The spate of new capital guarantee and return guarantee funds being launched in Asia will soon be followed by more sophisticated structured products promising higher absolute returns, says John McLaughlin, head of Schroders’ structured investment team based in London.

On a visit to Hong Kong to launch Schroders' own three-year guaranteed return fund, McLaughlin predicted that Asia will follow in the footsteps of the US and Europe. Retail investors on both continents are now dabbling in derivatives, having moved on from buying into funds with a core investment in equity and a capital guaranteed overlay.

In Asia, where mutual fund investors have suffered bad returns for the past five years, these products offer better performance with the security of a capital guarantee, he says. They’re designed to dampen the overall volatility of the investment because of the correlation in the different asset classes of the fund - as one goes up, the other comes down.

McLaughlin says two such products will be actively managed open-ended funds investing in derivatives, which he calls defensive funds, and capital-protected hedge funds that partly invest in an underlying hedge fund and partly in call options.

By their nature, these funds tend to be less volatile than equity-based, capital-protected funds, meaning that investors are likely to get higher returns. And they are also cheaper to run. The cost of investing in hedge funds and options is much less than pure equity and equity options, so fund managers can pass on a higher portion of the growth in the underlying asset to investors.

McLaughlin says investors in equity-based funds tend to get only 50% of the equity upside, while they get 70% to 80% of the upside from hedge fund based funds. The lower the volatility, the lower the cost of the capital protection, he says.

These funds will also appeal to high net worth individuals in Asia who have long been investors in other structured products such as private equity funds. Eventually, pension fund investors will also catch on once they overcome some of their reservations about hedge funds which have existed since the beginning of the currency crisis. McLaughlin says regulators tend to be more comfortable with structured products than they do with straight hedge funds because of the capital guarantees.

Schroders is hoping to raise $100 million for its guaranteed return fund when subscriptions close on May 15. The fixed-term fund is set to mature in May 2004 and investors are guaranteed 100% of the capital originally invested and an extra 7.5% return on maturity. The front-end load is 3.5%.

Interestingly, the fund will invest equally in two existing Schroders’ funds - the ISF Euro Equity fund and the ISF Emerging Market Debt fund - indicating that the firm’s economists predict that Europe will offer better market returns over the next three years than the US.