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1. The Hedgeweek Interview: John Godden, HFR Asset Management: Shaping the future of structured products in Europe

HW: What is the background to HFR Europe?

JG: HFR Asset Management Europe was set up in 2001 to market the products of HFR Asset Management to the European institutional investor community, bringing their technology in the area of highly transparent, highly risk-controlled hedge fund investing which seemed to be very well-suited to the requirements of European institutional investors.

HFR Asset Management is configured as an SEC-regulated fund of funds manager which uses the HFR Asset Management Fund platform to provide bespoke funds of hedge funds for our European clients. The amount of client activity coming into HFR from Europe has necessitated a dedicated portfolio management team for European clients.

The development of the HFRX Investable Index Trackers within the HFR Group range of products has been a significant factor in the development of HFR Asset Management in Europe. The demand for this product in Europe has proved to be exceptionally strong with more than USD 2 billion being placed into the trackers so far.

HW: Why are indexed hedge fund products relevant to institutional investors in Europe?

JG: The use of index trackers to gain exposure to traditional asset classes such as long-only equities is now part of the institutional investment landscape. The utility of being able to obtain exposure to a given index acting as a proxy for the returns of a given asset pool in a cheap and easy fashion is very popular, as is the ability to capture the market beta without exposure to the potential underperformance of making the wrong component selection. Clearly the loss of the potential out-performance is balanced against the low costs involved.

The new breed of investable hedge fund indices appeals to the same thinking. Investors are able to obtain exposure to various hedge fund strategy groups without manager specific risk, either the fund of hedge fund manager or the individual hedge fund manager.

Investable hedge fund indices open a new gateway for investors to get exposure to hedge fund returns. Some key barriers to entry are removed such as the double fee layer, the costs associated with manager selection and due diligence and the risk of underperformance.

In addition to offering a new bridge into hedge fund investing as a first step into the field, investable indices are also being used by experienced investors to gain rapid exposure to certain strategy areas to increase the ability of investors and funds of hedge funds to make dynamic strategy allocations.

HFRX offers eight individual strategy indices each of which can be used separately to provide a pure exposure to the respective strategies. Both fund of funds and institutional investors are using these to either add flexibility to their strategy allocation programme or to construct whole portfolios focussing on strategy allocation as a return driver, the return of the individual strategies being defined by the indices not a pool of managers selected in the traditional way.

The liquidity of the index trackers (all have full monthly liquidity with no limitations), enables much more active strategy allocation to be undertaken.

HW: Can retail investors access these trackers? Are there any examples of this within Europe?

JG: Structured products are driven mostly by accessibility issues. Most of these issues are regulatory or tax arbitrage in essence, allowing people who cannot hold a hedge fund asset in its raw form a way of tapping into them by creating a suitable structure around them.

The market in certificates linked to hedge fund economics on a one-for-one basis has become very large, particularly for listed certificates. There now are certificates listed in Switzerland, Germany, London, that are effectively securities.

The lowest entry level would be around EUR 10,000 so these products are not aimed at the man on the street, they are aimed at more sophisticated investors via qualified brokers or other intermediaries. These investors are characterised as those who already buy equity investments in collective schemes though their broker and want to add a component of hedge funds to their portfolio.

The most active banks in the listed certificates area are Dresdner, Deutsche Bank and Union Bancaire Privee.

HW: What are the advantages to European institutions of creating structured products linked to these indices?

JG: The use of structured products linked to a growth asset has been an established format for retail products and as a regulatory solution for institutions for more than 10 years now.

Until the late 90s such products were linked to equity indices, more recently we have seen structures linked to funds of hedge funds as the low volatility characteristics of these structures have been highly beneficial to the structured product buyer.

Investable hedge fund indices have allowed structured product providers to return to the original concept of products linked to indices to create highly efficient offerings for either retail or institutional markets. The low fee levels and the low risk attributes of the Indices lead to lower priced structures.

The wide availability of the indices has made for an easy, more constant product proposition for investors, structured products linked to Indices are more easily understood by purchasers than products linked to a series of different fund of funds with different risk, return and structural profiles.

The market is evolving rapidly in terms of investors understanding the possibilities. For example, a key development is among bond investors. A number of investors have bought bonds which have hedge funds underlying, predominantly in CFOs. They are looking at it in terms of investment grading in a classic 'bond' way, examining the rating attached to its principal and the relative strength of the coupon stream. This is a whole new area of hedge fund investing, where the investors are not investing for hedge fund economics.

Another example is in the portable alpha area, where people use leveraged access to alpha generators. We are seeing that pension funds, having divested their equity market beta, are getting a lot smarter in their engagement of hedge funds.

They are buying non-equity beta strategies using structured funds - they will buy a leveraged basket of hedge fund strategies excluding the beta that they don't want.

HW: How many institutions are currently creating products linked to the HFRX indices and in which countries is growth taking place?

JG: There are currently thirteen banking partners for HFRX all of which offer a wide range of different structures from basic 'delta 1' Certificates listed in Europe through to complex guaranteed structures and, most popular at the moment, leveraged structures.

Products have been produced to provide a risk profile similar to Treasury Instruments at one end, and equity equivalent risk at the other.

Geographically, development in the past two years was dominated by Switzerland, France, Scandinavia and UK-based institutions, Asia, the Middle East, and the US, where our warrants programme has been very strong in the last six months.

Build-out is going to take place this year into Germany, Southern Europe and the UK and Ireland. We have had to take on people with local knowledge in the UK market, we have strengthened our Southern Europe and French focus and we are hiring in Germany and Spain.

At a senior level, we've taken on Laurent Dambly who previously headed Hedge Fund structured products at ABN Amro, and Erik Bender who was formerly with Pru-bache and heads up our focus on the private banking area.

HW: What resistance or negative feedback do you encounter in Europe and how do you tackle it?

JG: When the investable indices were launched in April 2003, we saw some negativity coming from the community of funds of hedge funds. This was in part due to a fear on their part that the indices would represent a threat to their business.

This quickly dissipated as funds of hedge funds realised that they could use these indices themselves and, rather than threaten their position, the indices are attracting new money into hedge funds and are aiding the level of understanding by potential investors as to the  expected return and risk profile of hedge funds.

The indices occupy a very different area to fund of hedge funds. Indices have less ability to meet tailored risk or correlation profiles than funds of hedge funds that can meet very specific criteria as required by certain investor types. The application of a core/satellite approach to investing in hedge funds requires a strong funds of hedge funds sector.

A further criticism is that of the ability of investable indices to be properly representative of the strategies they are tracking. HFR have brought over 10 years of experience in hedge fund indexation to bear in creating our investable indices. A robust methodology applied to a full universal database enables the creation of optimal strategy representation that is statistically strong. It is necessary to select the component managers from a very wide, statistically accurate universe and to then apply the optimal allocation across those components. The detailed quantitative approach to this component allocation yields a very high level of correlation. Regular quarterly rebalancing is also necessary to retain the integrity of the representation.

The return profiles of the investable indices since their launch have proved their veracity and representativity to the satisfaction of many.

The main difference between and index and a fund of hedge funds (FoHF) is that an FoHF selects managers based upon a qualitative judgement of the capability of a manager to deliver going forward whereas an index selects a manager based on a backward-looking quantitative view, so they have completely different selection criteria.

HW: What can we expect to see from HFR Europe in the next few months?

JG: There will be three developments. The next phase in the evolution of our listed certificates products will be the launch of exchange traded tracker funds. These funds will create the same scenario as certificates, but they will be a lot more efficient. They will enable all asset managers to use these hedge fund tools in a very easy format.

We are looking at a range of partners right now - liquidity is the issue and we need liquidity providers to make a market for these products. We expect to roll-out these exchange traded tracker funds early this year.

Second, we're now coming up for two years with our investable indices that have been very successful. We are now launching two 'mezzanine' indices - the HFRX Market Directional Index and the HFRX Absolute Return Index - that sit between the single strategies and the global indices.

We can now clearly sort managers into the two new categories, based on including those funds with the 'most market directional' and the 'most absolute return' characteristics, with 20 funds in each new index.

We 'soft launched' these new indices in Q4 last year with our own money, and we will formally launch them in March this year.

A third development is the addition in January this year of Euro and Yen classes for the Global index, which was previously denominated in US dollars only as are our other indices.


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