5.1 THE BASICS

Investors can benefit substantially by adding hedge fund strategies to their portfolios due to their diversification properties and absolute return objectives. Structured Products (SPs) on hedge funds evolved to serve the needs of a significant constituency of investors who were unable or unwilling to invest in hedge funds in the formats in which they were offered. The advantages of SPs over conventional hedge fund investments are that SPs can offer enhancements such as superior risk management, enhanced (more frequent) liquidity, access to leverage and/or principal protection.

These products can be thought of as having three distinct components: the underlying hedge fund asset (Hedge Fund Asset), the payout and the wrapper. The Hedge Fund Asset is either a fund of hedge funds or an index tied to a basket of hedge funds. The payout formula determines how the value of a product at maturity relates to the Hedge Fund Asset. In tracker products (discussed later), the payout is linked one-to-one with the Hedge Fund Asset while in principal-protected structures, the initial capital invested is guaranteed at maturity. The wrapper is the packaging of the SP, which may impact the tax and/or regulatory treatment of the product. The most commonly used wrappers are notes, swaps and options, each one providing investors with a custom-tailored solution for access to the Hedge Fund Asset.

One of the most difficult problems facing the providers (Providers) of SPs linked to hedge funds is the lack of transparency and...