Handbook of Hedge Funds

27

Structured Products on Hedge Funds

Investing is hard. Staying invested is even harder.

Many investors are attracted to hedge funds by the promise of diversification benefits and superior performance, but they feel nervous and uncomfortable once they actually have to commit capital. Several reasons justify this feeling. First, hedge funds are still perceived as being extremely risky and carrying a significant potential downside, particularly after the torrent of negative publicity that accompanied the debacle of Long Term Capital Management. Second, regulated entities such as pension funds and other institutional investors are often restricted by their supervisors from investing in loosely regulated and/or unlisted vehicles such as hedge funds without some kind of financial guarantee. Third, many individuals are still discouraged by the relatively high minimum amounts required to invest in hedge funds, or have tax, regulatory, accounting, foreign exposure or other concerns.

To bridge the gap between supply and demand, a growing number of financial intermediaries have solved the above-mentioned problems by proposing structured products tied to the performance of funds of funds (hencefourth: funds of funds) or hedge fund indices. These structured products now come in a variety of guises and engender much debate. Simply stated, they are packages that are structured with a preset formula for calculating returns and a preset formula for calculating risk relative to their underlying ...