1. CAIA Level II: Core and Integrated Topics, Institutional Investor, Inc., 2015, ISBN: 978-1- 939942-02-9. Part V: Investment Products: Structured Products.
A. Coval, J., J. Jurek, and E. Stafford. "The Economics of Structured Finance." Journal of Economic Perspectives, Winter 2009, Vol. 23, No. 1, pp. 3–25.
B. Weistroffer, C. "Insurance Linked Securities." Deutsche Bank Research, October 2010.
C. “Going Mainstream: Developments and Opportunities for Hedge Fund Managers in the
’40 Act Space.” Barclays. April 2014
D. Maxey, C. “Alternative Strategy Mutual Funds: Opportunity or Mirage?” Fortigent, LLC.
October 2013.
Reading 2, Article A
The Economics of Structured Finance
The article provides a synopsis of the mechanics of structured products with extra focus on the details of the how the challenges of rating of these products affected the financial crisis of 2007- 2008. The authors use the example of a prototypical collateralized debt obligation to illustrate the processes of pooling and tranching, and how these processes amplify errors in evaluating the risk of the underlying securities. The details of tranching outlined in the section titled “Manufacturing AAA-rated Securities” are important, since these are crucial in understanding the way structured products repackage risk. This section also explains how small errors in estimating the risks and correlations of the underlying assets can translate into much larger errors in estimating the risks of the tranches. The risk estimation for tranches becomes even more challenging in the case of CDO-squared securities.
The article focuses on the challenges of rating tranches of structured products in the section titled
“The Challenge of Rating Structured Finance Assets.” The article provides both a conceptual framework for understanding these challenges and empirical results illustrating sensitivity of risk estimates to errors in parameter estimation. In the section titled “The Relation of Structured Finance to Subprime,” the article provides a historical overview of the events and market participants associated with the subprime crisis.
The section titled “The Pricing of Systematic Risk in Structured Products” highlights how pooling and tranching effectively manufactures securities whose payoff profiles resemble those of digital call options on the market index, providing investors with substantial exposure to systematic risk. Finally, in the last two sections of the article, the authors look at the history of structured product markets leading up to the crisis and the implications of the crisis for the future of structured products. Of particular interest in these sections is the conflict of interest between various market participants.
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Exercises
1. How did the factors shaping expected losses on tranches ofcollateralized debt obligations backed by mortgage-backed securities affect investors during the recent subprime crisis?
Solutions
1. All of the factors shaping expected losses on tranches of collateralized debt obligations backed by mortgage-backed securities had been biased against the investor during the recent subprime crisis. First, the overlap in vintages and geographic locations within mortgage pools increased the likelihood of higher-than-expected default correlations.
Second, the deterioration in credit quality of subprime borrowers and the predominance of “fire sales” of assets (which in turn led to lower asset prices) increased the probability of default and worsened expected recovery values. Finally, the commonness of CDO2 structures further exacerbated the harmful effects of errors in estimates of expected losses on the underlying mortgages for investors.
(Pages 220-242)
Reading 2, Article B Insurance Linked Securities
The author provides a primer on a fast-expanding niche asset class: insurance-linked securities (ILS). The article discusses the economics of how ILS work: by complementing and extending traditional reinsurance, expanding insurance capacity overall, offering additional hedging opportunities to insurers, serving as an additional source of funding for insurers, and their role as a potential portfolio diversifier. The mechanisms of how ILS structures are discussed, explaining how risk transfer works using catastrophe bonds. The author then describes the role of reserve capital requirements in the growth of ILS, as well as the basis risk for the insurer.
Finally, the author concludes with a discussion of the current market of ILS, which evolves into a discussion of the future of ILS, and the role of new regulations, for example Solvency II, in the growth of ILS.
Exercises
1. Describe cat bonds.
Solutions
1. In a cat bond transaction, the investor loses a portion of or the complete principal if the loss from a predetermined event materializes. Typical predetermined events are hurricanes in the U.S. and winter storms in Europe. The cat bond investors in turn are paid by a premium – proportional to the risk they are bearing – in addition to being compensated the market rate on the principal (e.g., LIBOR). In practice, the cat bond is issued by a special purpose vehicle (SPV) sponsored by the insurer. An SPV is a legally independent, bankruptcy remote vehicle, that is set up for the sole purpose of arranging
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the transaction. Finally, most cat bonds are being rated below investment grade. This is in contrast to senior tranches in credit securitizations.
(Pages 243-257)
Reading 1, Article C
Going Mainstream: Developments and Opportunities for Hedge Fund Managers in the ’40 Act Space
While the private placement hedge fund business has seen slowing growth in assets under management, assets are growing quickly in the '40 Act space, where hedge funds are offered in a mutual fund format. Hedge fund managers may find this mutual fund business to be attractive, as they can increase asset flows while diversifying their investor base. Managers with a larger and more diverse asset base may find that their asset management company has a higher valuation multiple, even as average fees decline.
However, managers must enter this space carefully. In order to offer a mutual fund product, the investment strategy must adhere to the rules of the Investment Company Act of 1940, from which the private placement manager is specifically exempted. These rules include restrictions on leverage, short selling, and asset concentration, while requiring greater levels of liquidity and transparency. Not all strategies fit well into the '40 Act framework, as some relative value and credit strategies may employ too much leverage or have too little liquidity to meet the regulatory requirements.
Managers will also need to consider whether raising assets in the lower-fee mutual fund will cannibalize their assets and fee income in the higher-fee hedge fund product. Finally, raising assets for a hedge fund is quite different than raising assets for a mutual fund, so some hedge fund managers have created joint venture or sub-advisory relationships with traditional mutual fund firms with strong distribution capabilities.
Exercises
1. In what ways do mutual funds regulated by the Investment Company Act of 1940 ('40 Act) differ from hedge funds that are exempt from the '40 Act? What changes to investment strategy are necessary before hedge funds can offer funds that are compliant with the '40 Act?
2. List and discuss three ways that hedge fund managers may enter the '40 Act
space. Specifically address the characteristics of a hedge fund manager that would choose one fund vehicle over another.
Solutions
1. Mutual funds subject to the regulations of the '40 Act have specific rules regarding leverage, short selling, liquidity, diversification, and transparency. While hedge fund managers typically do not have limits on their investment strategies, managers who choose to offer their funds in a
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mutual fund format must comply with all regulations of the '40 Act. Specifically hedge funds will need to 1) have a maximum leverage of 1.33x or asset coverage of 300%, 2) carefully segregate assets to cover short selling risks, 3) strike a daily NAV and offer daily liquidity, 4) limit illiquid securities to 15% of assets, 5) limit position sizes to comply with diversification requirements, and 6) file quarterly, semi-annual, and annual reports providing transparency into fund positions.
(Pages 258-277)
2. A. Sub-advise a multi-manager '40 Act product. This style is most similar to a fund of funds, where the hedge fund manager implements their strategy on only a portion of fund
assets. Because the '40 Act rules on diversification, concentration, and leverage apply to the full fund and not individual strategies, the choice to sub-advise a multi-manager product may be most appropriate for managers whose natural strategy has positions that are far from compliance with the '40 Act regulations. For example, a highly levered relative value fund manager may choose this structure to avoid reducing the level of leverage in their portion of the multi-manager product. This structure is also appropriate for managers who do not want to directly disclose their positions, as the transparency from the multi-manager fund will commingle the positions of all of the fund's managers.
(Pages 258-277)
B. Sub-advise a single-manager '40 Act product. In this structure, the manager will run their fund with a strategy similar to their hedge fund, but partner with a traditional mutual fund company who has experience in the regulation and distribution of mutual fund products. This strategy allows the hedge fund manager to focus on investment management, while leaving the fund raising and mechanics of fund management to another firm.
(Pages 258-277)
C. Sponsor and distribute their own '40 Act product. In this structure, the hedge fund manager will manage, distribute, and build the infrastructure for their own mutual fund product. This structure is best suited for a manager who has the operational infrastructure to handle both '40 Act and private placement products.
Both structures B and C subject the manager to cannibalization risk. Investors who see the same fund manager operating both a higher fee hedge fund and a lower fee mutual fund will demand better performance from the hedge fund to justify the difference in fees. If performance of the hedge fund is not significantly better than the mutual fund, hedge fund managers run the risk of seeing redemptions from the hedge funds with the proceeds potentially flowing into their mutual fund vehicle. Investors in structure A don't have this risk, as this structure doesn't create the opportunity for investors to directly invest in the single manager's strategy in a mutual fund format.
(Pages 258-277)
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Reading 1, Article D
Alternative Strategy Mutual Funds: Opportunity or Mirage?
Following the financial crisis of 2007-2008, investors and asset managers began searching for invest products that could participate in rising markets in a meaningful way, but at the same time provide significant protection during down markets. Privately placed products such as hedge funds and manage futures displayed some of these properties during the crisis, but they were not available to retail investors in most countries. Therefore, attempts have been underway during the last several years to package these privately placed products so that they can be offered to retail investors under the general title of liquid alternatives. These industry attempts have been helped by changes in the regulatory environment in the U.S., in particular.
This article explores the challenges and the opportunities presented by the evolution of
alternative mutual funds for investors and asset managers. It begins with a brief description of various alternative strategies and then proceeds to examine the benefits of adding alternative to a traditional portfolio.
Not all privately placed products can be packaged in liquid form that can be made available to retail investors. The article compares and contrasts privately placed products with their liquid counterparts, addressing issues such as fees and investment structures. Finally, the article examines the due diligence issues and various types of risks that arise while considering liquid alternatives.
Exercises
1. Describe regulatory requirements that are applicable to alternative mutual fund strategies.
2. Explain the challenges involved in evaluating alternative mutual funds Solutions
1. In the U.S., the Company Act or the 1940 Act is the primary source of regulation for mutual funds and closed-end funds. Mutual funds, whether offering traditional or alternative investment strategies must meet the regulatory framework set by this act. The regulations most directly applicable to alternative strategies include the following:
• Redemptions must be paid within seven days.
• No more than 15 percent of assets may be invested in illiquid assets.
• Mutual funds should not charge performance fees, unless designed as a fulcrum structure where fees rise and fall depending on the performance of the fund.
• For at least 75 percent of the portfolio, diversified mutual funds may invest more than more than 5 percent in any one issuer, may not own more than 10 percent of the
outstanding voting securities of an issuer, and may not invest more than 25 percent in a particular industry group.
• May not generate more than 10 percent of income from non-securities, such as commodity futures.
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• Mutual funds may employ leverage, as long as it maintains 300-percent asset coverage.
For practical purposes, this limits leverage to 33 percent.
(Pages 278-288)
2. Several issues arise when evaluating an alternative mutual fund:
• Limited track record. This pertains more to experience across different types of specific periods of time.
• Long-only managers launching alternative funds despite limited experience with shorts or derivatives.
• Operational infrastructure and its impact on a manager's ability to establish quality counterparty relationships.
• Disparity of style and approach across time (style drift).
• Personnel turnover.
• Investor turnover or sudden loss of assets.
• Strategies that we do not believe have the potential to perform well within the constraints of the mutual fund structure.
(Pages 278-288)
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