Monday, September 06, 2004
Japanese HF Interest and Structured Products - FT.com
Japan's serious flirtation with hedge fundsBy Barney Jopson Published: September 6 2004 03:00 Last updated: September 6 2004 03:00
Like much of the investment world, Japan has fallen in love with hedge funds. But the affair has blossomed in a far shorter space of time than in the US and Europe, and Tokyo finance houses are now trying to take it to the next stage by pushing hedge fund products to wealthy individuals.
With the help of financial engineers at international investment banks, several distributors have started selling fund of hedge fund hybrids constructed with capital protection features. They generate positive returns as long as investment managers make a profit but are structured to ensure that investors do not lose all their cash even if the managers do.
Capital-protected hedge funds are aimed mainly at high net worth individuals who benefit from private banking services. Shinsei Bank's wealthiest customers have put Y100bn ($910m) into such vehicles in the past two and a half years, Daiwa Securities has raised almost Y50bn and Nomura, Mitsubishi Securities, Merrill Lynch and Softbank Investment are also offering the products. Citigroup's Japan office once did, but has stopped.
"Most of the buyers are highly conservative," says Toru Irokawa, deputy general manager of Shinsei's speciality products division. "They don't want to take risks with stocks but they do want something."
Although Japanese regulators class them as stock investment trusts, Mr Irokawa says: "The risks and rewards are more like a fixed-income alternative."
Aside from the capital guarantee, already applied to many other funds worldwide, the products' main advantage is their low performance correlation with traditional assets, says Mike Watanabe, who constructs them as head of fund derivatives for BNP Paribas in Asia. "There is a significant market opportunity here."
Those low correlations are what attracted Japanese pension funds, insurers and banks to straight hedge funds as a means of diversifying investment portfolios. But the institutional scramble into hedge funds sparked concern that less sophisticated investors are setting themselves up for a fall.
Capital protection at least means they are unlikely to lose their shirts, as many did after a headlong rush into Argentine government bonds. And Mr Irokawa argues the "non-directional" nature of structured hedge funds means the sorry tale of distributors herding customers into a soaring market just as it peaks will not be repeated.
The danger is that, despite distributor checks on customers' financial savvy, many will be dazed by the technicalities of fund and fee structures and find themselves facing more restrictions and less money than they had bargained for.
In simple terms, capital protection is created by investing only a portion of client money, say 30 per cent, into a fund of hedge funds - or a security linked to a hedge fund index - and the rest into bonds with a multi-year lifespan the same as that of the product. If the hedge funds make good returns, that is fine. If they fall into the red by a certain margin, the 30 per cent is liquidated and put into bonds as well, ensuring the capital guarantee is honoured.
The structuring process is complex and the people who are able to carry it off cost money. Add their fees to fund of funds manager fees, and to the management and performance fees charged by each hedge fund - they often claim more than 20 per cent of the profits they make - and the bill is steep. It is not subtracted from clients' protected capital but squeezes potential returns by leaving less for investment in the hedge funds.
As for the vaunted capital guarantee, it is not always a promise that clients get back their whole principal. For yen products it is sometimes only feasible to protect 80 per cent.
Japanese bonds can be used to ensure a final payback equivalent to clients' original investment. But because of Japan's ultra-low interest rates, that would require as much as 95 per cent of the capital to be invested in bonds from day one, leaving virtually nothing to go into the hedge funds.
Two other concerns are transparency and liquidity. For individuals, the higher both are the better, but one reason hedge funds have performed so well in the past is that managers have not had to care about them. With hedge fund strategies such as distressed asset investment it is impossible to get a daily price. And when Shinsei's customers, for example, decide to liquidate their investments, they often have to wait four or five months to get their money back.
"You want to invest in the same strategy as the wealthiest guy and you want to get out at much shorter notice?" Mr Watanabe asks clients. "You may be able to, but you have to pay for it since someone has to take the liquidity risk on your behalf."
Looking ahead, Mr Irokawa says a dramatic tumble in Japanese stocks could trigger a wave of new capital-protected hedge funds from distributors.
"You may start seeing irresponsible distributors selling shoddy hedge fund products with perfunctory explanations," he warns. "You can't deny the possibility because there are no regulations to stop it if the structure complies."
Like much of the investment world, Japan has fallen in love with hedge funds. But the affair has blossomed in a far shorter space of time than in the US and Europe, and Tokyo finance houses are now trying to take it to the next stage by pushing hedge fund products to wealthy individuals.
With the help of financial engineers at international investment banks, several distributors have started selling fund of hedge fund hybrids constructed with capital protection features. They generate positive returns as long as investment managers make a profit but are structured to ensure that investors do not lose all their cash even if the managers do.
Capital-protected hedge funds are aimed mainly at high net worth individuals who benefit from private banking services. Shinsei Bank's wealthiest customers have put Y100bn ($910m) into such vehicles in the past two and a half years, Daiwa Securities has raised almost Y50bn and Nomura, Mitsubishi Securities, Merrill Lynch and Softbank Investment are also offering the products. Citigroup's Japan office once did, but has stopped.
"Most of the buyers are highly conservative," says Toru Irokawa, deputy general manager of Shinsei's speciality products division. "They don't want to take risks with stocks but they do want something."
Although Japanese regulators class them as stock investment trusts, Mr Irokawa says: "The risks and rewards are more like a fixed-income alternative."
Aside from the capital guarantee, already applied to many other funds worldwide, the products' main advantage is their low performance correlation with traditional assets, says Mike Watanabe, who constructs them as head of fund derivatives for BNP Paribas in Asia. "There is a significant market opportunity here."
Those low correlations are what attracted Japanese pension funds, insurers and banks to straight hedge funds as a means of diversifying investment portfolios. But the institutional scramble into hedge funds sparked concern that less sophisticated investors are setting themselves up for a fall.
Capital protection at least means they are unlikely to lose their shirts, as many did after a headlong rush into Argentine government bonds. And Mr Irokawa argues the "non-directional" nature of structured hedge funds means the sorry tale of distributors herding customers into a soaring market just as it peaks will not be repeated.
The danger is that, despite distributor checks on customers' financial savvy, many will be dazed by the technicalities of fund and fee structures and find themselves facing more restrictions and less money than they had bargained for.
In simple terms, capital protection is created by investing only a portion of client money, say 30 per cent, into a fund of hedge funds - or a security linked to a hedge fund index - and the rest into bonds with a multi-year lifespan the same as that of the product. If the hedge funds make good returns, that is fine. If they fall into the red by a certain margin, the 30 per cent is liquidated and put into bonds as well, ensuring the capital guarantee is honoured.
The structuring process is complex and the people who are able to carry it off cost money. Add their fees to fund of funds manager fees, and to the management and performance fees charged by each hedge fund - they often claim more than 20 per cent of the profits they make - and the bill is steep. It is not subtracted from clients' protected capital but squeezes potential returns by leaving less for investment in the hedge funds.
As for the vaunted capital guarantee, it is not always a promise that clients get back their whole principal. For yen products it is sometimes only feasible to protect 80 per cent.
Japanese bonds can be used to ensure a final payback equivalent to clients' original investment. But because of Japan's ultra-low interest rates, that would require as much as 95 per cent of the capital to be invested in bonds from day one, leaving virtually nothing to go into the hedge funds.
Two other concerns are transparency and liquidity. For individuals, the higher both are the better, but one reason hedge funds have performed so well in the past is that managers have not had to care about them. With hedge fund strategies such as distressed asset investment it is impossible to get a daily price. And when Shinsei's customers, for example, decide to liquidate their investments, they often have to wait four or five months to get their money back.
"You want to invest in the same strategy as the wealthiest guy and you want to get out at much shorter notice?" Mr Watanabe asks clients. "You may be able to, but you have to pay for it since someone has to take the liquidity risk on your behalf."
Looking ahead, Mr Irokawa says a dramatic tumble in Japanese stocks could trigger a wave of new capital-protected hedge funds from distributors.
"You may start seeing irresponsible distributors selling shoddy hedge fund products with perfunctory explanations," he warns. "You can't deny the possibility because there are no regulations to stop it if the structure complies."
# posted by Tom @ 7:17 PM 
