I Just Want to Trade!

Brutal truths about setting up a small UCITS Fund

ANDREW GEBHARDT, MANAGING PARTNER, FINEX LLP

Finex LLP (a UK investment manager) set up a UCITS IV-compliant fund in Malta in 2013; the fund is self-managed and trades exclusively in exchange-listed futures. Shares in the fund are listed in Malta.

I will start with the most painful part of the process, as true at the beginning as it is at the end. This is your fund: you need to read and understand all the documents. Do not rely on anybody else to do this work for you; if you do not understand what isbeing written ask the lawyers to write it again and again till you (not they) understand the document.

I cannot overemphasise enough how important this is, firstly to keep control of costs, but secondly because you never want to be in a position where an investor asks you about a clause and you cannot answer.

Last thing before we start is this; there is no perfect fund structure, no perfect jurisdiction, no perfect custodian or administrator. You only have to look at the last 10 years of scandals to see evidence of all this. For example, who would have thought that accounting giant Arthur Andersen would end being behind the Enron $74 billion loss in 2001, or that investment giant Bernie Madoff used an unknown accountant to lose $64.8 billion in 2008. Get going, get trading, and get your track record public. Nobody can with argue that.

Risk
UCITS has a bad reputation for being incredibly restrictive, especially for exchange-listed futures. I have no idea where this notion comes from but it couldn’t be further from the truth. For example, an Experienced Investor PIF in Malta uses the exact same risk rules as a UCITS fund.

Risk parameters for exchange-listed futures are ample – the Absolute VaR approach is easy to calculate and model. Value at Risk should not exceed 20% of assets under management (at the 99% level over one month). We use exchange margin in our models as it gives an additional safety net to make sure we never get close to the maximum allowable risk. We set the margin to equity ratio at 20% maximum if all models are in position at the same time. This only happened once in our history, in August 2012, and the returns were spectacular. Imagine having underestimated risk usage and having to stop some models. Also, all the margin data is directly available from the exchanges without needing to calculate it. Luxembourg has issued property UCITS funds and that is categorically not allowed in our opinion. We had no issue and no futures fund should have; in fact, we have successfully argued that SPAN margining is superior to Absolute VaR.

UCITS rules allow for various functions, including risk management, to be delegated to various service providers, including administrators. Don’t waste time arguing with your administrator over what risk forecasting model to use, just use theirs. Once you are up and running regulations dictate that the administrator tests their risk model to the actual variation in profit and loss on a regular basis. If these don’t match they will come to you.

Jurisdiction
Do the homework; it takes less time for you to contact the regulators in Ireland, Luxembourg, and Malta yourself than asking a structurer or lawyer to do it for you. Remember suppliers are never cost-sensitive as they assume all fees will be passed on to the investor. Be respectful of the investor, not of the supplier: minimise all costs. Regulators will not negotiate on fees but with suppliers there is no such thing as a fixed fee.

The various fund websites supply documents; look at trading styles that match yours and see where they are domiciled.

Meet the regulators; figuring out where to domicile is important. It will cost you less to meet the various representatives of the authorisation units than to let your lawyers decide for you. Meet them in person; it makes a huge difference. You do not need a £350 per hour lawyer to book your flight for you – don’t be lazy.

Suppliers (legal)
Now that you have selected your own jurisdiction you have removed one of the largest costs to the set-up. Namely the UK-based structurer/law firm. You no longer need them. Since the days of the abolition of the ban on fees by Emperor Claudius no initial estimate has ever come close to the final legal bill. Such a move can save you a good 70%on final fees.

The next step is again up to you. Search the data provider websites and see who has set up a futures fund in your jurisdiction. The lawyers used will be listed in the prospectus under Legal Advisors. Call them and make it very clear that you want to set up a fund similar to the one they have already set up. Try each one, and don’t be embarrassed. This is your money or, more importantly, your investors’ money and they are the most important people in the process.

Bear in mind that there should be nothing controversial in the fund prospectus and offering supplement. In theory if UCITS had been implemented properly all the documents would be effectively standard and setting up a fund would cost £10,000.

Suppliers (administrator/custodian)
My opinion on custodians is to find somebody who understand futures or, as they call them, FDIs. If you find one the cost falls dramatically as most of the work is really being done by the exchange itself and the clearing broker. In fact, the custodian only has a fiduciary duty as they cannot “custody” a futures contract.

The custodian is never going to be perfect, either too small or too big. Remember that sometimes you may have issues with big banks. For example, an employee of bank XYZ may not be able to invest in a fund which has a bank account with XYZ as well. This is worth bearing in mind if your initial investors are going to come from the institutional trading community.

Custodians, like any other supplier, can be changed at any time. The administrator follows a similar logic. However, if more expensive firms tout their peripheral services such as fund raising for the higher fees then test it. Get a list of all the small funds for which they have raised funds, check out their performance and AUM from their ISINs and decide if the administrator is the reputational risk, not you. After all, better to have no reputation than a bad one.

Suppliers (broker/clearing broker)
The easiest part; it’s about fees and market access. If you are starting small (less than $25 million) you will be largely ignored by most of them. Consider even using a retail broker as the access technology tends to be far superior to most institutional offerings. I know this sounds controversial, and most people coming out of an institutional background may not realise how far ahead retail technology is.

Whilst larger investors might baulk at such an arrangement there is nothing stopping you moving to a mainstream clearing broker once your assets and performance have grown enough to attract the attention of the larger allocators. Again, brokers/clearing brokers, like all other suppliers, can be changed at any time.

Further notes
UCITS regulations are supposedly harmonised; the short answer is that they are not. The individual countries are breaking more rules than ever – for example, the short selling ban, High Frequency Trading Tax, etc. etc. Very few EU countries fully respect EU rules and whilst the UCITS IV passport sounds very much like the MiFID outbound service, in practice they are poles apart. Each country will add its own stipulations and fees (whereas MiFID is free and it works). However, they generally serve no purpose whatsoever. Treat it as another euro-tax and move along.

Passporting
For example, if you plan to passport your fund into France a “Correspondant Centralisateur” is needed, their only practical provision is to hold a copy of your documentation. The below is extracted from AMF regulations:

In particular, pursuant to Article 411-135 of the AMF General Regulation, the centralising correspondent and any other correspondents, which must belong to one of the categories referred to in Article 1 of the Order of 6 September 1989, are contractually bound to provide the following financial services:

    1. processing subscription and redemption requests;
    2. making coupon and dividend payments;
    3. supplying information documents to investors;

The administrator does “1” and “2”, so all they do is “3”. They are of no other practical use. Do not pay more than €5,000 a year for such a service – fees build up fast.

As a UK firm, avoid passporting unless you really need to; just passport your own fund into the UK. Yes, again another euro-idiocy: if you have a licence in any member state you can attract investment from any EU-27 member and you do not need to passport. However, if you are marketing to retail it’s completely different. Ergo, don’t market directly to retail. Also remember that you only need to translate the KIID for the passport, nothing else. You can always apply to other regulators later down the line – it only takes a month.

Initial fees more than anything else are a big drain on resources but time is the most frustrating element. If you are setting up an investment manager from scratch you are looking at a 12 to 18 months to get the whole thing done, irrespective of which legal firm you use.

Using existing investment managers
Consider setting yourself up with an existing investment manager who has an umbrella structure (UCITS-licensed SICAV) which can host your fund. Had we found one 12 months ago we would have definitely taken that route, but the costs we were quoted were higher than setting up our own fund.

Alternatively, with costs nowadays much lower, you should be able to find an off-the-shelf regulated investment management firm for a fraction of the price. Contact a good accountant and they should have a list of IMs that have recently become “dormant”. Some lawyers will tell you to stay away because of legacy liabilities, but it pays to see if the opinion holds. A good starting point is the FCA regulated firm register; it’s free and will give you everything you need. Crucially, you are looking for the relevant IM permissions and for “able to hold client money” and “retail” to be absent. That should take care of 90% of liability issues. Again, as with all legal opinion, it pays to read the documents yourself. Only once you have read and understood as much as you can, talk to a lawyer.

Remember that the fund is the one with the permissions to accept investments from retail investors, but the fund is a professional customer of the investment manager. So the investment manager does not need to be eligible to advise retail customers.

Lastly when the regulator comes back with the first set of questions fly there and sit down with the legal team to thrash out all the answers. This will take a couple of days rather than two months of email ping pong.

Conclusion
Setting up a UCITS self-managed fund trading exchange-listed futures should be one of the cheapest structures to set up. All providers have access to cheap single-source data, there are no counterparty liabilities for the fund when trading, as the only counterparty is a regulated exchange, and there are no direct or implied credit lines. Liquidity and transparency are of the highest order

Yet we have seen some truly horrible quotes before we finally found our suppliers, and considering that even there we broke a number of our own recommendations, letting the costs rise, we still managed to keep the total true costs below €60,000. This has meant that we could easily absorb all fees and do not have to pass any set-up costs to the initial investor.

In comparison, the cheapest service provider we contacted in London asked for €55,000 as an initial ballpark for a Qualifying Investor PIF. This is such a simple process it takes 8-10 week at worst. The cheapest “initial ballpark” for a UCITS fund was €75,000 with the highest €250,000.

Nobody is reinventing the wheel; there is nothing wrong in using other people’s documents as a basis for the structure of your fund. All the professionals do it; sometimes they even mistakenly leave the URL link in the text.

Do all this homework yourself and in a couple of weeks you will have enough information, forms and examples to set up a fund in record time. I only wish somebody had told me these things 18 months ago… and I did search.