Even guaranteed funds can be risky
Threat to structured products grows as rising rates spark race among managers to unwind positions
Some guaranteed funds and alternative investments sold to Hong Kong's savers could turn out to be a lot more dangerous than at first thought.
Since 2001, when deposit rates fell to almost zero, savers in Hong Kong have been enthusiastic buyers of structured investment products such as guaranteed funds and multiple-manager hedge funds.
Guaranteed funds pledge investors a minimum return at the end of the fund's lifespan. Alternative investments, usually hedge funds, tout their ability to generate positive returns even if stock markets sink and claim to reduce risk through diversification.
Since mid-2001, more than 300 guaranteed funds worth about US$20 billion have been authorised in Hong Kong. Only 13 hedge funds worth about US$500 million have been approved by the Securities and Futures Commission. But that understates the true sum raised from Hong Kong investors because most hedge funds have been sold as offshore investments.
Now financial markets may be about to inflict heavy losses on both types of funds, even on some of those carrying guarantees.
That is because interest rates are rising. Since the middle of last year, the United States Federal Reserve has been tightening its monetary policy, raising its benchmark short-term rate to 2.5 per cent from a low of just 1 per cent. Some forecast the rate would reach 4 per cent by the end of the year.
So far, financial markets have barely responded, but when they do, there will be a rush for the exit. Managers of hundreds of billions of US dollars worth of 'hot' money, or speculative funds, will race to unwind their positions.
Inevitably, there will be casualties.
'There has scarcely been a tightening cycle in modern times that has not resulted in at least a minor financial crisis,' John Llewellyn, the global chief economist at US investment bank Lehman Brothers, warned clients last week.
Even a minor crisis could be a big problem for some of the guaranteed funds and hedge funds sold to Hong Kong investors. Some hedge funds will be caught on the wrong side of the move and lose money. That will trigger redemptions by investors, which in turn will force the managers to unwind more of their positions, pushing prices lower.
'The knock-on effect would be enormous,' said Paul Smith, the global head of alternative fund services at HSBC.
For some funds, it could be lethal, especially for multi-manager hedge funds, which use complicated derivatives strategies to gear up their investments.
Rapid unwinding could punch a hole in some guaranteed funds, too. Not all guaranteed funds set aside sufficient assets to cover their money-back pledge. Instead, to gear up the funds available for trading, some rely on the risk-management techniques used by investment banks.
Every morning, they calculate the maximum amount of money the fund is statistically likely to lose that day, based on historical volatility data. The managers then set aside enough money to make good the anticipated maximum losses.
Unfortunately, such 'value at risk' models may not prove as effective as hoped. During the Asian financial crisis of 1997 and 1998, similar risk-management techniques proved useless as market volatility exceeded anything thought probable.
There may be a risk of something similar happening now.
Volatility in financial markets has been near historical lows recently, meaning the data shows little probability of heavy losses. But if a rapid reversal of market sentiment forces runaway position unwinding, volatility levels will soar and historical data will prove useless for gauging market risk.
If that happens, some fund managers may find they have insufficient funds set aside and the guarantees they had offered investors are not worth the paper they were written on.