Popular Overseas Strategy Seeing Increased Demand in U.S.

Nov 18 2005 | 8:39pm ET

As the hedge fund industry copes with scandal after scandal this year, and both inflows and returns are sluggish, investors are looking for ways to enter the alternative marketplace while at the same time limiting their risk exposure. One way of doing this that has taken off in Europe and Asia, but remains on the sidelines in the U.S., is investing in hedge funds through principal-protected notes.

"Guaranteed principal notes have had huge growth in Europe," said Victor Park, managing partner of New York-based hedge fund Alternative Asset Management, adding that the notes are also popular in Asia. He predicts that demand will increase stateside as U.S. investors become more familiar with this type of product. 

With principal-protected notes, an investor buys a bond in which the underlying investment pool is either a single-manager hedge fund, or more typically, a fund-of-hedge funds, which diversifies risk. This type of fixed-income security guarantees a minimum return equal to an investor's initial investment. They are typically marketed to risk adverse investors or those who cannot invest directly in hedge funds or fund-of-funds for regulatory reasons.

The benefit of a principal-protected note to an investor is that he is getting a zero coupon bond plus a leveraged exposure to a fund-of-funds, while the risk bearer is the leverage provider. However, the drawbacks are that the returns tend to be lower than investing directly in a fund-of-funds and the notes have high fees.

So far, broker-dealers are the main suppliers of guaranteed principal-protected notes, but that could change as the demand grows for notes based on single manager hedge funds rather than notes based on a fund-of-funds.

"U.S. interest is picking up on notes tied to fund-of-funds and what we are seeing a lot of are notes tied to indices," says Ryan Pearson, v.p. of structured products at Greenwich-Van.

Pearson points out, however, that institutional investors are still hesitant to invest in the notes because they do not see long-term value in them, as the notes usually have a redemption period of one year.

"All investors in the notes of which we are the manager under the issuer are offshore institutional investors," says Pearson. However, "we have seen interest in [the notes], and we are working diligently to make a product that is appealing for U.S. institutional investors."

"Where we have seen the interest is from the insurance business, because this would allow them to make hedge fund-based investments on their general accounts, but not take such a risk-based capital hit," explains Pearson. He also pointed out that the notes issued tend to have a single '' rating or higher, and because of this the investment is more likely to be treated on the books as fixed income rather than equity.


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