Mutual appreciation

Mutual funds are one of structured products' fiercest rivals, dwarfing the nascent US business with $21 trillion under management. But US distributor Structured Investment Management has successfully combined the two products, bringing principal protection to the widely held format in a way that could change the face of both industries. Sophia Morrell reports

There are myriad reasons why mutual funds have captured trillions of investor dollars - transparency, liquidity and huge advertising budgets to name but three. However, they cannot protect against market downturns, as recent months have painfully reminded investors. It is fortunate for Structured Investment Management (Sim) that its principal-protected mutual fund, which has been in development for around three years, was ready for launch at a time when losses are being felt so keenly.

The business was founded in 2006 by structured products veteran Ramesh Menon, who has 17 years' experience in the industry. Menon's most recent role was at Citi, where he was head of US equity structured products. "I was highly instrumental in developing approximately $3 billion worth of principal-protected mutual funds at Citi, and during that process I confirmed my view that these funds could offer several advantages," says Menon, who is based in New York.

These funds used a constant proportion portfolio insurance model which allocates variably to equity throughout its life, an allocation which can drop irreversibly to zero. Sim's structure, the S&P 500 Capital Appreciation Fund, instead combines both principal protection and mutual funds in their traditional forms - the first of its kind which subsequently has both a US and international patent pending. Seeking to replicate the returns of the S&P 500, it incorporates a special redemption feature which guarantees investors 150% of their principal at the end of a 10-year covered period, minus operating fees and expenses.

Combining a mutual fund with a structured note carries some obvious advantages. "There are lots of regulatory provisions on mutual funds which protect investors and give fiduciary responsibility to the adviser. These don't apply with just principal-protected notes. Mutual funds have mandated daily liquidity - which structured notes don't," says Menon. The list continues - while principal-protected structured products are taxed as income in the US, mutual funds are taxed as capital gains, which could be at a rate that is half as much, he says, and funds avoid the punitive conditions taxing annual gains on notes even when they are not realised.

Credit risk, the overriding concern of the structured note market, is mitigated by the fund's construction. Assets are first of all ring-fenced under the 1940 Investment Act provisions for mutual funds. Sim used swaps from a variety of counterparties, including Morgan Stanley, Goldman Sachs and Bank of America. Each of the contracts is settled daily in cash, and credit default swaps used on each of the counterparties to protect against overnight risk.

However, it was a lengthy procedure convincing the US Securities and Exchange Commission to authorise the product. "Getting the fund through the regulator was an interesting experience," says Menon. "We were working with 1940 Act regulations that govern the mutual fund industry. They don't lend themselves to doing anything derivatives-based or principal protected, and neither does the tax law. Try to put them together, and the product becomes exponentially more difficult."

The fund is being marketed right across the investment spectrum, specifically to retail investors for retirement purposes, insurance companies, foundations and institutional clients. The latter is being handled by an in-house marketing team, while retail clients can access the product via the mutual fund platforms of Charles Schwab and Fidelity. The fund will soon be available on other discount and full-service platforms, says Menon. Four share classes are on offer, beginning with Class A for retail clients which have a minimum investment of $1,000 through to institutional class shares carrying a $5 million threshold.

Each has differing fees, the priciest being class A, which has a front-loaded sales charge of 5% to fund the special redemption feature and annual operating expenses of 0.96%. However, as a point of comparison, annuities may charge up to 11.5% operating expenses. The annual fees for target date funds, a prevalent choice for retirement investors which do not offer principal protection, range from 0.19% to 2.47% depending on the share class, in addition to potential sales charges and redemption fees.

"Target date funds haven't done what they were supposed to, and their performance has highlighted the need for predictable relative performance," says Menon. "Our product is being targeted extensively at the retirement space: defined contribution plans, 401k plans, and the consultants who are really the gatekeepers to the space." So far, he explains, initial subscription to the fund has put Sim well on track for its $1 billion target within the next 12 months. In the meantime, Sim has another product in the pipeline which is aimed at solving the post-retirement challenge, exposing investors to market upside, while providing them with the income that they need.