Tackling Tracking Error

AARNOUT SNOUCK HURGONJE, AXA INVESTMENT MANAGERS

At the end of November 2010, the UCITS III hedge funds space seemed to have taken its first significant misstep. BlueCrest Capital, a manager with over 10 years of experience in hedge funds, closed and liquidated the onshore iteration of its successful BlueTrend managed futures fund. The company cited concern that the tracking error of the onshore, UCITS-compliant fund had grown too much and therefore the manager intended to return the more than $600 million that the fund had under management.

This story was seen as a serious blight on the successful development of the UCITS hedge fund sector. Alternative strategies were supposed to be made more accessible by innovation in the use of the UCITS wrapper, but instead this showed how fragile the funds appeared to be in the face of regulatory requirements mandated by European oversight bodies. Replication of the offshore strategy was difficult, even in those strategies that are known to be more liquid such as a commodity trading advisor.

Tracking error
Nevertheless, we believe these fears are unfounded for several reasons. First, BlueCrest’s decision to liquidate the UCITS vehicle was entirely voluntary. Second, BlueCrest was attempting to translate its highly successful BlueTrend offshore strategy, which is hard closed, to a UCITS that relied on direct investment as opposed to a swap structure.

The BlueTrend strategy had significant investment in commodities, fixed income derivatives, and large government bond positions, which would be unavailable or limited by UCITS regulations. From this case it could be easy to conclude that UCITS hedge funds will always face difficulties in matching their offshore equivalents because the regulation imposes stringent rules regarding exposures that will result in a level of tracking error. In fact, what this episode shows is the need to realign the approach to UCITS hedge fund investing. Tracking error joins a set of criteria such as liquidity and governance as investment considerations. Furthermore, the need for operational due diligence, akin to those required in assessing offshore funds, remains integral to this form of alternative investment as well.

Due to the relatively recent popularity of launching UCITS hedge funds, the existing universe of these products has a very short track record. With numerous launches happening each month, it is difficult to gauge the aptitude of a manager based upon a fund’s track record. Therefore, the record of the corresponding offshore product is usually the only quantitative measure of a manager’s ability to manage a strategy through changing economic and financial environments.

Unfortunately, this becomes the root of the problematic tracking error assumption. There is no guarantee that a hedge fund’s offshore strategy can be fluidly translated to an onshore UCITS-compliant version. The first priority of the investor in this universe must be to maximize the return from the available opportunity set without focusing on the tracking error relationship between onshore and offshore vehicles.

UCITS investors are often much different to those within the offshore space. They can be less wealthy individuals or highly regulated institutions whose concerns regarding investment rest with other aspects of the fund such as the regulatory oversight and the improved liquidity and accessibility. Offshore returns will only give evidence of a manager’s ability to execute a particular investment strategy but can only offer limited indications of the future results of an onshore UCITS fund.

Strong contenders
When choosing a UCITS hedge fund in which to invest, many factors must be weighed. To begin with, the manager should have an established history of managing the strategy offshore prior to the launch of the UCITS fund. Furthermore, there should be delineation between the responsibilities of the investment team and those team members responsible for trade execution and management of portfolio risk.

However, one of the most important criteria to consider in the UCITS universe is the applicability of the manager’s strategy to the limits imposed by UCITS regulation in the first place without significant dilution of the fund’s ability to generate alpha. While this may mean that a portfolio of onshore hedge funds will have a majority of assets invested in equity and CTA funds, these are the strategies that best fit the limitations of the medium and therefore are the strongest contenders.

Note the examples illustrated here include (Fig. 1-3) an equity long/short fund, a quantitative market neutral fund, and a CTA. Naturally, these are strategies that focus on liquid, readily available asset classes and have the greatest potential to minimize returns dispersion between onshore and offshore vehicles.

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axa3As for those strategies where tracking error has become apparent, notably in the last year, the discrepancy is often a result of the limits imposed by UCITS-compliant investment. Recently, in the event driven strategy sub sector, the best performing investments have been in credit, an asset class that can be difficult to include in a UCITS fund. In addition, onshore global macro funds are hindered by limits on concentrated positions. Such positions often allow their offshore counterparts to take high-conviction views on particular asset classes; in addition there is the well known prohibition on commodities. Similarly, fixed income arbitrage managers are also hampered by UCITS-mandated restrictions on concentration as well as leverage.

Tracking error often seems to be the result of the medium. It is thus important that management and expectations are altered to account for the difference. When analyzing the offerings, particularly of the offshore equivalent, scrutiny must extend to the historical holdings. If the diversification and instrument array are incongruous from the possibilities afforded by the UCITS directive, it is misguided to expect a similar return profile.

Nevertheless, the alternatives universe does not rely on illiquid strategies entirely and there are obvious examples of offshore strategies that translate almost seamlessly to their onshore counterparts. The RWC Samsara/Europe strategy lends itself exceptionally well to UCITS guidelines and regulations. The manager is focused on the liquid parts of the equity universe, choosing to eschew the more volatile small cap names in favour of positions within the large cap market. Furthermore RWC prefers a diversified portfolio with a long-term fundamental style rather than concentrated shareholder activism.
Similarly, Blackrock’s EOS/EDEAR strategy has a highly diversified systematic equity strategy that is not restricted by concentration limits and use similar financing in both their offshore and onshore strategy. Notably, this allows the UCITS fund to track the offshore equivalent very closely.

Lastly, the DBX Systematic Alpha Index provides a convincing tracking vehicle of Winton’s offshore managed futures fund. While critics will point out the swap structure of the onshore vehicle, Winton’s investment philosophy favors those criteria which translate to a successful UCITS product. Investments are often liquid and the fund targets less volatility than most others within their sector.

Nevertheless the fact that these are exceptions only serves to support another integral element to UCITS investing: all investment risks, whether in terms of performance or philosophy, require in depth analysis that can only be provided by experienced strategic and operational due diligence professionals. While the UCITS wrapper guarantees a certain level of supervision and basic reporting, the format still allows enough freedom for the manager that credentials and soundness of investment method remain important for the fund buyer.

Operational due diligence
In conducting operational due diligence on a fund, an investor must start by judging the ability of the fund to meet the basic limits imposed by UCITS regulations. While most offshore funds have a custodian and depository, the historical portfolio must be checked for the capability to maintain the concentration limits enacted by the regulators, such as the “5/10/40 rule.” However, it is once regulatory fundamentals are satisfied that the true benefit of experienced due diligence professionals becomes even more apparent. Risks abound within the UCITS format and it is necessary to identify the quality managers on the basis of the infrastructure they have set in place. How robust the trading platform and risk management systems are is integral to any fund operating an alternative strategy. Furthermore, the middle and back office functions require proper division of duties with a proven reconciliation process that adds controls. The adoption of the UCITS format actually complicates this portion of a fund’s operation, particularly regarding the OTC market. Whereas offshore funds often have a prime broker overseeing all assets, the UCITS model requires the participation of the custodian, counterparty and prime broker.

The management of OTC market derivatives trades necessitates a reconciliation process between all of these entities. In this case, the fund manager has the responsibility to reconcile the portfolio against both the prime broker and the custodian. Other elements such as the understanding of the complex legal framework, particularly as it applies to alternative strategies, as well as the study of the compliance and risk manuals often require formal legal and accounting training. The strategies employed by these managers remain complex, particularly for non-professional investors; an experienced operational due diligence team akin to those employed for offshore investment can confirm the applicability and dependability of the infrastructure and strategy in place.

The fund of funds approach
Within the UCITS universe, a fund of funds can provide the necessary strategic and operational due diligence for informed investment in onshore alternatives. Historically, these products are created by teams with significant experience managing high Sharpe ratio portfolios with low correlation to traditional asset classes. In addition, they have the required proficiency to scrutinize potential funds as their teams have extensive experience researching offshore vehicles, often from the perspective of a legal, actuarial, or dynamic trading professional. These are skills that are easily transferable to the onshore universe and still just as critical in the investment process of these regulated alternative products.

Conclusion
Key in UCITS investing is the acceptance of its limitations—sacrifices that ensure the benefits afforded by a more liquid, regulated, and attractive product for a new class of investor. With these benefits come certain elements, such as higher cash levels, which can impact performance, resulting in tracking error compared to the equivalent offshore fund with monthly or quarterly liquidity.

However, the debate must be turned away from the shortcomings of UCITS products’ performance in comparison to offshore hedge funds; onshore funds are not meant to be perfect substitutes. Instead, they utilize an attractive medium to offer interesting and complex investments to a group of investors that either is unable to invest in an offshore product or favors the benefits provided by onshore investments such as higher liquidity.

A better assessment of “Newcits’” success is in its return profile as measured against a more quotidian mutual fund format of investment. These are the only other funds that would be applicable to an investor in the UCITS space and the value of alternative vehicles becomes apparent in their ability to complete a well-balanced portfolio with performance objectives that have lower beta-correlation. While the fund managers may be judged upon their abilities in the offshore market, the products they offer must be seen independently as stand-alone vehicles within their own investment universe.

Aarnout Snouck Hurgonje is a Director, Alternative Investments, in the funds of hedge funds business of AXA Investment Managers.