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We take you back to the credit basics to review everything you thought you already knew but were too afraid to ask...
FUND-LINKED NOTES, which combine traditional financial products with derivatives, belong with the growing breed of innovative
structured products aimed at tailoring risks and returns to investors’ specific needs while offering full or partial capital
protection.
Why are fund-linked notes in demand?
Investing directly in funds often requires a significant outlay of capital and it can be difficult to hedge against the risk
of a fall in the value of the fund. Fund-linked notes allow an investor to indirectly access the upside performance of funds
whilst obtaining capital protection on all or part of the investment. Notes can be linked to single funds, a fund of funds
or a portfolio of funds, and can be targeted at specific sectors, such as private equity. They can also be connected to indices
of funds such as Standard & Poor’s Hedge Fund Index. The use of derivatives as part of the underlying portfolio can help in
providing leverage and in tailoring the risk profile to the investors’ needs.
How are they structured?
The portfolio underlying the notes will typically be allocated between non-risky assets such as zero-coupon bonds or a synthetic
zero-coupon product which provide the desired capital protection, and an investment (either directly or synthetically by the
use of derivatives) in a dynamic basket of funds which constitutes the yield generation element of the security. Normally
this portfolio is continuously reallocated by switching investments between risky and non-risky assets. The quality of the
underlying fund management is important for fund-linked notes. Poor asset allocation can lead to depreciation in the value
of the portfolio resulting in a reallocation of assets. Selection of an experienced and skilful investment manager is therefore
often critical to a successful product.
What are the issues?
If an individual fund suffers a downturn, holders of a direct investment in that fund will have the option of selling or redeeming
their investment. Investors in fund-linked notes will generally have less flexibility and may need to hold the security to
maturity to obtain the benefit of any principal protection. Selling the note may be difficult as liquidity in such securities
is usually low. Investors need to be prepared to tie up their investment for a significant period of time. If the underlying
funds have performed badly, the security may yield no income throughout the investment period.
A downturn in the value of the underlying funds could also put the capital protection element of the arrangement at risk due
to the ‘gap risk’ inherent in many of these products.
Although active management of the underlying funds may produce attractive yields, a material portion of the initial investment
is likely to be earmarked for the capital protection element. The amount available for investment in the higher-risk assets
may be relatively low and make it difficult to provide the ideal level of diversity.
Many alternative strategy mandates are based on technical trading or other proprietary computer models which are often the
product of years of research. Managers are often secretive about the factors they study to determine triggers. Investors may
therefore be limited to looking at historical performance as the main selection method.
Notwithstanding the issues highlighted above, issuance of fund-linked securities is likely to continue to grow because significant
advantages exist for certain investors to hold such notes as part of their investment strategy.
Glossary
Gap risk: The risk that a rapid deterioration in the value of the yield generating assets could reduce the net asset value of the portfolio
below the value necessary to guarantee repayment of the capital on maturity before it is possible for the portfolio to be
reallocated.
Zero-coupon bond: A bond that doesn’t pay a coupon but offers the entire payment at maturity when the bond is redeemed for its full face value.
