Chapter 13 notes 2012 08 03


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Chapter 13 notes 2012 08 03

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 13Structured Funds and StructuredExchange Traded FundsAugust 2012
  2. 2. Chapter summary and outlineThis chapter outlines the features of structured funds andstructured exchange-traded funds (ETFs), what types of investorswould invest in structured funds and structured ETFs,governance, documentation, risks and common examples ofstructured funds and structured ETFs.Chapter outline:• Structured Funds• Structured Exchange Traded Funds (ETFs)finlogIQ 2
  3. 3. What is a structured fund• A fund that combines financial instruments, including equity, fixed income and derivatives to achieve specific risk/return and/or cost/savings profiles that may not be otherwise achievable in the marketplace – It is possible for a structured fund to invest only in derivatives• For structured funds with a fixed income component, they are designed to provide: – Some level of capital preservation – Regular interest payments• Derivatives such as options, futures and other derivatives – Used to provide ability to achieve higher returns linked to an underlying asset• Structured funds can be complex or simple – created by combining underlying securities like shares, bonds, etc.• Structured products for example, are designed to provide highly targeted investments tied to their specific risk profiles, return requirements and market expectations,• An open-ended fund is a collective investment scheme that can issue and redeem units at any timefinlogIQ 3
  4. 4. What is a structured fund -2• Closed-ended funds are funds with limited number of shares – An investor can trade shares of a closed-ended fund in a stock exchange if it is listed• Funds with fixed maturity schemes are designed to be held to maturity and any early termination may result in losses for the investor• Structured funds that offer a degree of capital preservation: – Also offer investor ability to earn a market-linked investment return, while having some level of security that they will get back the dollar value of the initial investment amount at the maturity date if investment markets turn sour – The guarantee will not apply if the guarantor is unable to fulfil its obligations in the event that the guarantor becomes insolvent• Most investments that have a degree of capital preservation are fixed maturity schemes – Designed to be held till the maturity of the fund – Guarantee is in respect of 100% capital invested less upfront sales charge and applies only when the investor holds it till the maturity datefinlogIQ 4
  5. 5. How are structured funds different fromtraditional mutual funds?• A traditional mutual fund: – Typically relies on manager’s expertise and discretion to decide on how their fund would allocate its investments – Involves active allocation• Structured funds are different in that – They aim to replicate the underlying asset, or – to provide a synthetic return linked to the underlying asset of the fund by incorporating derivatives – Allocation is typically static or rule-based and the investment view can be long, short or market neutral.finlogIQ 5
  6. 6. How are structured funds different fromtrackers?• Trackers are used to simply replicate the performance of their benchmark• On other hand, structured funds can be used to realize various anticipated market views – Structured funds have variable levels of exposure that are adjusted systematically in the light of market developments and, – Optimised on the basis of its expectations for market direction and volatility – Adjustments and optimisation - to deliver the promised level of capital preservation and participation (if any) in the underlying assetfinlogIQ 6
  7. 7. Input parameters for a structured fundChoice of the Underlying Asset• Fixed Income, Credit, Foreign Exchange, Commodities, Equities, Proprietary indices, Interest rates, Real estate, Derivatives such as options, futures, forwards, swaps, CDS, CDO, weather derivatives, carbon credits and/or a combination of theseChoice of Maturity• Short term (1 year), Medium term (2 to 5 years), Long term (more than 5 years)• No maturity for open-ended fundsDegree of Payout Schedule• Fixed or variable coupons• Participative returns based on the outcome of the underlying assets)Anticipated View on Market Scenarios• Bullish, Bearish or Market neutral viewfinlogIQ 7
  8. 8. Usage of derivatives within structured funds• Funds with indirect exposure to the underlying asset would track or replicate the underlying asset’s performance synthetically, by using derivative instruments rather than holding the underlying assets directlyExample 1: Total return Swap• A fund has many ways of tracking the index e.g. Straits Times index• It can simply buy the underlying shares with the corresponding weightings or more realistically trade the index futures – This would require ongoing active management either by Frequently rebalancing the stock portfolio and reinvesting the dividends, or rolling the futures contract close to maturity• Or, invest in a Total Return Swap (TRS) providing the Straits Time Index total return every 6 months for the next 5 years based on the notional amount – SIBOR plus e.g. 30 bps per annum – Matching the return of the index at a cost of 30 bpsfinlogIQ 8
  9. 9. Usage of derivatives within structured funds - 2finlogIQ 9
  10. 10. Usage of derivatives within structured funds - 3Example 2: 10 year investment product with upside and protection• Maintains 100% of the capital invested• Share in any Straits Times Index gains• To achieve this: – Invest (say 80%) in fixed income assets - to deliver the level of capital conservation promised at maturity, and – Other portion (ie 20%) is invested in 10 yr call option on STI IndexfinlogIQ 10
  11. 11. Various Structures and Design• Two major types of structured funds (depending on financial techniques) – Those which are based on derivatives; • Either a portfolio consisting of fixed income component for protection and a derivative component for returns • Or a structured fund which has its full exposure to derivatives – Those which are based on techniques derived from portfolio insurance (CPPI, cushion management, etc). • Capital invested in risk-free assets (fixed income) and risky assets, allocation depends on a dynamic, rebalancing mechanism • When the value of the risky assets are in a downtrend, the exposure to risky assets is reduced in favor of fixed income assets and vice versa • Important parameters are the cushion and multiplier • Risks include cash-lock or monetization (where no more allocation can be made to risky assets – thereby impacting returns)finlogIQ 11
  12. 12. Manager’s Functions and Responsibility• Manager should conduct all transactions with or for a scheme at arm’s length.• Some of the responsibilities of a manager include (but are not limited to) the following:- – The manager should maintain a record of all soft dollars received – The manager should not pay or cause to be paid any fees out of the property of the scheme that have not been provided for in the constitutive documents of the scheme – The manager should not pay or cause to be paid any marketing or promotion expenses out of the property of the scheme. Such expenses include those for advertisements in the media, mailers and fact sheets but exclude those for the preparation, printing, lodgement and distribution of prospectuses, profile statements or product highlights sheets – The manager should not invest the monies of the scheme in the manager’s own securities or those of any of its related corporations – The manager should not lend monies of the scheme to related corporations – The manager should not retain for its own account, cash or commission rebates arising out of transactions for the scheme executed in or outside Singapore – Soft dollar restrictionsfinlogIQ 12
  13. 13. Trustee’s Functions and Responsibility• Independent of the fund manager• trustee should conduct all transactions with or for a scheme at arm’s length• Responsibilities include: – Working in the capacity of a fiduciary to the investors and be accountable to the investors – Ensuring that the unit trust is managed according to the covenants laid out in the trust deed – Minimizing the risk of mismanagement by the fund manager – Protecting the interests of investors and ensuring compliance of the fund manager with investment guidelinesfinlogIQ 13
  14. 14. What Type of Investors Would Invest inStructured Funds• One scheme can float different classes of shares depending upon the type of investors subscribing to the scheme• Differences exists due to features such as: – Sales, conversion, redemption charge, minimum subscription amount, dividend policy, etc. are different for different classes of investors• Restricted schemes are those offered only to accredited investors, other relevant persons, and those who subscribe with SGD 200,000 or more per transaction• Retail offer: a Prospectus in compliance with the SFA must be lodged• In case of Accredited investors and other relevant persons – a prospectus is not required• For Institutional Investors - Information memorandum is not requiredfinlogIQ 14
  15. 15. What Type of Investors Would Invest inStructured Funds - 2• “Institutional Investor” – as defined in SFA• “Accredited Investor” means an individual: – Whose net personal assets exceed in value SGD 2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount – Whose income in the preceding 12 months is not less than SGD 300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount• Or a corporation with net assets exceeding SGD 10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by:- − The most recent audited balance-sheet of the corporation, or − Where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date shall be within the preceding 12 monthsfinlogIQ 15
  16. 16. When Are Structured Funds Unsuitable forInvestors• Investors should seek independent advise on risk and suitability of fund before making decisions• Salesperson or representative providing financial advice also has a responsibility in advising on suitability of product• Investors are advised to keep relevant considerations (risk/return structure, tax, legal, etc.) in their minds before investing in any structured fund.• Of particular importance is the tax consideration arising out of any such investment.• It is the investor’s responsibility to consult his/her own tax adviser before making such investmentsfinlogIQ 16
  17. 17. Typical Types of Documentation• Fund prospectus – states fund’s objectives, its past performance, description of the fund manager and the fees associated with the fund• Should contain: – Basic information – Information on the manager – Information on other parties – Structure of the scheme – Investment objectives, focus and approach – Fact of inclusion – Risks – Subscription of units – Realisation of units – Performance of the scheme• Product highlights sheet − This is a product specific summary of the key features and risks of a structured fund − Should not contain information that is not contained in the prospectusfinlogIQ 17
  18. 18. Types of Risks• Credit risks – Uncertainty in the counterparty’s ability to meet its obligations• Market risk – General risk that applies to all investments• Exchange rate risk – underlying asset may directly or indirectly provide exposure to number of different currencies – shares may be denominated in a currency different from the investor’s home currency• Interest rate risk – Fluctuations in the interest rates of the currency or currencies in which the shares of funds or underlying assets are denominated can affect the real value of the fund shares – Specifically to bonds• Liquidity risk – May be difficult to buy or sell due to adverse market conditions – Difficult to obtain the prices of securities forming the underlying asset – Fund may not be able to sell the security at a fair price if it has to sell in a hurryfinlogIQ 18
  19. 19. Types of Risks - 2• Valuation of the Fund and the Underlying Asset – May be complex and specialist – Limited number of market professionals – Subjective• Operational Risk – Execution of a company’s business functions – Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events – Role of third parties (brokers, administrators, custodian, back office processing providers, external risk management) – Risk management models/ techniques can also cause riskfinlogIQ 19
  20. 20. Potential Conflicts of Interest• Sometimes different entities involved in various functions may be part of the same group of companies• E.g. Fund management company’s affiliates may act as swap counterparties or valuation agents – The affiliates do not have a fiduciary role to act in the best interests of unit holders• Board of Directors of the fund manager would need to ensure that each of the affiliated entities undertakes to resolve any conflicts of interest fairly to protect the interests of the unit holders and the fund manager• Possible solution – using Chinese walls within the organization, or different reporting lines.finlogIQ 20
  21. 21. How to Best Manage the Underlying RiskExposure• Risk in a structured funds is of financial, operational or legal in nature• Internal controls and risk procedures used to keep various risk in check – Processes like assignment of orders, control of execution prices, transaction settlement, valuation control, reconciliation of cash and securities, etc are checked frequently for their correctness – Independent risk controls – various automated IT tools• Automation of investment decisions for the rule based structured funds• Manager keeps close tabs on financial risks such as market risk – Using techniques such as stress-testing, VaR methods, duration − Exposure ranges by asset type, volatility, credit-risk, diversification limits• Managers often have Legal terms to obviate legal risks and also follows the set-out investment restrictions.• Trustee (Independent of the fund manager) – Custodian of the fund assets – Managed according to covenants laid out in the trust deed• Auditors audit the processes annuallyfinlogIQ 21
  22. 22. Common examples of structured funds• Funds with features that aim to preserve capital invested• Formula funds – final payout to the investor depends on a pre-defined, rule-based formula – Typically set up to track indices• Capitalised / Distribution Funds − accumulating or reinvesting funds − Income funds• Indirect Investment Policy Funds (Swap-based Funds) – return (either on such payout dates and/or at the maturity date) linked to the performance of the underlying asset – fund will in principle not invest directly (and/or fully) in the underlying asset – Invest in derivative transaction or in a hedging asset – exchange all or part of the performance and/or income of this hedging asset for a performance linked to the underlying asset – The underlying asset can be based on a passive strategy (financial index or rule- based strategy) or an active strategyfinlogIQ 22
  23. 23. Common Examples of Structured Funds• Popular Underlying Investment Themes Seen in Structured Funds’ – Commodities and hybrids underlying – Investors chose to receive fixed coupons for certain period, followed by a period of variable coupons – A high fixed coupon would typically affect the variable coupon or the final payout as the participation ratio has to be kept low to accommodate high fixed couponsExample 1: Formula Fund• Agriculture-related and open-ended fund (in USD) which aims to track the agricultural index which provides investors with a diversified exposure to the agricultural sector• The agriculture index employs the ABC Optimum Yield rolling mechanism as a source of alpha generationExample 2: Another Fund with Option based and Structured Payoffs• The investment objective of this fund is to provide a return linked to a basket of 25 stocks from the infrastructure, utilities and real estate sectors, and a quarterly potential dividend paymentfinlogIQ 23
  24. 24. After Sales• Where to Get NAV – fund issuer might arrange for the publication of NAV in one or more leading financial newspapers – NAV can also be accessed at sources like Bloomberg, Reuters and the website of the fund issuer using the fund ISIN or name• How to Get Information on Fund Performance – Semi annual and Annual Accounts and Reports to Unit holders – annual accounts to be audited by independent auditors – Investment Manager Report – contains the performance of underlying assets, performance of each share class of the fund, volatility, outlook for performance – Factsheet - concise document which highlights key information for the fund – Monthly performance report - Principal terms of the fund, overview of the fund and performance figuresfinlogIQ 24
  25. 25. What is a Structured ETF• Instruments which track an index• Usually listed and traded on stock exchange• Indices categorised by country, region, sector specific and based on emerging market, developed markets, fixed income, money market, and other asset classes• Provides investors instant diversification – One unit represents an investment covering multiple companies and sectors• Different ETF providers Adopt different replication methods to track performance• Most common methods for replication: – Physical – Synthetic (uses swaps other derivatives to gain exposure to underlying benchmark)finlogIQ 25
  26. 26. What is a Structured ETF - 2• Implementation of the UCITS III fund regulations from 2001 onwards: – Resulted in the development of synthetic replication ETFs in Europe – Possible for ETFs to invest in instruments such as swaps subject to certain counterparty risk exposure limits – Major category of synthetic replication ETFs are swap based ETFs – Majority of ETFs in Europe adopt a swap-based replication structure• Instead of holding all or a representative sample of the index constituents, swap-based ETFs use index swaps or equity-linked swaps to replicate the index performance – Under the UCITS III guidelines, the marked-to-market value of the swap cannot exceed 10% of the fund’s NAV on a daily basis – Depending on the swap counterparty involved, this UCITS limit on counterparty exposure can be decreased to less than 10% voluntarilyfinlogIQ 26
  27. 27. Governance• Regulations play a major role in the structure of ETFs• Emergence of Synthetic ETFs in Europe reflect differences in regulatory environment;• U.S ETFs are organized as a management investment company (a mutual fund-type structure) or as a unit investment trust and fall under the jurisdiction of the Securities and Exchange Commission (“SEC”)• UCITS-compliant – A fund once meeting the requirements of its domestic regulator can be “passported” and offered through out the EU – Most UCITS are domiciled in the European fund centres of Luxembourg, France or Ireland • Open-ended investment company or SICAV• UCITS regulations (the current version of which is referred to as UCITS III) stipulate that an ETF is not allowed to invest more than 10 % of its prevailing NAV in derivative instruments including swaps issued by a single counterparty.finlogIQ 27
  28. 28. What Types of Investors Invest in StructuredETFs• Self directed retail investors – For benefits of a liquid, convenient investment tool which can be used to diversify their investment portfolio in a cost-efficient manner• Institutional investors – For asset allocation, cash flow management, hedging and other trading strategies• There is an annual fee for ETFs (a.k.a Total Expense Ratio) – Includes the management fee and fees paid to cover administrative, license and other operational costs of the fund – The TER is calculated and accrued daily in the NAV calculations and directly deducted from the ETF on a running basis – ETFs typically charge lower annual management fees• Performance of ETF should be similar to benchmark index• ETF replication through swaps – Tracking error risk of ETF before fees is passed on to counterparty => swap based ETF appeal to investors who want to minimize tracking error of ETF vs. benchmark. – Synthetic replication – facilitated development of ETF on market or asset classes (such as credit or volatility) which would be difficult to access through direct investments in the underlying.finlogIQ 28
  29. 29. Risks of Structured ETFs• Market risk – in general, managers do not have the discretion to take defensive positions in declining markets – Investors must be prepared to bear the risk of loss and volatility associated with the underlying index/assets• Tracking Error – Refers to the disparity in performance between an ETF and its underlying index – Arise due to factors such as the impact of transaction fees and expenses incurred to the ETF, changes in composition of the underlying index, index replication costs resulting from liquidity and ownership restrictions on the underlying, cash drag, and the ETF manager’s replication strategy – In general, tracking error is lower for synthetic replication ETFs than physical replication ETFs in particular for benchmarks with higher volatility such as emerging marketsfinlogIQ 29
  30. 30. Risks of Structured ETFs - 2• ETFs Trading at Discount or Premium to NAV – Caused by supply and demand factors – Likely to emerge during periods of high market volatility and uncertainty – E.g. in markets subject to direct investment restrictions (i.e. China A-shares) or ETFs that trade in a different time zone than the underlying assets it tracks• Foreign Exchange Risk – Applicable when the underlying asset is not denominated in the home currency of the investor• Liquidity Risk – most ETFs are supported by one or more market-maker, but no assurance that active trading will be maintained• Counterparty Risk Involved in ETFs with Different Replication Strategies − Physical replication - counterparty risk if the ETF engages in securities lending of the funds’ assets − Synthetic replication - counterparty risk of the swap dealers/derivative issuers − In the case of collateral is obtained by an ETF, it is subject to collateral provider fulfilling its obligations.finlogIQ 30
  31. 31. Common Examples of Synthetic ETFs• Synthetic ETFs use swaps or other derivatives to replicate the performance of an index• One of main advantages of replicating an index through swaps is that the tracking error risk of the ETF, before fees, is passed to the swap counterparty• Under guidelines, marked-to-market value of the swap cannot exceed 10% of the fund’s NAV on a daily basis• UCITS limit on counterparty exposure can be decreased to less than 10% voluntarily.• Counterparty risk from securities lending is borne by the swap counterparty and does not expose the ETF to additional counterparty risk.finlogIQ 31
  32. 32. Funded swap• Under funded swap structure – proceeds of shareholders’ investment in the ETF are transferred to the swap counterparty in exchange for the performance of the index being tracked – In turn, swap counterparty will deposit assets (“collateral”) – ring-fenced collateral account opened with a third party trustee or custodian – This is to reduce counterparty exposure under the fully funded index swap, – The fund is entitled to assert its rights over the collateral at any time, including the event of the default of the swap counterparty• Allowable collateral under UCITS – cash and financial instruments equivalent to cash, high quality bonds or shares satisfying predefined criteria – In the event that the aggregate exposure of the ETFs to the swap counterparty exceeds 10%, the swap counterparty will be required to deliver additional collateral to ensure that the net counterparty risk exposure remains under the UCITS limitfinlogIQ 32
  33. 33. Funded Swap - 2 Figure 13.2.6(1): Typical Configuration of a Structured ETF (Funded Swap)finlogIQ 33
  34. 34. Unfunded Swap• In an unfunded swap: – ETF buys a basket of securities (invested assets) and then enters into a swap to exchange the performance of the invested assets for the performance of the underlying index, – Composition of the invested assets of the ETF is not by definition identical to that of the index, – Invested assets are deposited with a custodian for safekeeping and cannot be lent out, – Invested assets serves as the same purpose as that of the collateral under a funded swap structure to limit a fund’s risk exposure• Swap will be: – reset periodically or compulsorily if the exposure limit of 10% of NAV to the swap counterparty is reached – This results in a settlement of the differential between the value of the invested assets and the value of the index. – Many funds set counterparty limits lower than 10%.finlogIQ 34
  35. 35. Unfunded Swap - 2finlogIQ 35
  36. 36. Swap based ETF with Multiple Counterparties• ETF which uses multiple swap counterparties: – Index return is delivered via funded swap agreements with the fund and each of the swap counterparties, – An ETF is not allowed to invest more than 10% of its prevailing NAV in derivative instruments issued by a single counterparty, – ETFs with multiple counterparties may have up to 10% net counterparty exposure with each of its counterparties and thus, an aggregate counterparty exposure exceeding 10%Derivative-Embedded ETFs• Not all synthetic replication ETFs use swaps or comply with UCITS – Some may invest in derivatives to gain exposure to markets that cannot be accessed through a direct investment in the underlying – Some ETFs tracking restricted markets such as China and India which have Foreign investment or tax limitations invest in access products such as Participatory notes (“PNs” or “P-Notes”) • Derivative instruments by third party providers • Return linked to an underlying security in the index • Carry the credit risk of the issuerfinlogIQ 36
  37. 37. ETFs versus Exchange-Traded Notes (ETNs)• Both are structures are traded on an exchange and provide a return linked to the performance of an underlying benchmark• ETNs are debt securities issued by banks – Not subject to the requirements of funds such as diversification rules – Typically senior and unsecured – Investors are subject to counterparty risk of the issuer• Under European regulations, funds cannot be exposed to underlying assets in single or physical commodities: – Most popular exposure provided by the ETN structure is commodities – Exchange-Traded Commodity (“ETC”) • Are debt securities issued by banks to track the performance of single or physical commodities. • Special type of ETN backed by securities or physical assets such as gold or platinum.finlogIQ 37
  38. 38. ETFs versus Mutual Funds• Key differentiating factor – ETFs offer investors two sources of liquidity: • Primary liquidity via the creation and redemption process • Secondary liquidity through the trading of shares on exchange. Investors can buy and sell throughout the trading day − There are Authorised Participant (“AP”) or market makers who sit between issuer and investors – Ability to buy and sell shares of an ETF intraday is one of the biggest differences between mutual funds and ETFs – For mutual fund – can only purchase units at end of the day NAV – But for ETF, you can buy and sell an ETF at anytime during market hours at the bid/ask price quoted in the exchange – There is no difference in the secondary trading of ETFs on exchange, regardless of whether they are physical or swap-basedfinlogIQ 38
  39. 39. After Sales• Major investment banks and dealers are involved in the provision of liquidity for ETFs trading on exchanges, – Obligated to quote bid and offer prices continuously during market hours subject to maximum spread and minimum quantity requirements – Spread includes cost of hedging which in turn, reflects how efficiently an AP or market maker can access the underlying market• Liquidity of an ETF is dictated by access to and liquidity of the underlying market• Open-ended nature of ETFs means that (on any given day): – APs or market-makers will have the capacity to create sufficient shares to meet the settlement requirements resulting from their trading activity on the stock exchange – Subscriptions/redemptions by market makers and APs with the management company are typically done in large sizes – ETF trades done at NAV are not reflected in the exchange-traded volumes of an ETF – Thus, liquidity of an ETF is measured by the liquidity of the constituent of its underlying index rather than the trading volume of the ETF on the stock exchangefinlogIQ 39
  40. 40. After Sales - 2• ETFs share many similarities with closed-end funds – Both are listed and traded on an exchange and can be bought and sold at anytime during market hours• There are however, differences between closed-end funds and ETFs, which are open-ended – Closed-end funds can and generally do trade at a premium or discount to NAV• Trading price of an ETF refers to prices that an ETF can be bought and sold while trading on an exchange – Trading price of an ETF should be close to its iNAV, which is the estimated NAV of the ETF intraday – Certain situations where the trading price may differ from the NAV e.g. ETFs giving access to restricted markets such as China A-shares – Trading prices are likely to be farther away from its NAVs when an ETF is trading out of the time zone of its underlying investments – ETFs that invest in Asia will typically trade closer to their NAVs during Asian trading hours than when they are trading in the U.S. where market-makers will be trading at a risk pricefinlogIQ 40