Are Capital-Guaranteed Hedge Funds Worthwhile And Safe?

by Carla Johnson, Investors Offshore, London

09 September 2002

Recent weeks have seen the launch of a number of capital-guaranteed hedge funds in Europe, where the expansion of the hedge fund market to take in institutions and a top slice of the retail sector has created a population of hedge fund investors who are noticeably more cautious than plain old rich folks who can afford to take a punt on a slice of their wealth.

In order to create a capital-guaranteed hedge fund investment, part of the capital can be used to buy sufficient zero-coupon bonds to repay the investment at maturity, while the remainder is normally used to buy call options on hedge funds of funds. Evidently, there is no risk either for the investor or for the financial institution issuing the investment, although the cost of the bonds could be considered a 'dead' expense in normal times.

A second type of capital-guaranteed product, and the more popular, is however riskier: the capital is simply invested in appropriate funds of hedge funds, and the issuer relies on being able to hedge any capital exposure as it arises using various types of financial product, depending on the circumstances.

The Wall Street Journal says that some analysts are becoming concerned that as the value of capital guaranteed funds grows (currently perhaps around €15 billion in Europe), there is a growing systemic risk of collapse, if all issuers were to rush for the door at the same moment.

Perhaps these fears are overdone: the total of hedge fund investment is said to be a mere 3% of all fund investment, at between $500bn and $800bn, and only a fraction again of that is capital-guaranteed. And the exit door in a crisis varies according to the type of hedge fund chosen; for that matter, a well-chosen batch of cross-strategy funds of hedge funds should be proof against most disasters.

The real problem with capital-guaranteed products is that a hefty premium is being paid to extinguish a small risk, so that managers will get rich while investors get skinned. In all likelihood, as European investors (and the journalists who advise them) become more knowledgeable about hedge funds, people will stop wasting their money in quite such an obvious way.

Recommended