Principal-protected notes and other capital-guaranteed products that use hedge funds as an alpha source have found a market among pension plans in Europe, and are triggering some interest in the U.S.
Societe Generale Corporate and Investment Bank, New York, earlier this year launched a $50 million principal-protected strategy for an unnamed U.S.-based pension fund. The principal-protected note is overlaid on a hedge fund-of-funds portfolio managed by its subsidiary, Lyxor Asset Management, Paris. Michel Serieyssol, the banks New York-based managing director and head of pension solutions, said the firm had done a number of similar deals with U.S. pension plans in an early effort to reach out to plan sponsors.
Capital guarantees wrapped around one or more hedge funds of funds offer investors protection that the money they invest in the strategy wont be lost. These wrappers, or insurance-based approaches, are typically created by investment banks.
Cautious clients use them as a risk-free way to invest in hedge funds, others use them to get around local legislation in Europe that limits exposure to hedge funds, and some use the principal protection to get exposure to alternatives through a form of portable alpha if a plans own funding position and asset allocation make this difficult, according to Rene Herren, head of product structuring at Man Investments, Pfaffikon, Switzerland.
Societe Generales Mr. Serieyssol said principal-protected notes offer pension plans a portable-alpha approach that can meet some of the pension liability sensitivities while generating a higher return in their existing portfolios. The institutions we speak to say they see this approach as a complement to their existing asset allocation, he added.
According to industry sources, Societe Generale, BNP Paribas, and AXA Group are believed to be some of the main providers of these strategies in Europe. Jean-Eric Pacini, BNP Paribas head of structured products sales, and Sara Dennehy, AXA spokeswoman, did not respond to calls for comment. No one was available to comment by press time at Credit Suisse, according to Amy Thompson, spokeswoman for the firms investment banking division.
But the jury is out as to whether capital guarantees are the most effective way for pension plans to invest in hedge funds and hedge funds of funds, in particular.
According to Aoifinn Devitt, independent consultant and director of London-based Clontarf Capital, capital guarantees on hedge funds of funds can be misconceived because by their nature, hedge funds of funds volatility is generally much lower than in equities.
The chance of losing your shirt in a fund-of-funds investment is very low. You could lose much more in direct equity investing, she said. And the layers of fees associated with structured products can truncate overall returns.
Little information is available about the use by European pension plans of principal-protected notes based on hedge funds. In continental Europe, most investment banks work directly with pension plan clients.
In the U.K., executives at a handful of pension plans have expressed an interest in using hedge fund-based principal-protected notes, particularly where they have hedged their interest-rate risk, but as yet no deals have been done, according to two independent consultants who specialize in hedge funds and structured products.
At the end of March, 44% of London-based Man Investments $68 billion in assets under management was in these products. A significant part is sold to pension plans, particularly in Germany and Italy and increasingly in Spain, said Mans Mr. Herren. In Europe, demand varies according to each countrys local regulations, and interest appears to be across pension plans regardless of size or sponsor.
We cant put these users into a category, he said
The potential demand for capital guarantees on hedge funds of funds is large if institutions are expected to allocate between 5% and 10% of total assets to alternatives, but European pension plans have not yet made such a commitment to hedge funds, said Laurent Le Saint, Paris-based managing director and head of structured alternative investments at Societe Generale Corporate and Investment Bank.
Most demand at Societe Generale has been from pension plans in Scandinavia, the Benelux region and France, with some interest in the U.K.
A number of large and mid-sized pension plans lacking internal resources to manage direct hedge fund investing have been using capital guarantees on hedge funds, Mr. Le Saint said. A typical investment for a mid-sized pension plan client would be e20 million ($29 million) and e50 million, he added.
Our aim is to transform the payoff structure of a hedge fund portfolio to meet capital requirements or the needs of a particular investor, said Mr. Le Saint.
In some cases, this can take the form of portable alpha.
One trade that has proved popular is a structure that pays an annual income and is linked to the alpha (excess return over LIBOR) of a fund of hedge funds. Effectively we sell the client a corporate bond guaranteed by SG with an annual income that is a multiple of the alpha of the fund of hedge funds, said Mr. Le Saint.
The client holds a bond that is exposed to the alpha of a fund of hedge funds, rather than the credit exposure of traditional bonds. Mr. Le Saint described this as a form of portable alpha. The underlying source of alpha can be tweaked and targeted to generate alpha with the volatility and risk profile desired by the client.
He says Societe Generale is working on building a U.S. business for capital guarantees on hedge funds.
The U.S. pension market has deep pockets. We dont need to go for a large part of (pension plans) investment portfolios to make a sizable transaction, he said.
He agreed that the cost of these guaranteed products is an issue for investors. If investors do not need a structure or a capital guarantee, then they should go direct into hedge fund of funds, thats for sure. But if you want to match duration or have a stream of coupons you need to match, then the structure becomes attractive, he said.