Editor’s Letter – August 2013

Issue 88

Originally published in the August 2013 issue

UCITS hedge fund assets have surpassed the €100 billion milestone, says the Alceda Quarterly UCITS Review. This dwarfs many other ways of wrapping or accessing hedge fund managers or strategies: hedge fund replication products, hedge fund exchange-traded funds, exchange-listed closed-end funds, investible hedge fund indices, or commingled managed account platforms are all, we estimate, running less than this. In fairness, nearly all of these can also come under the versatile UCITS umbrella. The attractions of UCITS – liquidity, transparency, regulatory oversight, risk reporting, safekeeping of assets, passporting inside Europe and brand recognition outside Europe – are well known.

Reservations about UCITS are based on popular perceptions that UCITS offers diluted, lower risk, lower return, higher cost hedge funds. These generalisations may, on average, apply but they are not inherent features of UCITS hedge funds. Granted, UCITS hedge funds frequently have lower targeted and realised volatility than broad hedge fund indices. For those that choose the “Commitment Approach” as part of their risk management policy, the consequent caps on leverage – and indeed the ways in which it is calculated – may result in reduced risk.

Yet funds choosing the “Value at Risk” approach can avoid explicit limits on leverage. The absolute Value at Risk cap for UCITS hedge funds is 20% for a one-month, 99% confidence interval. If this metric is not the most intuitive measure, it can be easily translated into annualised volatility. A 99% confidence interval is equivalent to 2.58 standard deviations, which works out at monthly standard deviation of 7.75%. This annualises at a standard deviation of around 27%. Clearly, that is well ahead of the volatility of most hedge funds. So, the volatility targets of UCITS hedge funds are almost always self-imposed, and not dictated by the regulations. There are even examples of UCITS hedge funds with higher risk targets than their offshore siblings.

If, on average, UCITS hedge funds target lower volatility, that largely reflects the motivations and constraints of investor groups being courted. UCITS hedge funds could be aiming at retail investors or high-net-worth individuals. As pension funds that are increasingly closed to new members become ever more mature, their liabilities shorten and so too does their risk appetite; non-UCITS hedge funds wooing the pension fund market have also scaled back risk targets in recent years. And insurance companies alike have limited tolerance of volatility, since they must demonstrate to regulators their ability to pay out on claims with a 99.5% confidence level. Insurers have other reasons, sometimes dubbed “regulatory arbitrage”, to choose UCITS – since non-UCITS hedge funds incur a capital charge of 49% that does not apply to UCITS hedge funds.

Moving onto returns, it seems that UCITS hedge funds have, in absolute terms, lagged hedge funds in general, since 2008. However, this partly reflects the fact that UCITS hedge funds have, on average, been targeting lower levels of volatility. Lower post-crisis returns from UCITS hedge funds may also reflect the fact that they generally cannot expect to pick up illiquidity premiums, as owning less liquid assets will not be consistent with maintaining at least twice monthly liquidity. This also applies to any other liquid hedge fund strategy, such as replication products, which also outperformed during the 2008 crisis.

In some cases, extra layers of costs that are passed onto investors can explain under-performance of UCITS hedge funds – even when they are targeting risk comparable to other hedge funds, as many do. But each fund is different – extra costs can be absorbed by managers. If we look at the 600 funds (and growing by the week) in our UCITS Hedge database, we see a huge range of fee structures. Management fees range from 0.15% right up to 4.5%. Performance fees range from 0% to 20% – so, yes, there are even UCITS hedge fund products with no performance fee. It is the diversity of UCITS hedge funds that has helped them to become one of the most popular structures.