Application of commission hedging technique set to spread

New Angles

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SG Constellation and Citigroup – the two firms dominating the niche market for financing and hedging mutual fund managers’ deferred commissions – are talking with clients about making greater use of the hedging and securitisation technology in the insurance sector.

“The technology has an obvious application for providers of variable annuity-type products,” says Paul Donlin, head of global securitisation at Citigroup in New York. He declined to comment on whether the firm had yet completed any such transactions.

Thomas Mann, a managing director at SG Constellation in New York, a US division of Société Générale’s investment banking arm, says his group is seeking to bolster its business with insurers and, more broadly, non-US firms.

In deferred commission-type mutual fund products, the fund manager pays a selling agent a commission, rather than the upfront commission coming from the investor in the mutual fund. In such funds, investors pay ongoing asset-based sales charges (called 12b-1 fees) and a contingent deferred sales charge (CDSC), determined if the investor redeems their shares within a specified period.

Shares in funds structured in this way are called B-shares. Irrespective of the class of shares offered, mutual fund brokers collect commissions at the time of sale. So, in the case of deferred commission-type products, managers must pay for this through collection of the 12b-1 fees and CDSCs.

Managers can be subject to significant cashflow risk because of the time lag between paying the broker and receipt of the fees from investors. It’s this type of liquidity risk that off-balance-sheet financing of the kind provided by Citigroup and SG seeks to mitigate against.

“It’s an attractive alternative to self-financing for mutual funds,” says Constellation’s Mann. “We advance them the upfront cash to be paid to the intermediary in exchange for the stream of future cashflows,” he adds. This way, the cashflow risk associated with B shares is transferred from the mutual fund company’s balance sheet to that of the counterparty in the transaction.

On-balance-sheet alternatives can be unattractive to mutual fund companies for various reasons. Internal cash could be used, but then the company is exposed to the deferred commission asset risk associated with the variability of the fund’s net asset value (NAV); analysts and rating agencies are not big fans of such unhedged risks. For this reason, many companies use revolving credit lines provided by commercial banks or, more likely, raise cash in the capital markets. The latter option is only viable for the largest investment companies.

Product innovation

SG acquired Constellation in June 2003. Mann says product innovation is the main benefit of becoming part of one of the most innovative equity derivatives houses. “One product we are working on jointly could have required an investment of around $2 million to create independently,” he says. This is far from small change for Constellation. It invested a total of $20 million in systems during the period from 1994 – when it was founded by Mark Garbin and Mann – up to 2003. Given SG’s existing systems, Mann characterises the cost of the current project as marginal.

Essentially, Constellation and their like make money on the spread between the cost of sourcing capital and the cost charged to clients. It seeks to lock in that spread by managing the volatility of those cashflows over time. “We developed a proprietary system to collect information as well as understand the nature of the cashflows and delta-hedge them,” Mann says.

Equity futures and forwards are used predominantly as they are relatively cheap hedges. “After the delta hedge, there is some vega and gamma risk that can be hedged with options,” adds François Barthelemy, head of US equity derivatives at SG in New York. Citigroup’s Donlin says his team uses index options extensively to manage NAV risk.

Paul Freeman, director of retail product development at Schroders Investment Management in London, likes the product and says Constellation is flexible in its approach to designing hedging solutions. “We don’t want to finance these commissions upfront. It’s not our area of expertise and it’s easier to have it off balance sheet,” he says. Schroders has used the product for around two years.

Scott Wennerholm, chief operating officer at CDC IXIS Asset Management Distributors in Boston, says Constellation’s approach to deferred-commission risk management is sophisticated and rigorous. The asset manager has been financing deferred commissions off balance sheet for nearly a decade.

SG Constellation and Citigroup dominate this market: Constellation has financed around $3 billion during its 10-year existence, while sources suggest Citigroup has purchased up to $5 billion of deferred commissions since it entered the market in 1994.

Other firms wanting to get a slice of the action face natural barriers to entry. First, the modelling and data required to risk manage such a business is complex. Constellation, for example, has tracked individual pools of assets and cash flows on a monthly basis since 1999. “We’ve also learnt from our mistakes and advanced along the learning curve far beyond the point at which any firm entering this area would begin from,” Constellations Mann says.

Citigroups Donlin says economies of scale are an important factor in the success of this kind of business line: “It’s important to have a portfolio of cashflows, diversified by the type of manager,” he adds. But with many mutual fund manager suffering a post-Spitzer paralysis when it comes to considering anything out of the ordinary, Citigroup and Constellation plans for increased activity with non-mutual fund clients have an added urgency.

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