A retail solution or an expensive investment vehicle?

Originally published in the April 2008 issue

Following the introduction of funds of hedge funds and commercial property into the FTSE APCIMS (private clients’ investment indices produced by the FSTE) there has been a growing appetite for alternative investment vehicles. The FSA in its consultation paper published in June 2007 is finalising the introduction of Funds of Alternative Funds (FAIFs) and intends to pave the way for alternative investments to become more widely available to retail clients.

Despite the severe correction in equity markets, UK retail private clients have less than 5% allocated to hedge funds (APCIMS data, November 2007). And equities still constitute the predominant portion of UK retail private clients’ portfolio (67.5% weight in the Balanced APCIMS index). The low allocation to hedge funds can be explained by a poor understanding of hedge funds as a range of asset classes. Many investors and advisors still confuse hedge funds with funds of hedge funds and their investment decisions are driven by liquidity, tax and ‘invest in what I know best’ issues. Advisers will quite often prefer to time the market and retain cash as opposed to investing in asset classes they are not familiar with.

Are FAIFs likely to improve accessibility to alternative assets for retail clients?

The following issues are important for retail clients in considering the inclusion of FAIFs in their portfolios.

FAIFs vs listed vehicles: liquidity perspective

One of the principal reasons for the success of listed funds of hedge fund vehicles is their liquidity. Whilst the cost of listing may be high (1.75% to 2% upfront for listed funds of hedge funds in the form of closed-end vehicles) the London listed funds of hedge fund and listed single manager hedge fund market has been a growing success. The obvious disadvantage of closed-end vehicles is the price volatility which is significantly higher than the NAV volatility of the underlying. Despite these in-built costs many funds of hedge funds and single manager hedge funds have raised GBP 500m or more.

FAIFs would be the main competitors to listed closed-end alternative investment vehicles. However, given their open-ended structure and liquidity terms (up to 6 months redemptions) I believethat the retail market will take a long time to appreciate the benefits of FAIFs. UK retail private clients are still prepared to pay a high cost to have access to liquid and traded investment vehicles and are more likely to favour listed vehicles to the detriment of FAIFs. IFAs and retail private client managers still have a minute exposure to illiquid investment vehicles. It would take an important amount of convincing to persuade advisers that a listed vehicle does not eliminate risks in case of blow-ups in one of the underlying funds but can accentuate the sell-off/price correction.

“FAIFs would be the main competitors to listed closed-end alternative investment vehicles. “

Tax – still a case of wait and see

Retail private clients, IFAs and managers are quite often unlikely to invest in alternative investment vehicles which are not eligible for capital gains tax relief. Quite often, the decision is made at the level of the investment vehicle and not at that of the portfolio. Consequently, the tax status tends to have an overbearing weight on the overall investment decision. The FSA mentions in its consulting document that ‘to avoid any taxation regime being used to gain unintended tax advantages we propose to include a genuine diversity of ownership condition in our rules’. One of these conditions, according to the Treasury’s discussion paper issued in December 2007 (draft regulations for the genuine diversity of ownership conditions), is that the minimum investment in the scheme must not be unreasonably high in view of the risk profile of the scheme. It is not very clear if that is likely to be in units of hundreds of pounds or of thousands of pounds. However, this may pose significant challenges to the smaller firms and their administrators (which may not have the operational infrastructure and back-offices in dealing with investment inflows of small amounts).

Most funds of hedge fund providers including the larger ones are adopting a wait and see attitude untill the tax implications are finalised. It is unlikely that FAIFs can compete successfully with closed-end listed funds if they do not benefit from similar tax advantages.

Transparency or lack of

Many retail clients and advisers have complained of lack of transparency as an issue when it comes to funds of hedge funds closed-end investments. Although, some funds of hedge funds have disclosed their entire portfolios, others have been very slow to publish their top 5 positions. Whilst for offshore vehicles many funds of hedge funds are willing to reveal the names of the underlying managers to investors who have signed a non-disclosure agreement, the case is very different for listed funds of hedge funds.

The issue of transparency and reporting was not sufficiently discussed in the consultation papers of the FSA and based on a principle-based approach this is likely to be left at the discretion of the FAIFs managers. However, regulation can sometimes be the source of information asymmetries, such as refusal to answer crucial questions because these would breach insider trading rules. In January, a well-known listed fund of hedge funds was down by more than 3%. The fund took another month to organise a conference call to explain their performance and even then did not answer important questions which were only taken online. If investors in FAIFs are subject to similar regulatory constraints, investors may fail to have their important questions answered promptly and may put them at a disadvantage to other investors invested in the offshore versions of the FAIFs.

Whilst some private clients like buying the funds of brand names, there is an important risk in terms of selection bias with FAIFs. Experience has proved over time that bigger does not mean better risk controls. Given the high costs of implementing FAIF compliant structures, the smaller funds of hedge funds managers are unlikely to consider FAIFs. It is important to remember that the industry is not just a basket of different asset classes but is mainly driven by skills. Would FAIFs therefore become a level playing field if talented funds of hedge fund managers were to be excluded on the basis of their fund sizes?

For FAIFs to succeed, the tax issues will have to be addressed and investors would need to be educated with respect to the benefits of these vehicles compared with their listed counterparts. Furthermore, a selection bias privileging only the bigger players would not be in the best interests of retail private clients.

FSA’s main proposals

Introduce retail Funds of Alternative Investment Funds (FAIFs) into the existing non-UCITS Retail Scheme (NURS) regime

Lift the existing 20% investment restriction into unregulated collective investment scheme for NURS

Apply due diligence criteria for managers of FAIFs

Removing the 15% rule that prohibits NURS from investing more than 15% of its assets in collective investment schemes.