New strategies for hedge funds under UCITS III

John Donohoe, Carne Global Financial Services
Originally published in the February 2007 issue

Why would a number of our hedge fund managers be asking about potential product opportunities offered by UCITS III? A UCITS III fund is specifically designed for pan-European distribution to retail investors and has quite onerous investment restrictions, which most hedge fund managers would find it hard to live with.

However one of the many benefits of the product is that you get regulatory approval to establish such a fund in one European Union (EU) member state such as Ireland or Luxembourg. You can market it to retail investors in other EU member states once you register it in those countries. This registration process varies between countries and is in the process of being simplified. These funds can of course be marketed to institutional investors as well, often without the need for local registration.

How does this product have relevance to hedge fund managers? The answer to this depends on the type of investment strategy being adopted and the target investor base of the manager.

Given the disintermediation of product manufacturing and ultimate distribution, the manager can sell its product to various European banks or institutions who can then potentially distribute it to retail investors.

Also, European funds of funds managers have greater ability to invest in other managers funds if they are constituted as UCITS funds. These ‘re-distributors’ in general require UCITS III funds if they are going to target the huge retail market in Europe.

In relation to the investment strategy being adopted, the investment manager must comply with the investment and borrowing power restrictions laid down in the regulations. The manager must still comply with restrictions such as that no more than 10% of the Net Asset Value is invested in any single security. The difference between UCITS I and UCITS III that some hedge managers are interested in exploring, lies in the fact that you can now use a much broader range of financial derivative instruments (FDIs) and that you can use such derivatives to leverage these funds by up to 100%. In addition FDIs can be used for investment purposes; previously you had to pass the efficient portfolio management (EPM) tests to use them.

As you can imagine, fund managers are constantly exploring the potential opportunities offered by this product. Some examples of derivatives and strategies include:

CFDs for long/short equity funds

Under UCITS I, a fund was able to perform some limited shorting using permitted EPM techniques such as written options or selling futures. Generally this was confined to index based instruments although call options could be written on specific stocks provided the underlying stock was held in the portfolio or uncovered call options could be written up to 10% NAV. Generally, these techniques are not useful to managers of long/short portfolios. Long/short equity managers like to be able to short specific stocks for which they do not hold the underlying security.

Further, they often like to be long up to 100% of the portfolio and short up to 100% of the portfolio with different stocks. This type of strategy is now possible under UCITS III rules. Under the UCITS III rules, an investment manager can be long up to 100% in directly held equity securities. Additionally he can be short up to 100% using stock specific derivatives such as contracts for difference (CFDs) or stock specific futures. The new rules permit a fund to be leveraged up to 100% of NAV through the use of derivatives. Permitted cover in respect of a derivative instrument can often be any liquid asset including any listed equity security that meets the liquidity criteria.

Credit default swaps

Credit default swaps (CDS) can be used in a number of ways both to buy protection and to write protection as a way of boosting revenues. This was permitted under UCITS I but was subject to overall prohibition on leverage in the Fund. Under UCITS III leverage is permitted up to 100% NAV.

Total return swaps / Structured products

A number of managers have launched UCITS III funds that involve investing in bonds and swapping the income through a total return swap for a return that is related to an index (for example a commodities index). Some of these products offer capital guarantees. Unfortunately at this stage the Committee of European Securities Regulators (CESR) has not approved the use of hedge fund indices as an eligible asset for UCITS III funds but the industry continues to try to persuade them that they should. This continues to be a very important issue for the hedge fund industry.

Investments in loans

The ability to invest in loans within a UCITS III fund may vary between EU jurisdictions and is the subject of debate. Some Financial Regulators have approved UCITS III funds to invest into loans up to certain limits. The industry is seeking to get approval for loans to be classified as ‘transferable securities’ which would open up this asset class to UCITS III funds.

Enhanced Fund of Funds

Investment in other funds under UCITS I rules was limited to 5% of NAV. The UCITS III rules permit a fund to invest up to 100% in other funds provided that the funds meet certain criteria (ie must be regulated to a standard equivalent to a UCITS) and subject to certain diversification rules (eg maximum 20% in any one investment). Some UCITS III funds of funds have been launched which use derivative overlays (options and futures) to manage certain aspects of the investment risk such as volatility and value at risk.

It is worth pointing out that UCITS III funds using derivatives must have a derivatives risk management process and document in place that corresponds to the risk and complexity of the strategy being adopted. The relevant regulator requires the manager to explain how the derivatives are being used, the risks involved, and how such risks are being controlled and monitored.

Through working with our clients and the regulators it is becoming more obvious to us that UCITS III funds can offer fund managers greater product development scope as well as access to a greater investor base. It is by no means a product of interest to all hedge managers but it is worth understanding its potential. Other product developments that are in train at present include a UK domiciled fund of unauthorised funds which could invest in hedge funds and be sold to retail investors in the UK. This potential product is dependent upon the successful outcome of discussions with the UK Revenue authorities. Another product of interest to hedge managers is the proposed new Luxembourg ‘specialised funds’ which may be an alternative to a Cayman domiciled fund. These potential funds could be sold to high net worth investors with a minimum investment of €125,000 but will not require prior approval by the local regulator, the CSSF.

John Donohoe is Chief Executive of Carne Global Financial Services – business advisor to the hedge fund industry