The alternative UCITS market has been shaping up for this test since Merrill Lynch began to sign up hedge funds to its Investment Solutions platform over five years ago. Since 2005, assets under management have doubled to around €75 billion (See Fig.1) after early rapid growth in alternative UCITS. This followed the introduction of the updated UCITS III provisions in 2001 which permitted the use of some basic hedge fund investment techniques, including moderate leverage, short selling and derivatives exposure. Following the wide spread gating that took place in the post-2008 credit crunch, the UCITS provisions giving minimum 15 day liquidity suddenly looked appealing and had the virtue of addressing a key investor concern.
Even so, this is a sector still in a relatively early phase of evolution. Our own UCITS Hedge database tracks over 500 funds compared with over 10,000 in the offshore sector. Moreover, regulation of this new market is developing as the European Securities and Markets Authority is holding a consultation on UCITS. Though this is cloaked as an examination of exchange traded funds and structured UCITS, it is clear that several aspects of the Newcits phenomena are being scrutinized closely. This is also the case with continuing deliberations on the part of the French regulator, the AMF. Some changes in how UCITS operate are probably inevitable even if the broad approach that has developed is maintained.
“The regulatory authorities are focusing on the migration to UCITS IV,” says Florent Josset, head of Nomura Alternative Investments Group. “I don’t see that directly affecting alternative UCITS. Some of the debate around index structures and synthetics,especially regarding synthetic and physical ETFs, will continue but shouldn’t lead to fundamental issues for UCITS.”
What seems clear is that there will be no turning back from an increasingly pan-European, onshore asset management sector using reasonably sophisticated portfolio management tools. The commercial advantages UCITS offer, chiefly transparency and liquidity, are appealing to new market segments both in terms of geography and client type. Not only have alternative UCITS fund structures thrived in Europe, their seal of approval now extends to investors in the Middle East, Asia and Latin America. This is attracting the attention of alternative fund managers, notably in America and some emerging markets.
“In my view, UCITS is increasingly becoming an attractive investment vehicle for many investors, who appreciate the enhanced liquidity, transparency and regulatory oversight that the structure has to offer,” says Roman Rosslenbroich, CEO, Aquila Capital. “At Aquila Capital, we recognized the advantages that UCITS offers both managers and investors very early on. We converted our AC Risk Parity Fund to a UCITS structure in 2008, making it one of the first absolute return UCITS funds available in the market. Since then, we have seen significant inflows into our UCITS fund range, with our AC Risk Parity strategy recently reaching assets under management of over €1.3 billion.”
New platform providers
The UCITS sector’s quickly growing horizons attracted some big new entrants to the market in 2011. Goldman Sachs International launched a platform for external managers in the third quarter which now has three funds. With the entrance of the leading hedge fund prime broker to offshore funds, it would appear that the UCITS market is primed for further expansion. Indeed, several funds have been conspicuous by their success with each getting to $1 billion in AUM and beyond: Winton Capital (DB Platinum platform), Aquila Capital (Alceda platform) and York Capital (Merrill Lynch Investment Solutions). Other investment banks have entered the fray, notably, UBS which acquired the Luxembourg Financial Group platform in mid-2011. Post-integration of LFG, UBS is gearing up for a renewed push into UCITS later in 2012, says Mike Fullalove, the bank’s global head of alternative fund distribution. He adds that the refocusing of the UCITS strategy at UBS will result in additional managers and strategies being launched on the platform later this year.
Helping managers adapt
Managers of hedge fund investment strategies are accustomed to advising lightly regulated offshore funds. In comparison, the legal and custodial structures for the onshore hedge fund strategies via UCITS are more circumscribed. Consequently, there is much learning and adaptation required to tap the emerging investor appetite for UCITS compliant investing. The ready solution for managers and investors is the UCITS hedge fund platform, of which around 20 are on offer.
“For investors one attraction of investing via a platform is the additional risk oversight,” says Alex McKenna, head of fund structuring, at Deutsche Bank, which runs the db Platinum UCITS platform. “Deutsche Bank is a trusted institution and has a great deal of experience with hedge funds and alternative investments. Investors see the platform environment as a well controlled environment. Deutsche Bank has the platform to meet the highest standards within that regulatory framework.”
For investors, the UCITS format for hedge funds strategies offers particular benefits. These include: regulated standards of operation and oversight; formal controls on counterparty risk; an open-end fund structure with frequent dealing and commensurate high fund liquidity; and increased transparency through mandated reporting and risk measurement processes.
UCITS adds complexity
For hedge fund managers, these very attributes of a UCITS product introduce challenges. There is the need to register with another regulator, most often in Luxembourg or Ireland. In addition, more parties are needed to run an onshore fund (notably the custodian as well as the administrator), while there are also increased burdens on operations, compliance, marketing and to some extent the investment staff of the investment advisor.
Having a turnkey solution to handle these matters is the key attribute of any platform. At Swedish investment bank SEB, EFA acts as the administrator, while the bank itself is global custodian. With pre-approved service providers, a fund can be up and running on the SEB Prime Solutions UCITS platform in three to four months compared to the year a manager might need to launch independently, says Peter Herrlin, client executive for European hedge funds with SEB’s prime brokerage unit. “For us it is very much a part of our prime brokerage offering.”
Freedom of choice
Among the platforms, there is substantial variation. Some platform sponsors, like SEB, Merchant and Matrix, are agnostic about what choices investment managers make by service function. The choice of prime banker (that is the onshore equivalent of prime broker) is typically unrestricted. As a rule, the fund manager can extend the existing prime brokerage relationship for the offshore fund to the onshore product. In some cases, investment banks have set up a UCITS platform to satisfy prime services clients with offshore hedge funds.
Sometimes the fund manager has a strong banking relationship that can influence the choice of custodian. However, it is often the case that the choice of administrator and custodian is more circumscribed than the choice of prime broker/banker. In some cases, the selection of an administrator or custodian may be proscribed by the particular domicile where a fund platform has been set up. So a platform sponsor with a history of activity in Ireland, like Lyxor, for example, will find it natural to select a Dublin based administrator and custodian with a strong presence there. Similarly Alceda, which has a business background in Luxembourg, finds it natural to line up administrators and custodian banks with a presence and understanding of working in Luxembourg.
“Our long-standing experience in structuring both alternative and traditional investments ensures that our fund set-up process is timely, efficient and cost-effective, even when highly complex issues are involved,” says Hamid Parsa, Director of Business Development at Alceda. “Whether a client is looking to launch an alternative investment absolute-return or long-only fund, Alceda is able to complete the process of setting up a UCITS fund within a period of six to eight weeks.”
Getting a fund onto a platform and approved by regulators is, of course, just one factor that managers face in selecting a platform. Cost efficiency and speed to market are particularly important in the early stages of a fund’s life. This is notably true of the UCITS sector where managers are keen to get products before investors at a time when growth is high and first mover advantage is tangible. However, once a fund is up and running distribution takes on primary importance. With the growing adoption of UCITS in places as far flung as Chile and South Korea, the value of having global distribution networks to institutions is substantial. And as a number of respondents to this survey indicated, moves to develop distribution to retail investors are being ramped up.
“Using a UCITS platform’s marketing networks is key since it is better to market under a well known platform as it gives extra credibility,” says Apostolos Avlonitis, portfolio manager of RP Capital Group which recently launched the RP Systematic Emerging Markets UCITS Fund on ML Capital’s Montlake platform. He also cites the advantages of a cheaper initial set up and more efficient regulatory application process since platforms have professionally trained UCITS staff with knowledge of compliance and risk management procedures.
One of the faster growing platforms in 2011 is the FundLogic offering run by Morgan Stanley. Several fund managers have embraced its strong European distribution capabilities.
At the same time, the platform has appealed to investors’ appetite for diversification by enlisting a growing range of managers, many of whom are outside of Europe.
“For hedge fund managers, FundLogic offers a completely outsourced and turnkey solution enabling them to tap into the UCITS market while benefiting from Morgan Stanley’s unique distribution capabilities, including institutional investors and intermediaries,” says David Armstrong, the investment bank’s Global Head of Fund Linked Products. “To investors, we provide a comprehensive range of highly skilled investment managers. We believe our edge lies in our ability to offer a large number of US based investment managers under our unique platform, allowing investors to obtain a diverse range of investment exposures by accessing a wide range of managers under one fund umbrella.”
Land grab slows
With 2011 just completed two data points in the UCITS sector stood out. First, not only hedge funds but also UCITS funds lost money. But the performance of the onshore sector was far less volatile. The UCITS Hedge Index ended 2011 with a drawdown of 4.55% compared with an 8.87% fall for the offshore bellwether HFRX Global Hedge Fund Index.
The second data point is that new launches for alternative UCITS funds in 2011 fell below the levels recorded in both 2009 and 2010. Indeed, launch volumes in 2010 were approximately double the levels recorded during the past year. Several reasons may help explain this. First, there is some evidence that the three main UCITS strategies – long/short equity, managed futures and macro – had already seen fund origination outpace capital allocation. So a slowdown in line with a falling off in investor commitments was understandable. There is also anecdotal evidence that some managers delayed setting up new UCITS funds to concentrate exclusively on steering existing funds through a highly difficult market environment.
“There were a lot of funds that weren’t as successful as they would want to be,” says George Cadbury, head of Merchant Capital’s UCITS umbrella for alternative funds. “Some managers saw UCITS as a lifeline even though some strategies weren’t suited to it. That accounted for the big flurry of launches. But we are strong believers in the continuity of growth in the UCITS market. I can’t see a scenario where the UCITS market will become diminished.”
Managers more discerning
It is probably no bad thing that fund managers have become more discerning about the suitability of a strategy to the UCITS framework. Bubbles beget busts. With memories of 2008 still fresh a more considered approach to the sector’s development is in the interests of managers, platform providers and, of course, investors.
Merrill Lynch, now Bank of America Merrill Lynch, was the first investment bank to launch a UCITS platform. BAML is continuing to build its fund offering even though it has come through the initial growth phase that newer platform providers are still experiencing.
“We are continuing to broaden our offering to diversify our product range,” says Miriam Muller, head of BAML’s fund platform group. “The mandates in the pipeline will take us beyond 20 funds and we have said the optimal number is 25 to 30 funds. We have reached critical mass and have a broad selection of strategies available to investors.”
Several regulatory changes will impact the evolving UCITS landscape in 2012. Platform operators have until mid-year to finalise Key Investment Information Documents or KIIDs. Operators will also be studying the advent of UCITS V and whether they will incur higher costs from assuming custodian responsibilities and related liabilities.
Perhaps the biggest change, however, is the retail distribution review or RDR that comes into effect in the UK at the year-end. Under RDR, third party marketers, notably IFAs, will charge a direct advisory fee from investors instead of taking an upfront fee. “It will become clear what investors are paying to whom and how much,” says BAML’s Muller. “We think that will level the playing field to the extent that there will be greater transparency on fees and more emphasis placed on fund quality for the end investor in terms of the various competing products.”
The timing of RDR may dovetail with the evolution of alternative UCITS to seek retail channels to market. Certainly, the growth in alternative UCITS platforms has resulted in a number of operators coming into the market to focus exclusively on tapping the retail investor opportunity. Here the approach of Merchant Capital, which has acquired a network of 120 IFAs, is instructive. “We see the opportunity for UCITS being the retail market,” says Cadbury. “It is very much an educational drive. Many IFAs are unaware of the opportunity in UCITS,” he says, noting that market volatility underlines the attractions of hedge funds as risk managers. “We are hoping to change this sentiment a little bit and offer a better alternative.” One noteworthy success in the retail UCITS market is BlackRock UK Absolute Alpha, which has taken in over $4 billion.
Another is Schroders GAIA Egerton European Equity, which has attracted over $600 million from investors who like its success in achieving better than equity-type returns with less risk.
“Schroders is a very reputable asset management firm with a high quality product offering and distribution,” says Jeff Blumberg, CEO of Egerton Capital, which manages the fund. “Our collaboration with Schroders thus far has been seamless and, most importantly, a success for our mutual clients.”
Given these successes and the fact that around $8 trillion is invested in the UCITS market, overwhelmingly in long only funds, it’s clear the opportunity for Newcits is palpable. Perhaps nowhere is this more the case than in Germany. Not only is it Europe’s biggest market, it is one where alternative fund investing has been hampered by both the business culture and tax provisions. But German platform operators like Alceda and Universal-Investment have made great strides in bringing alternative fund products onshore to the country’s huge investor community.
“We will see a lot of new asset managers from overseas offering well established successful strategies for German investors,” says Stefan Klein, an executive in investment product management with Universal-Investment. He cites the US and Scandinavia, among others, as among the main centres for Newcits managers now marketing to German investors.
Klein confirms that the Alternative Investment Fund Manager Directive, even though it doesn’t take effect presumably until mid-2013, is having an impact on the Newcits market. “AIFMD is mainly having a positive effect because we see many offshore managers coming onshore now,” he says. “Sometimes it is hard to handle all the issues, but net, net it has had a positive effect.” Luxembourg and Ireland have attracted most of these funds, but Germany, the UK and new centres in Malta and Gibraltar are also gaining funds.
The main emphasis on some UCITS platforms falls squarely on distribution. With Matrix Group, for example, there is more flexibility for managers to come on board with their own service providers and the partnership with funds is a genuine two way process.
“The main thing is the breadth of the distribution channel,” says Luke Reeves, a director with Matrix and head of retail and institutional business development. “We can work with existing teams as appropriate. Quite a lot of the groups we work with have their own sales teams. But we can be complimentary and work with them to develop different sales channels.”
A network effect
Some of the UCITS platforms are being run by big institutional fund management groups combining internal and external funds. External managers on such platforms get highly visible brand recognition and global scale. At Schroders, the three funds on the platform advised by external managers come from very prominent hedge fund firms: CQS, Egerton Capital and Sloane Robinson. Indeed, Schroder GAIA Egerton European Equity has raised over $600 million since inception in November 2009.
“One thing we offer managers is the whole-hearted backing of our distribution network,” says Gavin Ralston, global head of product with the fund manager. ”We sell these funds as if they were Schroder funds. We have strong distribution of UCITS not just in Europe but in Asia and Latin America. We can position UCITS funds to be sold globally.”
For some specialist UCITS platform operators, securing distribution lines is a function of setting up ties with specialist teams targeting specific investor niches. ML Capital, the operator of the Irish-domiciled Montlake UCITS platform, has cemented a significant distribution agreement with Acolin Fund Services of Zurich. It will provide managers on the platform with access to several hundred banking groups across the German and Swiss marketplaces.
“The market is clearly recognising the vital importance of distribution which a well placed UCITS platform can deliver,” said John Lowry, chairman of ML Capital.
“The deal with Acolin will further enhance our competitive position as these distribution deals can often take a year or more to structure. We are currently also in discussions with a number of distribution partners and private banking groups in Latin America and Asia, which are experiencing significant demand for alternative UCITS products.” He sees demand for alternative UCITS growing in some of the classic hedge fund strategies, notably global macro and managed futures along with a renewed interest in global emerging markets strategies.
The growing interest in the UCITS sector among investors is seeing some start up managers consider launches early in a fund’s life cycle. Many of the funds on the more established platforms proved themselves initially offshore before evolving a UCITS offering in the last few years. It means they have a substantial investor base and commensurate financial resources. But with start-up and emerging managers resources are likely to be more limited. For them, a UCITS wrapping with a pared down cost base may prove to be very attractive.
A soon-to-launch UCITS platform from Prodigy Capital Partners is aiming to address this market. Prodigy is awaiting regulatory approval for an umbrella structured Luxembourg SICAV, which will host its merged UK UCITS and Cayman emerging market fund. When the platform is established in the coming months, a fund will be able to launch in UCITS format for a one-off flat fee of circa €25,000 (as well as avoiding the typical repeating share of the management fee that other platforms charge). That will cover start-up costs, local fees, directors and audit. Citi is tasked with being the depositary and custodian, with Andbanc the administrator.
“There are quite a number of small start-up fund managers wanting to get a UCITS,” says David Robinson, managing principal and portfolio manager with Prodigy. “They want to focus on raising money rather than spend time going through the UCITS setting-up process on their own. We have gone through this process and now we can offer the same to a manager with minimal pain or interruption. We think there may be people who want to join our syndicate and share the costs, which are extremely competitive and attractive to small and mid-sized funds.”
The cost savings come from combining small managers to create economies of scale. The managers maintain complete operational freedom—unlike large bank platforms, a fund won’t be tied to any particular provider for, say, swaps or other business needs. Instead, the aim is to ensure that individual fund managers aren’t subsumed in a vastly bigger entity, enabling them to build their own brand equity and evolve their businesses as required.
“The beauty of this concept is low cost, tremendous speed and flexibility combined with own branding and ownership,” says Robinson. “Once set up, a new manager can focus on building their business and selling their fund.”
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