From the November 2002 issue of Investment Advisor • Subscribe!

The Principal of the Thing

The latest import from abroad: principal protected

Anew wrinkle in hedge funds is taking hold in the United States: principal protected hedge funds. These products have been used extensively in Europe, Asia, and the Middle East over the past decade to guarantee returns for investors while equity markets abroad performed poorly. Now that the U.S. markets are in a funk, principal protected hedge funds are making their way stateside, which should help advisors tackle clients' biggest concern these days: preserving their capital.

These new-fangled products basically combine the fixed income of a zero coupon bond with the higher return potential of a hedge fund. Product manufacturers get a bank or insurance company to guarantee notes linked to a hedge fund index, and the bank or insurer charges a fee for the guarantee. Countries abroad have had more leeway in offering principal protected hedge funds--and hedge funds of all stripes--to investors because they don't have to contend with stringent Securities and Exchange Commission regulations. Now that these products have exhibited success overseas, companies are seeking the SEC's okay on new domestic versions. Wells Fargo, Man Investments, Asset Alliance Corp., and Partners Group are just some of the firms that plan to offer domestic products.

Shealyn McGuire, an independent consultant who helped Financial Research Corp. (www.frcnet.com) in Boston pen its recently released report, "Principal Protection: Asset Retention in Down Markets," offers this explanation of how principal protection products work. Say an investor gives $100,000 to a manager, she says; "the manager takes $60,000 and puts it into zero coupon bonds, which over the course of a five-year term will return 100%" of the investor's initial principal.By doing this, "the manager doesn't have to worry about returning that guarantee of original contribution of principal because all they have to do is cash in the zeros." The remaining $40,000, she says, "can be invested in another vehicle that will help the [client] earn money above and beyond the original principal."

Registered investment companies in the U.S. have been combining zero coupon bonds with relatively conservative equity investments like an index or Standard & Poor's Depositary Receipts (SPDRs) since the 1990's, McGuire says. But European countries have been giving the equity portion of these types of investments "a little gas" by investing in hedge funds.

Like funds of funds registered under the Investment Company Acts of 1933 and 1940, allowing lower minimum investments, principal protected hedge funds provide "a good way for investors to take a baby step into alternative investments without risking their initial investment," McGuire says. Investors still have to meet the $1-million-in-assets threshold.

But detractors say the fees associated with adding principal protection to hedge funds is "double protection," and may be unnecessary since hedge funds are designed to offer lower risk and higher potential returns, McGuire says.

Don't Forget Diversification

Bruce Lipnick, CEO, president and founder of Asset Alliance Corp. in New York, says just because there's a guarantee "doesn't mean you're going to make money; hedge funds do go down." That's why diversification is so important in clients' portfolios. "We try to teach our clients to have a diversified portfolio so they won't have any real big drawdowns on a single manager plan." The bank or insurance company providing the guarantee--which should be rated AA or AAA--will levy a larger fee, he says, for a single-manager strategy versus a fund of funds, which spreads risk among 10 to 20 managers.

Asset Alliance has been "wrapping" principal protected products around "a basket of our managers plus outside managers that we don't have an interest in, and offering [the product] to institutions worldwide," Lipnick says. His firm also uses warrants in the products, which provides "embedded leverage linked to a basket of managers or to a single manager."

Lipnick says New York-based Asset Alliance is now talking with brokerage firms and insurance companies in the U.S. about putting together a package similar to the one his firm markets in Europe. "We went to a distributor, who then went to different types of institutions who repackaged it to their individual high-net-worth clients," he says. "So [the institutions] would buy, let's say, a $20 million tranche from us and they would break it up to their clients. I think that's what's going to happen here--firms will come to an Asset Alliance or other provider and buy $10 million worth of a product, put a fee on top of that, and market it to clients."

Asset Alliance, Lipnick says, is now contemplating whether to register its new principal protection hedge fund with the SEC. "We're looking at whether we want to bring this down to the retail market" by registering a fund for smaller investors.

Structured Products Solutions

Jim Hedges, president and chief investment officer of LJH Global Investments, a global hedge funds advisory firm in Naples, Florida, says firms like LJH, which are in the fund of funds business, "are increasingly realizing that we have to be able to create structured products solutions because our different investor constituents want different types of things out of these products."

Structured products, which include principal protection and a litany of other derivative products, "will be a fundamental part of investing in hedge funds in the future," Hedges believes. As hedge fund products are allowed to mature, he says, institutional and retail investors "will be able to invest through lots of different channels." Options will include hedge funds with principal protection as well as principal protection with a ratchet, meaning that as the investment appreciates, the guarantee protects a larger amount of principal. The product could also include warrants, he says, so an investor "can convert the character of income as a U.S. investor from being treated as ordinary income to long-term capital gains." Hedges also places insurance products like private placement variable life and variable annuities under the structured products rubric.

Registered investment advisors, Hedges says, who have become partial to funds of funds, can look forward to more "bells and whistles" on these products. "Principal protection and leverage are going to be part and parcel of" the offerings, as well as "variable life insurance wrappers, which will seek to defer income tax ramifications."

But adding options means making the process of investing in hedge funds even more tricky, Hedges says. Advisors "not only have the complicated aspect of manager selection, asset allocation, and risk management, but we're now introducing a new series of decisions and risk factors in terms of, 'Are you going to leverage it? Principal protect it? What are the fees?'" Hedges argues that "a prudently structured, diversified, multi-strategy fund-of-funds product does not need principal protection."

Since product manufacturers are structuring these products many different ways, McGuire says it's imperative that advisors understand each product's "underlying structure, goals, and what the principal guarantee really covers." John Kelly, president of Man Investment Products Inc., the U.S. member of the asset management division of London-based Man Group, concurs: "Ignore the guarantee. Pick the product and the investment program and see if it fits" into a client's portfolio. "Take the guaranteed format, provided that the product has been robustly structured, which means that the addition of the guarantee does not mean there is a probability of you being locked out of the market on a drawdown." Advisors should also adhere to the golden rule of first deciding whether alternative investments are right for a client before determining how much to allocate to hedge funds.

Kelly, who works out of Man's Chicago office, says Man plans to replicate its offshore principal protected products here in the states. While not providing any details, he says Man "absolutely has plans to get these products into the marketplace, and that means working with regulators." Man was the first company to launch a publicly offered, principal protected offshore product in 1986, Kelly says. And by the early '90s, Man was "doing deals" with large banks like ABN Amro.

When Man decided to bring these products to the U.S. in the late 1990s, Kelly says he was bombarded with comments like: "'People don't want guaranteed products in the U.S.'" But now the sentiment has changed. "I haven't heard that [comment] for the last six months. There's been a major shift in the perception of these products."

From Your Friends at Merrill

Scott Higbee, an associate in the New York office of Partners Group, an alternative investments firm based in Switzerland, says Merrill Lynch will be distributing in the U.S. a principal protected hedge fund for Partners. The domestic product will be a fund of funds backed by a AA-rated European financial institution and will mimic a similar structure that the firm has distributed in Europe. "Generically, what Partners offers on the hedge funds side is full downside protection through a capital guarantee, and annual income, which is very attractive given current market conditions," Higbee says. "The opportunity cost isn't very high given the interest rate levels now, meaning if you stick your money in cash, you're not going to get a whole heck of a lot more if you were to invest in a product like this. Yet you have the upside of a diversified hedge fund portfolio."

Principal protection hedge funds may offer advisors a perfect solution in helping clients preserve their capital. But because the concept is new here in the U.S. and the products' structures can be complex, it's imperative for advisors to do their homework. As LJH's Hedges warns: "This is rocket science. Don't try and do it on your own. Work with a partner that has the ability to do manager selection, asset allocation, risk management, and can also properly evaluate these things."

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