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Structured solution

Investment managers and hedge fund managers are starting to use structured products as a gateway to hedge funds for retail investors.

In the last four months, Tilney Investment Management, Close Fund Management, Matrix Money Management and Premier Fund Management have teamed up with hedge fund managers to offer products with minimum investment levels as low as £5,000.

Opal Alternative Investment Funds investment director Frances Clayton, who designed Tilney&#39s Opal tailored solutions, says the past few years of poor stockmarket performance has reminded investors that risk cuts both ways.

She says: “Investors have been watching hedge funds. They used to be a weird and wonderful presence that were the preserve of institutional investors but now people are thinking &#39I ought to look at this asset class&#39. Structured products linked to hedge funds start to look attractive because the worst that can happen is that investors get their money back.”

Arete Consulting managing director Robert Benson, who founded StructuredRetailProducts.com, says the banks providing the guarantees have become more comfortable with writing options on hedge funds, particularly on funds of funds or baskets from their own hedge fund platforms.

He says: “Most of the mainstream index providers now have investable hedge fund indices. It is likely that the next year will see some structured products linked to these indices and rolled out to retail investors.”

Those in favour of providing greater retail access to hedge funds argue that a diversified portfolio should contain exposure to hedge funds because they are not correlated to bond and equity markets, which could limit an individual&#39s losses during a downturn. The problem is that hedge funds are complicated products and perceived by retail investors as risky, which makes them difficult for IFAs to sell.

Towry Law product res-earch manager Simon Farrant says hedge funds are a difficult area for IFAs because only investment specialists have the in-depth knowledge to go thr-ough the due diligence process required to recommend funds, especially as hedge funds are opaque and information is not always forthcoming.

But Premier Fund Managers managing director Jon-athan Fry thinks bringing hedge funds into the structured product arena could make them easier for IFAs to sell.

He says: “Most hedge funds have an aggressive bias so if they get it right, investors will make a fortune. But the bigger the return, presumably the higher the risk. If the manager gets the fund selection wrong, the capital-protected wrapper means you are going to get your money back. All you will have lost is the interest you would have had on a deposit account.”

The current crop of capital-protected hedge funds are closed-ended funds, which makes them tax-efficient. Usually, hedge funds are subject to income tax but a closed-ended structure enables gains to be offset against investors&#39 CGT allowances. As closed-ended funds are also Isa eligible, another level of tax efficiency is provided.

However, putting a guarantee on a hedge fund and making it Isa eligible does not automatically make it suitable to retail investors. In fact, some IFAs and providers argue that a guarantee should not be necessary on a fund which aims for absolute returns.

Farrant says: “Linking structured products to hedge funds is interesting because a fund that seeks absolute returns should lower the risk, especially where lower-risk hedge funds with lower volatility are used. But this will also have an impact on returns, which will also be lower.”

Matrix Money Management managing director Bridget Cleverly says Matrix tried to put a capital guarantee on its fund of hedge funds but the cost of providing the guarantee outweighed the potential benefits to investors.

She says: “I do not think a capital guarantee is essential on a fund of hedge funds for retail investors. If the fund is designed to produce absolute returns, you could spend money unnecessarily on a guarantee. We chose the Winton fund because it has a higher risk and return ratio than our fund so the guarantee offers investors more value.”

Farrant points out that specific hedge funds are chosen as the basis of structured products because of strong past performance. But performance may be explained by a strategy working well at a particular stage in the economic cycle, not necessarily the skill of the fund manager.

This point is taken up by Clayton, who says: “Hedge funds do not operate in a vacuum. People should understand the external reasons why something did well. Sometimes, hedge funds are going to outperform by virtue of economic trends.”

IFAs who are looking at capital-protected hedge fund products need to understand why the underlying funds have done well and the structure of the guarantee. Premier&#39s product has a relatively simple cash and options strategy, where a fixed amount goes into zerocoupon bonds to provide the capital guarantee while the rest is invested in call options to provide the growth.

However, the Close Man product uses constant proportion portfolio insurance which means the split between cash and options is constantly shifting to achieve the target return in all market conditions.

The danger is that the manager could hold too much in cash in an attempt to cover the guarantee and would need to use gearing to achieve the target level of return, which could increase the risk.

Farrant says: “These products, by their very nature, lack transparency. You are dependent on the capital protection and it is often difficult to assess the real risk and return.”

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