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Hedge funds face very few restrictions on their use of derivatives in their portfoliosDerivatives and Hedge Funds Hedge funds face very few restrictions on their use of derivatives in their portfolios. Hedge funds can use derivatives to create leverage, to more carry certain types of positions, and to create patterns of return that cannot be created with the underlying instruments. Despite the usefulness of derivatives, many hedge funds do not use derivatives to implement their investment strategies. Many hedge funds own only common stocks and use little or no leverage. These types of funds gain little from derivatives and may find it easier to limit their portfolios to cash securities. This chapter, however, does not describe the use of derivatives by hedge funds. Instead, the text reviews various ways that the returns of hedge funds can be used to create derivative securities that replicate hedge fund performance. These hedge fund derivatives offer several advantages over direct investments in the funds. This chapter discusses the advantages of investing in hedge funds via derivative securities and the means for investing in funds. WHY USE DERIVATIVES TO INVEST IN HEDGE FUNDS ? Derivative securities act as substitutes for the underlying securities. Frequently, derivatives closely resemble an investment in an underlying instrument paired with financing of the instrument. Other times, the derivatives transform the returns, to create a unique pattern of return. In both situations, hedge fund derivatives can offer advantages over investments in the underlying funds. One advantage derivatives have over direct investment in the assets is that derivatives allow the investor to create leverage. The amount of leverage differs, depending on the structure of the derivatives. Total return swaps create almost infinite leverage at the start because they are usually designed so that neither party to the swap pays anything at the time the swap is initiated. Calls and puts on hedge fund returns may effectively create leverage because the value of the options may be considerably less than the value of the underlying investment. However, the option prices often move less in response to changes in the underlying assets. (This sensitivity is called the option delta and is discussed in Chapter 11.) The derivative structures based on life insurance products described later may create no leverage. A second advantage of hedge fund derivatives over direct investment is greater flexibility to adapt the pattern of return. For example, some engineered investments can guarantee an investors return of principal after a specified period of time. Other derivatives (calls) can create profits when hedge fund returns are positive but limit losses to the purchase price of the option when hedge fund returns are negative. Similarly, puts can create profits when hedge fund returns are negative but limit losses to the purchase price of the option when hedge fund returns are positive. Derivatives can offer tax advantages over investments directly in hedge funds. In some cases, shortterm gains and ordinary income can be taxed at lower capital gains rates. In some cases, returns on hedge funds can avoid taxation altogether. Lowering or eliminating tax on hedge fund returns can substantially increase the effective return on hedge fund investments. Fourth, it may be possible to provide access to hedge fund returns to investors who might not be able to invest directly in hedge funds. There are many reasons why investors cannot invest directly in hedge funds. In the United States and in many other countries, hedge funds are restricted to the affluent. Other investors may be barred from investing in hedge funds because of investment restrictions placed on the managers. Creating derivatives to sidestep these kinds of restrictions is a dangerous game if such engineering could be seen as aiding and abetting investors to violate securities laws, but there may be situations where such engineering is prudent. An example of a situation where derivatives trading might be prudent could allow taxexempt investors to participate in hedge fund strategies that would trigger unrelated business income tax (UBITsee Chapter 10). Taxexempt investors avoid problems with UBIT by investing in offshore hedge funds that are organized as corporations and, hence, dont flow interest expenses back to the investors. Taxexempt investors may also be able to avoid receiving interest expenses by investing in certain hedge fund derivatives, such as structured notes, or bonds that receive a coupon based on the performance of a hedge fund or hedge fund index. Hedge fund derivatives could be used to avoid the restrictions on secondary trading that accompany a private placement partnership because investors would buy or sell derivatives based on the partnership returns instead of buying the partnership interest. TYPES OF HEDGE FUND DERIVATIVES Several types of derivatives can be used to replicate a direct investment in a hedge fund. Total Return Swap A total return swap can be used to replicate a long or a short position in an asset or portfolio of assets. Suppose an investor bought $1 million of a particular hedge fund and simultaneously borrowed $1 million secured by the hedge fund assets. In practice, a hedge fund is not a marginable asset, so any dealer or bank that falls under the U.S. Federal Reserve Systems Regulation T could not count the value of the hedge fund as collateral. Also, the lender would likely lend only a percentage of the total value of the assets. However, for the purposes of the example, assume that the investor can, in fact, borrow the entire purchase price of the hedge fund investment. Suppose that each quarter, the investor withdraws the gains from the hedge fund investment and makes up any loss. The investor would also pay interest to the lender on the same day. While the investor would have to make the entire interest payment to the lender, the cash flows would net at the investors bank, as long as the hedge fund pays out the returns on the same schedule as the interest payments. The cash flows for this leveraged transaction appear. In Figure 13.1, the $1 million investment is displayed as a downward arrow representing a cash outflow (truncated in scale). The investor borrows an equal amount, but the time line shows both cash flows, which net to zero. Then, each quarter, the investor receives a payout equal to the hedge fund return and makes an interest payment on the borrowed money. For convenience, the hedge fund returns in Figure 13.1 are all positive, but a hedge fund can have losses. This leveraged transaction would require the hedge fund investor to pay the counterparty the interest payment and make up the loss on the fund. The total return swap acknowledges the $1 million investment as a notional amount but the investor makes no cash payment at the onset. The swap counterparty pays the investor the cash amount equal to the return on the hedge fund on a $1 million notional amount, reduced by the interest on $1 million. At the end, the investor receives no return of principal and makes no loan repayment because the net return payments keep the value of the hedge fund investment equal to the loan amount. The counterparties can modify the total return swap in a number of ways. The accumulated return can be deferred, much like the interest on a zero coupon bond. Depending on tax considerations, the investor may be able to defer recognizing the net interest until the cash is paid. The investor may be able to recognize the return as capital gains if the investor and the counterparty close out the swap agreement at a gain before the accumulated return is paid to the investor. The total return swap may allow certain types of investors to invest in hedge funds that would otherwise not be permitted to do so. First, a fund may be closed to new investment but an investor may be able to find a swap counterparty to pay the return on the fund. A fund manager or marketing partner may participate in hedge fund returns via incentive fees. Hedge fund investors may also be willing to commit to pay out hedge fund returns on a swap if lockup provisions restrict access to previously made investments. Second, the total return swap may permit investors to share an investment in a hedge fund if they qualify to invest but are not able to make the minimum investment alone. Finally, a pension fund may be excluded from a hedge fund because the qualified retirement funds represent nearly 25 percent of the assets in a hedge fund and the hedge fund may not accept additional plan assets (see Chapter 8). The pension fund may be able to participate in the return of a hedge fund closed for pension fund investing. Calls on Hedge Fund Returns Alternatively, the investor might have purchased a call option to enter into the swap transaction. Take, for example, the total return swap that pays the net return at the end of the swap period. The value of this agreement rises and falls on the return of the hedge fund. A call would grant the owner the right but not the obligation to replicate an investment in the fund after the returns have been earned and disclosed to investors. Figure 13.3 depicts the value of a $1 million investment under a range of return scenarios. The swap would gain value when the hedge fund return exceeds the shortterm interest rate in the swap agreement and would lose value when the shortterm interest rate exceeds the hedge fund return. This call in Figure 13.3 represents the right to buy the swap after some period of time as if the investor made the investment as of the beginning period (that is, a strike price of zero). Clearly, the investor would exercise the call only when the swap agreement gained value, so the value of the call rises dollar for dollar along with the hedge fund and cannot go below zero. Figure 13.3 does not suggest that the call buyer makes money whenever hedge fund returns are positive. Not shown on Figure 13.3 is the fee paid to purchase the option. Unlike the direct hedge fund investment, the call buyer makes a profit only if the hedge fund returns exceed the price of the option. Investors may buy calls on hedge funds to leverage the hedge fund returns. Hedge fund managers have bought calls on their own performance as a way of increasing their participation in the returns of their own funds. Hedge fund investors may buy calls when portfolio considerations justify the expense to eliminate the chance of hedge fund losses. Investors may gain some tax advantages from purchasing calls instead of making direct hedge fund investments. First the calls effectively postpone the timing of hedge fund gains. Second, it might be possible for the investor to convert the hedge fund returns to capital gains by selling an appreciated call prior to expiration. Finally, the call can change the characterization of return for taxfree portfolios because the return on the call does not flow through the interest expense (both of the underlying hedge fund returns and the interest component of the swap) and may avoid a problem with UBIT. Puts on Hedge Fund Returns Many hedge fund structured products contain some element of protection from losses. Put options offer a way to protect a portfolio for some of the risk of loss. A put gives the owner the right but not the obligation to replicate an investment in the fund after the returns have been earned and disclosed to investors. The put operates much like the call in that the payoff of the put is based on the difference between the value of the portfolio and the value of the initial investment. However, the put gains value when the value of the portfolio falls below the starting level. Figure 13.4 shows the payoff profile of a put option. Like the call option, the put can be worth no less than zero. Unlike the call, the put gains value dollar for dollar when the underlying hedge fund loses money. Puts offer many of the same advantages to investors that calls offer. In addition, puts act much like a short position in hedge funds, which is difficult to create without using some form of derivative instrument. Providing Downside Protection with Zero Coupon Bonds Hedge funds and commodity pool operators have developed a structure to guarantee return of principal regardless of the returns on the hedge fund or commodity pool. The secret to this strategy is to commit a portion of the hedge fund investment to a zero coupon bond that matures at the full value of the initial investment some years later. Also, the zero coupon bond must be placed in a segregated account, preventing possible creditors of the hedge fund from getting it if the hedge fund loses more than 100 percent of partner capital. Zero coupon bonds sell at a discount from face value. The amount of that discount can be invested in a hedge fund without regard to risk because, even if the hedge fund loses 100 percent of the money, the zero coupon bonds will still mature at the full value of the initial investment. Figure 13.5 shows the allocation to zero coupon bonds at a 5 percent rate of return for various maturities. Zero coupon bonds trade near par for short maturities, so little discount is available to invest in the hedge fund strategy. For a commitment period of five years, only 22 percent can be allocated to the hedge fund strategy. At lower levels of interest rates, nearly all the assets are allocated to the zero coupon bond portion of the strategy. As a result, the blended return on this portfolio is low. However, when rates are higher, the discount on bonds is larger and more of the money can be allocated to the hedge fund strategy. (See Figure 13.6.) As rates rise from 5 percent to 10 percent, the allocation to hedge funds nearly doubles from 22 percent to 39 percent. Higher market returns make it easier to achieve a guaranteed breakeven but the opportunity cost of merely breaking even rises. For example, at a rate of 14.87 percent, a zero coupon bond could double an investors return in five years.1 Few investors should be happy about having the same value when a riskfree alternative could double the value in the same number of years. 




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