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New Exotic Financial Instruments, Closed-end Funds, Hedge Funds and Structured Products (June 27, 2005)

Location: Chicago
Author: RiskCenter Staff
Date: Monday, June 27, 2005

Last week ninety people gathered in Chicago to hear a panel discussion on the topic "Opportunities in New Exotic Financial Instruments - Closed-end Funds, Hedge Funds and Structured Products."

This is a topic of growing interest in that individuals and portfolio managers recently have invested tens of billions of dollars in such instruments in order to boost their risk-adjusted returns or diversify their portfolios.

The panelists for the meeting were (1) Mr. Keith A. Styrcula, Chairman of the Structured Products Association, and VP, JPMorgan Chase Equity Derivatives; (2) Mr. John Larkin, Managing Director, HFR (Hedge Fund Research) Asset Management, and (3) Mr. Paul C. Williams, Managing Director. Nuveen Investments. The moderator for the evening was Mr. Matt Moran, VP, CBOE, and a member of the Chicago QWAFAFEW steering committee.

Key Issues Covered

Among the topics covered at the meeting were the following:

  • Many investors recently have explored opportunities in new financial instruments such as certain closed-end funds, hedge funds and structured products, which recently have attracted billions of dollars in new investments. Bullishness was expressed on the potential for future growth in these products. One of the factors that is driving this growth is the fact that many investors are dissatisfied with the recent performance and yield on "traditional" financial investments such as stocks (e.g., the DJIA, Russell 2000 and Nasdaq Composite indexes are all down this year) and traditional long-term fixed income instruments (e.g., the recent yield on 10-year Treasury notes has hovered around 4%).
  • There has been work on a certificate of deposit linked to a hedge fund index, with 7-year maturity, 100% principal protection, FDIC-insurance up to $100,000, investor suitability requirement, and an investment minimum: of $50,000 (or $25,000 for an RIA).
  • There also has been work done on a hedge fund index short share class.
  • The number of closed-end funds doing covered call writing is expected to rise from zero in June 2004, to 25 in July 2005. Such funds have raised more than $10 billion in the past year, and there is potential for much more growth in the future. Investors are looking for 8% to 10% yield with such funds (which can underperform when stocks do well).
  • The approximate market share breakdown of investors in closed-end funds is 95% individual investors and 5% institutional investors.
  • The Structured Products Association is working on fostering more innovation and best practices.
  • U.S. investors are accustomed to taking on investment risk and usually do not ask for the principal protection feature in structured products, whereas European investors and regulators often request the principal protection feature in structured products. Marketing efforts for structured products in Europe have been very successful.
  • In regard to tax efficiency of structured products in the U.S. , upside products can be pretty tax-efficient, but products with downside principal protection can be tax-inefficient in the U.S. because of issues such as phantom income and OID. European products with downside principal protection can be tax efficient under European tax laws (all investors should check with tax counsel for tax advice).

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