should not be forgotten that there are
offsetting collateral and risk measures taken throughout the
market, and some of the measures like PRV of derivatives is
the amount that would apply if 100% of the counterparties
were to default. In other words, the call on capital is likely
to be low overall.
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This does not mean, however, that major stability issues
cannot arise in the case of concentrations of risk for
particular firms.
Exposure of prime brokers to the hedge funds group
One prime broker amongst the top 10 firms separates
out its exposures between bank and hedge fund
counterparties, for 3 of the 4 categories above (excluding
margin loans). We have used this as a guide, together with
broad discussions with other market participants, to come up
with shares for each of the 4 activities as they pertain to
hedge funds, shown in Table 7. Notice that these numbers
are also broadly in line with the Greenwich percentage
numbers on share of hedge funds in market turnover (see
Table 2).
And particularly so
with respect to hedge
funds
Overall, the prime brokers are very well capitalised
against hedge fund exposures. The exposure of prime
brokers to hedge funds, as a ratio to Tier 1 capital, is 2.4.
This is equivalent to a capital adequacy of around 42%
versus the hedge fund sector.
Table 7. Hedge fund shares of prime broker counterparty exposure
Loaned Securites
Reverse Repos
Derivatives PRV
Margin Loans
Total
Total
Ratio to
Credit Exp $bn Tier 1 Capital
555
1.09
1864
3.65
885
1.74
367
0.72
3672
7.20
Hedge Fund
$bn
222
466
292
242
1223
HF% Total HF Exp Ratio to
Exposure
Tier 1 Capital
40%
0.44
25%
0.91
33%
0.57
66%
0.48
2.40
Source: Prime broker published balance sheet accounts, Thomson Financial and OECD estimates.
The overall credit exposure of prime brokers with
respect to hedge funds is estimated to be around USD 1.2
trillion. This number is not far off the AUM of the hedge
fund industry that we discussed earlier – possibly reflecting
the fact that most hedge fund trades are carried out with
derivatives, and other activities that require cash margin
deposits or collateral to be posted. It is these sorts of
deposits that are picked up in the prime broker accounts.
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Derivatives are the
biggest source of
leverage for hedge funds
VIII.
The command over notional assets, however, is much
stronger than reflected here. The implicit leverage in
derivatives is very large. If we took out USD 5.5 trillion
calculation for total leverage, and treated loaned securities,
reverse repos and margin loans as fully collateralised, then
derivatives PRV of USD 292 billion would, as an example,
reflect an implicit derivatives leverage of USD 4.6 trillion
(= USD 5.5 trillion – USD 0.9 trillion other debt).1 So
derivatives are easily the biggest source of leverage for
hedge funds.
What is a structured product?
Structured products are
not discretionary
The term „structured product‟ is the name given to an
investment product that provides a return that is predetermined with reference to the performance of one or
more underlying markets. The performance of a structured
product is therefore based only on the performance of this
underlying product and not on the discretion of the product
provider. Most often the product relies on the use of
derivatives to generate the return, and contains downside
protection or guarantees of some form via options.
Structured products are therefore passive in nature,
with the cost depending on option and other derivative
premia. This contrasts with hedge funds, where the fees are
justified on the basis of buying the manager‟s active skills.
Structured products may be of the growth variety,
offering equity-like returns, but typically including varying
elements of capital protection. They also include structured
notes, which replicate fixed income products. CDOs
(Collateralised Debt Obligations) and CLOs (Collateralised
Loan Obligations) would fit into this category of
description if they came with derivative transformations.2
1.
This would imply an average margin of about 6% (= 292/4600 %). If anything
this is on the large side for margins, suggesting even higher leverage. But
different deals have quite a wide range of margin requirements, and this average
number is not wildly out of line.
2.
Some of the income products provide a high income component, but with a risk to the
capital return if markets fall (e.g. an equity underlying security with a sold call to
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Tranche and continuous
product varieties
The products are sold in two broad forms: (1) the
„tranche‟ variety, i.e. with a fixed maturity date (typically
1-5 years), or (2) as „continuous‟ product with no fixed
maturity date. They may be closed-end funds, or the seller
may be able to cancel shares on redemptions like a mutual
fund.
Complex derivative
structures are used
While structured products have been around for a long
time in various forms, the new-generation portfolios sold
use highly complex derivative structures. They use
synthetic options replication techniques to tailor products
to all combinations of risk and return for investors.
Use of complex derivatives
Constant proportion
portfolio insurance
The most popular products use Constant Proportion
Portfolio Insurance (CPPI). This is the name given to a
trading program that is designed to ensure that a fixed
minimum return is achieved either at all times or, more
typically, at a set date in the future. Essentially the strategy
involves continuously re-balancing the portfolio of
investments during the term of the product between socalled risky assets (usually shares) and non-risky assets
(usually bonds or cash). As the value of the risky assets
rise, more of the portfolio is placed in these assets; but
conversely, as they fall in value, more of the portfolio is
placed in the non-risky assets. By following the rules set
out by the strategy the minimum return can be achieved as
long as the value of the risky assets does not fall too
sharply. In this case, however, the product provider
offering such a product would rely on a guarantee or option
provided by a third-party investment bank to ensure that
the minimum return was achieved – this is the capital
guarantee aspect of the product, wherein lies most of the
cost in buying them.
Because structured products emphasise downside
Sold to retail private
banking and institutional protection with simultaneous participation in the upside,
they are very attractive to retail investors. They are sold by
clients
investment banks to their retail broking arms. However,
they are also sold to private banking clients and to
institutions (fund managers, hedge funds, etc).
boost income – so that some of these products can participate in a falling market to
some degree).
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Financial Market Trends, N°92, Vol. 2007/1
These CPPI products are difficult to understand for
technical analysts, so there can be no doubt that the retail
buyers of these products will not understand what they are
buying. They are often sold with promises of best ex-post
returns from a basket of securities, with downside
protection – sometimes very much like betting on the
winner of a horse race after the race is run. For the 1-1.5%
spread cost to the client, such outcomes are deliverable,
provided volatility remains normal.
Policy issues
The policy issues that arise here are:
Consumer protection
issues arise
1. Financial education and consumer protection, given
the complexity of the products; and
Capital adequacy is
critical
2. The extent to which financial institution capital
standing behind these products (as an ultimate
guarantee) might be at risk, if volatility moves into
abnormal patterns.
IX.
Structured products: the new growth area
Structured products are very popular in Europe and in
Australasia, and are becoming more popular in the USA.
Structured products
sales have been booming
in recent years,
particularly in Europe
and Asia
Figure 2 shows that structured products are one of the
fastest growing areas within the financial services sector.
In 2002 about USD 65 billion of these products were being
issued to retail clients in Europe, whereas by 2006 this had
grown to over USD 180 billion of new issues per annum.
In 2002 about USD 20 billion was issued to retail clients in
Asia, whereas by 2006 the volume was closer to USD 100
billion. These sales considerably understate the flows into
the market, because the industry provider of the retail data
only has coverage from clients that subscribe to the
service. Furthermore, there are no data on the sales to
private bank clients (very wealthy individuals with large
minimum size investments), nor to the institutional market.
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Figure 2: Gross sales of structured products p.a. to retail clients
200
$m
Europe-Retail
180
Asia-Retail
160
140
120
100
80
60
40
20
0
2002
2003
2004
2005
2006
Source: www.structuredretailproducts.com, and investment banks.
The outstanding size of
live global structured
products could be
around USD 3.8 trillion
The approximate size of the outstanding AUM on the
retail side of the market is about USD 1.2 trillion. But the
private banking and institutional parts of this market are
also very large. Industry intelligence suggests that both of
these other areas are similar in size to the retail market for
structured products. If this is broadly correct, it would put
the size of the structured product market at about
USD 3.8 trillion (see Table 8). This (very approximate)
size of the total structured products market is just over half
the estimated size of the hedge fund notional size (allowing
for leverage) of about USD 6.9 trillion.
Table 8. Stocks of outstanding products
Retail
Private Banking
Institutional
Total 3x (?)
EU
USA + Can
$bn
$bn
788.39
192.34
#N/A
#N/A
#N/A
#N/A
2365.18
577.02
Asia
$bn
290.00
#N/A
#N/A
870.00
Total
$bn
1270.74
#N/A
#N/A
3812.21
Source: StructuredRetailProducts.com, and guesses based on discussions with the industry.
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Financial Market Trends, N°92, Vol. 2007/1
X.
Structured products and hedge funds in a „gap‟ scenario
The volume of issuance (sales) and the size of
outstanding structured product portfolios have a material
impact on derivative pricing and spreads. An investment
bank will issue derivatives into the market to construct
portfolios for sellers of these products, creating natural
opportunities for hedge funds to come in on the other side
of the trade. It is common knowledge in investment banks
that hedge funds help to reduce their volatility risk,
providing liquidity in a very complementary way.
Falling volatility and
spreads as the volume of
product grows requires
normal volatility
For example, active hedge fund spread trades alluded
to earlier are carried out by selling puts – while portfolio
insurance by buying puts is a very important part of
providing downside protection to risky assets within a
CPPI product. All of this volatility reducing and spread
narrowing activity assumes markets continue to perform in
the manner that they have in the past few years.
The risk is a major
exogenous event that
reverses the virtuous
circle
The main risk is that a major (exogenous) volatility
event occurs. A sharp rise in volatility (known as a „gap‟
event) poses a risk to the virtuous circle situation described
earlier. It is by no means clear that the CPPI and related
products could cope with such a gap event, and positions
would have to be closed. The size of the potential
stability issue that could emerge would depend on:
1. the size of the fall in the market – a move of 20-25%
– would be a major test;
2. the extent to which investment banks had similar
products and had to close positions at the same time,
leading to bigger market fall – knock-on effects;
3. the extent to which sellers of protection, including
hedge funds, could meet their calls – any defaults
would further accelerate the process;
4. the extent of redemptions demanded by structured
products and hedge fund clients as risks became a
public concern.
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If products could not deliver the prospectus-promised
returns, in such a vicious circle event investment bank
balance sheets would have to cover losses.
This is a major area of policy interest. Investment
banks and hedge funds both need to be encouraged to
stress test their portfolios for an event like this, allowing
for worst-case knock-on effects. If the size of position
closures required is a large proportion of daily trading
volume, a severe liquidity crisis could emerge. Investment
banks in particular need to ensure that their capital remains
sufficient to cover such a contingency.
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