Tim Andrews on the Structured Funds' Landscape (Euromoney)

By Timothy Andrews, Scotia Capital
Special to Euromoney, Published April 2008

The structured fund derivatives landscape has evolved substantially in recent years with an estimated current notional size of over US$700bn globally. An increasing number of treasurers, portfolio managers and other investors are seeking increased returns through exposure to alternative assets via a variety of fund-linked derivatives products. Common fund-linked derivatives products include various options, total return swaps, portable alpha strategies and structured notes. These products can be linked to single hedge funds, fund of funds, fund indices or a basket of the same (each a ‘reference fund asset’).

1. Black-Scholes call options
In the basic form of a ‘plain vanilla’ or ‘black-scholes’ call option referencing a reference fund asset, an investor purchases an over-the-counter call option by paying a premium amount to the financial institution (the ‘bank’) on the trade date. The strike price of the call option is typically fixed either ‘at’ or ‘out of the money’ at inception. The call option is structured to be ‘European style’ which means the investor can exercise the option only at maturity. The cash settlement amount, if any, owed by the bank to the investor at maturity is equal to the amount by which the net asset value of the reference fund asset exceeds the strike price of the call option. In some cases, the call option may also be physically settled where the investor would pay the strike price to the bank and receive physical delivery of the reference fund asset. To the extent that the net asset value of the reference fund asset was less than the strike price, the option would expire worthless and the investor would lose the premium paid at inception.

2. Accreting strike call option structures
The accreting strike call option (‘ASCO’) is among the most widely used fund-linked derivatives today. Take the example of an investment manager looking to launch a leveraged fund (the ‘leveraged fund’) to raise additional capital. Assume the leveraged fund offers investors US$3 of exposure to the underlying reference fund assets for every US$1 invested, or ‘three times’ leverage. Suppose the leveraged fund has US$100m in new subscriptions.

Under an ASCO structure, the leveraged fund would purchase a cash settled over-the-counter call option from the bank for premium amount equal to the US$100m in subscription monies and receive a notional exposure to a basket of reference fund assets equal to US$300m, equating to three times leverage. The bank would most likely hedge its position on a ‘delta one’ basis by purchasing US$300m of the reference fund assets, but could also hedge via another derivative.

For Tim Andrews' full article on the structured fund landscape, click here.

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LATEST POSTS: SPA Blogsite, April 2008

Structured Products Association Annual Conference 2008
For full coverage of SPA-2008 from Prospect News:
Click here for Day One (Wednesday, April 9, 2008)
Click here for Day Two (Thursday, April 10, 2008)

FINAL DRAFT: SIFMA Principles for Distributor-Individual Investor Relationship -- On March 20, 2008, SIFMA and ISDA circulated the latest draft of the proposed "Principles for Managing the Distributor-Individual Investor Relationship," a set of voluntary guidelines on the marketing of structured products to individual investors. Last chance to comment.

Andrew Scherr on the Agony and Ecstasy of Structured Products (Euromoney) -- "Financial weapons of mass destruction " in the eyes of Warren Buffett, feared by government regulators, banned from the general public, and lampooned by politicians, academics and media. And yet, despite all of the foregoing . . . the U.S. Structured Products industry is . . . exploding.

Some RIAs See Structured Products as Key Strategy (Investment News) -- A small but growing number of advisers are turning to derivatives-based strategies. "We're taking risk off the table by replacing equity exposure with principal protection and buffered notes" said Frederick Wright of Smith & Howard Wealth Management.

SPA-2008 Day 2: Future Challenges, Opportunities (Prospect News). Mutual funds have put up a "very aggressive lobbying position" against exchange-traded notes (ETNs), said Adrienne Browning of Deutsche Bank. "In Congress right now, the fight is going on," said Ray Shirazi of Cadwalader, but HSBC's Eric Miller said, "Structured products has arrived … beating closed-end funds in issuance" n 2007.

SPA-2008 LeadingEdge Award Winners (Prospect News Special Coverage) - Steve Braverman of MyCFO Harris Bank, Frederick Wright of Smith & Howard Wealth Management, Tom Balcom of Financial Planning Association, Tony Proctor of Proctor Financial and J. Scott Miller of Blue Bell Private Wealth Management are winners of the first SPA LeadingEdge Advisors Awards, presented by Raina Mathur of Societe Generale.

SPA-2008 - Distributors: SPs Market 'Vibrant, Innovative' (Prospect News) - "The ETN market is a growing vibrant area," said Som Seif of Claymore Investments in Canada, but despite rising innovation, the market is still reverse convertible-driven, said Guy Gregoire of Pershing LLC.

Structured Products on . . . the Job Market? (Business Week) - New financial products linked to the nonfarm payrolls data are the first of several the Chicago Mercantile Exchange plans to launch.

Structured Commodities Boom: Buyer Beware (Reuters) -- Investors pouring money into structured commodities may be concerned after the collapse of Bear Stearns, and some risk-prevention features in such structured products.

ETNs' Steady Growth Pose Threat to ETFs, MFs (Investment News) -- "ETNs are definitely a threat [to mutual funds and exchange traded funds]," said Jeff Ptak, director of exchange traded securities analysis at Morningstar Inc. of Chicago.

SPA-2008: ETNs Elude Tax Strictures (Investment News) "You are not likely to see anything happen on this in 2008," said Thomas Humphreys, a partner at Morrison & Foerster LLP in New York.

Goldman's Golden Duo to Form $1B Hedge Fund (Bloomberg) Josh Birnbaum, whose bearish mortgage derivatives trades propelled Goldman's $11.6 billion last year, plans to form a $1 billion hedge fund.

FINAL DRAFT: SIFMA Principles for Distributor-Individual Investor Relationship

On March 20, 2008, SIFMA and ISDA circulated the latest draft of the proposed "Principles for Managing the Distributor-Individual Investor Relationship," a set of voluntary guidelines on the marketing of structured products to individual investors. SPA members are advised to review these principles as soon as possible and provide comments to jmaurello@sifma.org.

The following is the introduction to the principles, which can be found on SPA's website by clicking here.

The distributor-individual investor relationship should deliver fair treatment of the individual investor. Individual investors need to take responsibility for their investment goals and to stay informed about the risks and rewards of their investments. Distributors can play a key role in helping them achieve these objectives.

In light of the increased interest in structured products as part of individual investors’ investment and asset allocation strategies, it is important for firms to keep these principles in mind in their dealings with individual investors in structured products. These principles complement our recently released, "Retail Structured Products: Principles for Managing the Provider-Distributor Relationship," available at the websites of the five sponsoring associations, which focus on the relationship between manufacturers and distributors. These principles apply to the relationship between the distributor and the individual investor.

Although these principles are aspirational in nature and do not create enforceable obligations or duties, firms involved in the distribution of structured products to individual investors are encouraged to reflect these principles in their policies and procedures. Further, each firm is encouraged, given differing regulatory environments and both cultural and client base differences, to consider the extent to which the firm should adapt these principles to its particular circumstances.

Overview
The term "structured products" refers to a variety of financial instruments that combine various cash assets and/or derivatives to provide a particular risk/reward profile that allows investors access to broader investment opportunities. The return of a structured product is usually derived from the performance of one or more underlying assets. Examples of underlying assets include, but are not limited to; interest rates, a particular equity or debt instrument, a basket of securities, a securities index or indices, an individual commodity or commodities, a commodities index, an individual currency or currency basket or any combination thereof.

Some structured products offer full or partial principal protection, while others have no principal protection. Some offer a yield; others do not. It is possible that the value of an individual structured product may not increase as much as the underlying asset, or may decrease more than the underlying asset. Some structured products offer individual investors access to new asset classes that can help with portfolio diversification.

Structured products can be more or less risky than other investment products such as equities, fixed income products, or mutual funds: there is no necessary link between product complexity and investment risk - complex products, may be low risk, and non-complex products may entail high risk. It is important that an investor understands the role in an investment strategy that can be played by any particular structured product in light of the investor’s specific investment objectives, risk tolerance, and investment horizons.

To review the full March 20, 2008 draft of the SIFMA-ISDA-SPA "Structured Retail Products Principles, click here.

To make any comments, suggestions or recommendations, email SP-Principles@structuredproducts.org as soon as possible.