Suppose you wanted to invest in hedge funds and your principal was guaranteed by the Federal Deposit Insurance Corp. (FDIC). At first blush, this...
Suppose you wanted to invest in hedge funds and your principal was guaranteed by the Federal Deposit Insurance Corp. (FDIC).
At first blush, this sounds like an easy way to anchor a risky investment within a safe vehicle.
Two federally insured certificates of deposit (CDs) are sold that are linked to the return of a hedge-fund index maintained by Hedge Fund Research of Chicago. One is offered by HSBC Securities USA, a unit of Europe’s largest bank. The other is sold by Bear Stearns, the New York securities firm.
While these certificates may add hedge-fund diversification to your holdings without any risk of losing your initial investment, these products are not to be confused with the insured products you can buy at almost any bank, backed by the FDIC up to $100,000.
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There are a few catches with the principal guarantees on both CDs. Although Bear Stearns says it intends to maintain a secondary market for the CD, early redeemers would receive the lower amount in a bid-ask spread. The guarantee is only good up to $100,000 and only if you hold seven years to maturity.
There’s no minimum interest with either product. Both certificates pay only if the return of the underlying index — the HFR U.S. Global Hedge Fund Index (HFRXGL) — is above an “initial index level equal to the closing price of the index on the month the CD is issued,” according to the Bear Stearns CD’s terms.
Then there are expenses. Unlike a standard CD sold by a bank, Bear Stearns investors are charged a monthly fee called an “adjustment factor” that reduces the return of the index by 1.8 percent annually.
“The CD might fit nicely into an investor’s overall asset allocation plan,” said Harry Engelman, a senior managing director at Bear Stearns. “The HFR index is published on a daily basis and gives us relatively good liquidity in terms of hedging.”
Engelman said the certificate is designed for “suitable investors with a net worth between $1 million and $10 million,” with a minimum purchase of $50,000 and available in $10,000 increments thereafter. Unlike most hedge funds, there are no minimum net worth requirements for these products. Bear Stearns plans a new offering of the certificate later this year.
HSBC first sold its hedge-fund, index-linked CD four months ago and is getting ready to offer a new CD in late October or early November, said Anthony Bradley, HSBC’s vice president of derivatives and structured products. Certificates from the first offering are not available for purchase, as the bank prepares for a second offering.
Each HSBC certificate costs $1,000, with a minimum investment of $25,000. Principal in the product is also FDIC-insured up to $100,000 and a variable return is also based on the HFR Global Hedge Fund Index.
Like the Bear Stearns product, HSBC does not charge investors a commission, so all of your initial stake would be invested in the certificate, the bank says. Brokers are paid a concession by HSBC.
The HSBC product also penalizes investors for selling before maturity. You would pay an “early redemption fee” before seven years. In this case, that charge could be as high as 4 percent, which declines the closer you get to maturity.
And in an odd twist akin to holding a zero-coupon bond in a taxable account, you would still have to pay ordinary income taxes on a “projected payment amount” calculated by HSBC. So you would be paying taxes on phantom income.
What if you needed to cash in the certificate and asked HSBC to sell it to a third party?
“There is currently no established trading market for the CDs,” the bank’s document states.
The Bear Stearns offering has the same shortcoming, although Engelman said “historically, we’ve always maintained a market for our products.”
Additionally hobbled by its high expenses, the Bear Stearns product must return at least “12.5 percent relative to the initial index level over the term of the CDs” for there to be a positive return, the Bear Stearns offering states.
Hypothetically, if the certificate was bought on Jan. 1, 2004, and could be redeemed without penalty on Dec. 31 of last year, the nominal return of the index of 2.7 percent would be 0.9 percent after fees.
How much can you potentially gain from these CDs? The HFR index itself has little performance history, having been started on March 31, 2003.
The index’s total return from inception to Sept. 23 was almost 14 percent, according to Bloomberg data.
In comparison, the Vanguard Total Stock Market VIPERs exchange-traded fund, representing more than 6,000 listed U.S. stocks, was up 51 percent during the same period.
Unlike the broad diversification you would obtain from a total market index, the HFR index is weighted according to investment strategy.
Only eight are represented: convertible, relative value and merger arbitrage; equity hedge; equity market neutral; event-driven; distressed securities and macro.
With the HFR index used for the initial offering of the HSBC certificate, for example, almost 70 percent of it was represented by just three strategies and 69 funds total: equity hedge, event driven and relative value arbitrage.
That places too much risk in these strategies.
Mike Dubis, a certified financial planner with Touchstone Financial in Madison, Wis., said he was troubled by the fact that neither certificate pays interest or dividends annually.
“I do not like what I’m seeing,” he said.
“It’s expensive, confusing, illiquid, no dividend inclusion, tied to a poorly managed index and psychologically confusing to investors. I would not allow any of my clients to buy this product.”
Achieving a decent total return is a matter of keeping your costs low, understanding your risk exposure and spreading your money among multiple asset classes.
The devil is always in the details, so it always pays to read the fine print.