SG offers HK investors to profit from volatility

When I receive offers to attend a fund manager's press conference on its latest line of guaranteed mutual funds, my first reaction is say, "Surely I have a dental appointment at that time." Although guaranteed funds continue to be a huge trend, and the only one really making money for asset managers, actually sitting through the slide presentation gets dull after you've heard the umpteenth version of market spin.

So I was happily surprised to find yesterday's chat with SG rather interesting. Nicolas Reille, SG Securities senior vice president for structured products in Asia ex-Japan, led me through the ups and downs of a new derivatives product called Swing, which has been dressed up in the form of a retail mutual fund. SG claims this product is the first of its kind in Asia and it is certainly the first time I have come across something like it.

Guaranteed funds are essentially bullish in nature, offering investors a principal guarantee and sometimes a bit more, plus a share of the upside should the underlying stocks do well, all in return for a sometimes hearty fee. So no matter how volatile the markets, the investor is protected (although it has been argued that they could put their money to work in more efficient ways).

SG has turned the concept on its head. If volatility and uncertainty are the unfortunate hallmarks of our time, why not invest in a way that makes money from volatility? Derivatives traders do this all the time, but this has not been an option for the retail market.

The investment bank has an asset management arm called Lyxor (not to be confused with SG Asset Management, which is a completely separate company), which has launched two guaranteed funds in Hong Kong, Swing 1 and Swing 2, that track a basket of 18 global stocks. Investors pay a premium up front. Then each year over a 4.5 year period, Lyxor picks that stock out of the 18 which has had the lowest price change. Supppose the least movement was a stock that either rose or fell by 5% - it does not matter which way. SG pays out a coupon based on a percentage of that amount, which varies between Swing 1 and Swing 2.

This percentage will be declared just before the launch of the two funds by SG on 18 September. For Swing 1, which is more aggressive, investors will get 80% to 100% of the absolute amount of the least volatile's stock movement. In other words, if an investor puts in 100 and the smallest price change of the 18 stocks after one year is 5%, then the coupon will be 80%-100% of that 5%, i.e. a coupon of 4%-5%. Swing 2 has a lower participation rate of 35% to 50%, but also comes with an annual coupon floor of 2%. The process is repeated each year of the fund's life.

This of course assumes the investor holds the fund to maturity. Both funds offer 100% principal protection. In the meantime, SG invests 82.5% of the revenues into bank certificates of deposit, 11.5% to its existing options trading desks, and 4.5% to its management fee, which works out to only 1% per year. SG is happy to take the premium and use the capital in its existing options business, where presumably the profits exceed the coupon payments.

"This is the first step toward a hedge fund," says Reille. "Most guarantees are based on an expected upside. This one is market-neutral. It's a new idea created last year by SG."

The investment bank has already begun providing such option and guarantee services to third-party fund managers such as Franklin Templeton as well as to DBS Asset Management in Singapore.

These funds will be sold in Hong Kong via eight banks (Bank of America, Chiyu Banking Corporation, Citic Ka Wah Bank, Hang Seng Bank, IBA, Bank of China, Nanyang Commercial Bank and Standard Chartered), alongside other Lyxor products already sold by banks including Citibank and HSBC. This is also the first fund Lyxor is now registering with Singapore's authorities to sell on a private placement basis.

Reille does not think customers will have any problem grasping that this is a bet on volatility, and that they are not in fact investing in any of these 18 stocks. "It is a new idea but it's pretty simple," he says. It will be interesting to see how effectively the local banks can sell it. Reille says SG, which is Lyxor's representative in Hong Kong, has already trained bank sales staff. He expects Swing 2 will be the bigger hit because of its 2% annual guaranteed coupon, which is already higher than local bank savings deposit rates.

Lyxor is a Eur13 billion subsidiary of SG dedicated to structured funds, mainly funds of hedge funds or guaranteed funds. It was established in February 1998 and registered with the Hong Kong Securities and Futures Commission in November 2001. Because it is an arm of SG's investment banking operations and not a traditional long-only manager, it has no relationship to SGAM aside from the common owner.