08.06.2004
In the last few years, there appears to have been an explosion of hedge fund offerings and interest rate derivatives. Some of these are dressed up as high credit quality instruments; albeit of slightly longer tenor. Indeed the number of callable notes issued by reputable institutions under their EMTN programmes and otherwise, have increased multi-fold. Many would regard these principally, as a play on the projected yield curves. With interest rates trending and remaining low, and yet threatening to increase at the drop of every statistical hat in the U.S. , the heightened volatility in the bond markets is not entirely surprising. However, a good measure of what mature financial engineering can come up with is the versatility and variety of hedge funds and structured products that have been unleashed in the market place.
The guaranteed versions of hedge funds are also currently in vogue. Investors have become risk averse and are rattled by every skeleton that is coming out of the corporate cupboards in the U.S. and Europe . If the principal amount of their investments can be protected in some manner, even if by using their own money, and leveraging the rest, the investors feel reassured. In all these cases, the opportunity cost is not calculated or considered by the average investor. Therefore, it becomes a case of hedging one's bets. However in reality, all these are variances of taking a view and committing, even if only a small amount, to fund that speculative position. Borrowing the rest on the strength of an internal structure and earmarking sufficient fees for the intermediaries (the distributing institutions and the sales staff) have made such investment scenarios (sic) almost an art form!
Cynics might deride these as nothing more than rampant speculation wrapped up under different garbs. But alternative investments and interest rate / derivative structures are here to stay. In the last three decades, they have changed the contours of the investment universe. What has also changed dramatically, is the amounts of leverage that go into these structures and the "short" positions that global finance managers are beginning to put on to their books. In terms of scale, these run into several hundred billions of U.S. Dollars every year. The regulators are worried and have now threadbare-analysed the risks for capital adequacy and financial systems stability. In terms of risk-taking, only the most sophisticated institutions in the world are engaged in proprietary positions on a massive scale. In that sense, they have replaced the traditional foreign exchange trading syndrome that used to rule the roost in major commercial banks and in the larger financial centres from the middle to the end of last Century.
On the positive side, alternative investments have multiplied the choices available to the average investor, albeit requiring a higher sophistication, risk tolerance and homework / due diligence on his part. Derivative-embedded Notes by reputable institutions with good credit rating are aplenty now. The markets have effectively evolved to vary the downside, except the loss of income for certain periods, and provide some 'interesting' upside. Hedge funds that build in capital guarantee, even if derived / devised by using the investors' own money, or contrived to contain credit facilities, have created a bundle that can, in overall terms, be branded as reasonably secure. It is true that the capital guarantees are often available only at maturity and thus stretched over long tenors of five to twelve years.
Therefore, with some ingenuity and innovation as well as good fees in tow, such products have modified the focus of financial institutions from purely chasing the traditional deposit-taking activities to including these in their retail offerings.
Sometimes choice can be crippling and certainly bewildering to the lay investors. Regrettably an aggressive approach and economy with truth in disclosure have lead to mis-selling. Many relationship managers seeking a larger share of the customers' wallets, can be wolves in sheep's clothing. Evaluation of the risks or verifying the prices can be arduous tasks to the average investor, who could be dazzled by what is presented to him in bold font and multi-coloured visuals and less diligent to check the small print. Mercifully the guaranteed products are not pure equity play and therefore, the downside excepting for opportunity cost is contained.
Hedge funds are opaque and the multi-manager ones being little other than leaps of faith! One can only rely on the track record of the intermediate institutions that appoint such hedge fund managers with varying strategies. These range from high falutin' labels such as relative value to convertible arbitrage to statistical arbitrage to long-short, risk arbitrage etc., if you please! What a gamut of strategies; some contrarian and others are supposed to be trend-busting! The sponsors are expected to carefully pick them on the basis of their underlying performances, and be in a position to switch and obtain the best value for the underlying investors.
All in all, these are interesting times for the investors - not quite what the Chinese mean when they say "may you live in interesting times!".
[The author is General Manager of Emirates Bank. However, the views expressed in this article are not necessarily shared by the Bank].
