“There are expectations of rapid growth within the UCITS industry over the next couple of years, but key constraints within the current framework appear to be holding back its potential success.”
This statement comes from a recent report published by Create Research and RBC Dexia1, which aims to assess the impact of the UCITS III framework.
However, many of the constraints highlighted in the report have, in fact, now been overcome by a select number of UCITS III funds. These innovative UCITS III funds provide exposure to true hedge fund strategies, often mirroring the managers’ existing offshore hedge funds/funds of hedge funds. The following paragraphs give background on these developments.
The demand is there – it just needs accessing
Using cautious estimates, projections for 2012 indicate that over €8,000 billion will be invested in UCITS products, an increase of 60% (equating to double-digit growth each year) from €5,000 billion at end 2007 (see Fig.1).
Many asset managers are using UCITS as a main channel for globalising their businesses with considerable interest outside the EU and as far out as Asia and South America.
So what are some of the key constraints to meeting the global interest in UCITS products? (see Fig.2).
Given these turbulent market times, it is understandable that the most frequently cited key constraint is market uncertainty. Investors are extremely cautious in their investment choices these days, regardless of regulated status, and many are adopting a ‘wait and see’ attitude. Also high up on the list of constraints are regulatory limitations on physical shorting/leverage and the range of asset classes allowed, which are perceived as particularly onerous by asset managers interested in employing hedge fund strategies.
Withstanding these constraints, rapid product development has led to the availability of genuinely innovative UCITS III products such as absolute return focused UCITS III offerings. These products have what is regarded as a ‘real and direct’ exposure to absolute return hedge fund strategies and can apply a range of techniques to provide the absolute return hedge fund strategy exposure. UCITS III regulation, issued by the European Commission (EC), provides that a UCITS structure may invest in financial derivative instruments, some of which are detailed below, provided that the position exposure is calculated by an appropriate approach. For sophisticated UCITS III structures, namely those that employ financial derivatives to gain access to specific strategies, risk measures must be calculated on a daily basis and the EC recommends the use of a Value-at-Risk (VaR) model to quantify maximum loss in normal market conditions. The directive requires the use of both Relative VaR and Absolute VaR and imposes limits on both of these measures2. In addition, the UCITS must use stress testing in order to help manage risks related to possible abnormal market movements.
Examples of Financial Derivative Instruments that can be used:
• CFDs: Under UCITS III rules, the manager can be long up to 100% in directly held equity securities and short up to 100% using stock specific derivatives such as contracts for difference (CFDs) or stock specific futures. Therefore, the fund can be leveraged up to 100% of NAV.
• Total Return Swaps: This involves investing in a portfolio and swapping its return through a total return swap for a return that is related to a reference basket (or index). Examples of a suitable reference basket could be an equity long/short strategy or a commodity index. This structure is ideal for managers that find the restrictions of the previous option too onerous as the reference basket itself does not have to comply fully with the UCITS rules.
• Credit Default Swaps: CDS can be used in a number of ways in fixed income strategies, for example hedging exposures and buy/write protection, or playing the basis between the CDS and underlying corporate spreads.
Certificates (either individually or in a series) can also be used within the UCITS III framework to replicate the risk/return profile of FOHFs. Alternatively, a UCITS eligible index can be created to replicate all of the underlying hedge fund strategies; the index needs to meet the UCITS criteria of eligibility though.
With any of the techniques mentioned, distribution is paramount to global take-up of UCITS III and the most dominant channels for cross-border sales of UCITS funds are those owned by third-party distributors and open architecture platforms (see Fig.3). Hedge fund managers, sitting in a larger asset management company with existing mutual fund platforms, are ideally positioned to distribute UCITS III funds offerings, benefiting from access to a wider spectrum of clients.
The appeal of UCITS III products accessing true hedge fund strategy returns has now spread from the retail to the institutional market which is drawn to the high transparency, regulated risk management and improved liquidity offered.
Clients’ increasing demands including consistent returns, capital protection, high risk-adjusted absolute returns, competitive fee structure and alpha/beta separation are met by UCITS III hedge fund offerings. However, clients are particularly looking for regulated vehicles with superior risk management from trusted brands. Asset management companies with excellent client servicing and distribution reach, as well as seasoned expertise in hedge funds, are ideally positioned to capture this growing demand.
Pioneer Alternative Investments has recently collaborated with Structured Invest SA to launch two UCITS III absolute return strategy vehicles focused on European and Asian equity markets. The funds are managed by Structured Invest SA and capture returns of underlying long/short equity strategies via a total return swap. THFJ