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.