US banks help cut losses on locked hedge funds

The same Wall Street dealers that offered sophisticated derivatives that allowed investors to magnify their risks are now pitching elaborate instruments designed to reduce exposure to cratering hedge funds.

Dealers say they are seeing strong demand for these derivatives as hedge funds make it harder for investors to withdraw funds. But some investors are skeptical.

"It looks great on paper but we are not willing to stick our necks out with a new product," said Steve Braverman, president of investment advisory services at Harris myCFO, a unit of BMO Financial Group that manages money for wealthy families.

These products, offered by banks, including BNP Paribas SA and Nomura Holdings Inc, are based on mathematical models of expected hedge fund returns. That could make it difficult to win over investors in a credit crunch that was largely created by faulty assumptions fed into flawed models.

"I don't think it will be an easy sell," said Frank Partnoy, professor of law at the University of San Diego. "But it does show that Wall Street, even on its death bed, will keep kicking as long as it's alive."

Bankers say there is demand as the $1.2 trillion hedge fund industry experiences its worst investment losses on record, having fallen more than 20 percent this year.

As investors clamor to bail out of the funds, many funds have refused to hand client money back, arguing that redemptions will force them to sell assets at depressed prices.

That is where banks come in, offering derivatives known as swaps that are meant to offer investors the opposite of returns in hedge funds: if the funds fall 10 percent in value, these swaps should rise 10 percent.

And while banks have been pitching these derivatives for some time, it was not until indexes showed the hedge fund sector nosediving 5 percent in September alone that investor interest picked up.

"Nobody was really interested in these products until] September triggered the need," said Fabrice Hugon, head of fund derivatives sales at BNP Paribas in New York. "Now every day we are having conversations about this with clients."

BNP Paribas has sold about $350 million of these structures since mid September and Hugon thinks this could double by year end.

BEATING SWORDS INTO PLOWSHARES

Customers for the products include individuals and Andrew Scherr, director in hedge fund derivatives at Nomura in New York, said he is working with some fund managers to help their clients mitigate specific exposures to alternative investments.

"People have basically said look, we want to reduce our exposure to this particular asset class, but we don't want to give up our carefully constructed portfolios," Scherr said.

This is a big shift for investors, who for years used derivatives to boost their exposure to hedge funds. Two years ago, they might have bought products that allowed them to earn twice the gains or losses of a hedge fund of funds, meaning if a fund rose 10 percent, the derivative would rise 20 percent.

But the modeling involved in these derivatives spooks some clients and using a complicated instrument to offset a hedge fund could result in investors paying big fees all around.

But some view these products as their only option if they are locked into funds that are losing money.

"Some investors have kind of a fatalistic view that they've already lost enough and so what's the harm?" said Alice Yurke, a partner at law firm McKee Nelson. (Editing by Andre Grenon)