UCITS or the Undertaking for Collective Investment Schemes in Transferable Securities are a set of EU directives, which establish a common regulatory regime for collective investment schemes, and enable a Europe-wide distribution of such products. Even beyond the European Union, UCITS enjoys a high level of recognition; it has become the ‘gold standard’ of investment funds, leading to a proliferation of products with total assets under management in excess of €5.3 trillion at the end of 2009. For the sake of this article, we will define as a UCITS hedge fund any UCITS regulated fund with an absolute return objective, generally employing active investment management techniques to acquire both long and short positions and eventually some degree of financial leverage.
It is difficult to properly assess the size of this market. There is no such thing as a classification of UCITS, which could allow for isolating hedge fund strategies from traditional investment strategies. News articles and press releases on the topic put figures forward ranging from 100 to 350 UCITS hedge funds already launched. We believe there are about 150 to 200 of such funds open for investment. It is undeniable that this market is growing rapidly in terms of number of funds and in terms of assets under management. Institutional investors have been the early adopters of the concept but it is the private banks, which are likely to bring this to the next level. Funds of hedge funds are also entering this space with more than 25 multimanager UCITS launched by March 2010. The fact that the investment universe is still relatively small is an impediment to the development of such offerings but this issue is getting smaller every time a new UCITS hedge fund is launched.
A significant number of private banks are keen on having a UCITS fund of hedge funds offering rather than a single manager UCITS offering. The main reason for this is their general reluctance to take single manager (selection) risk. Some funds of hedge funds are patiently waiting for more depth in this investment universe and some single managers are counting on funds of hedge funds to partially seed their UCITS hedge fund; a chicken and egg classic.
Arguably a growth story
Investor demand is arguably strong, fuelled by concerns about transparency, risk management and liquidity. An increasing number of investors are looking for UCITS to add to their hedge fund portfolio.
As far as hedge fund managers are concerned, the uncertainty related to the proposed Alternative Investment Fund manager Directive constitutes in itselfa good reason to look into UCITS. Under the current proposed directive only alternative investment fund managers established in the EU will be able to provide their services and market their funds in the European Union. Managers based outside the EU will be prohibited from selling their funds to EU investors, unless they meet various fiscal and regulatory requirements.
For managers within the EU, the lower risk strategy is to set up their UCITS to secure at least one distribution channel into the European Union. UCITS constitutes a real opportunity to access, to retain or to increase investments from institutional investors. It is worthwhile pointing out that capital coverage requirements are often lower in the presence of regulated funds, which is a further factor contributing to the increasing popularity of UCITS among institutional investors. The same popularity holds for high net worth individuals and even retail investors in the EU and beyond. It is therefore not surprising that a very significant number of hedge fund managers are either managing or seriously considering the launch of a UCITS hedge fund in the coming year. The emergence of so-called ‘UCITS platforms’ developed by some investment banks and investment managers to facilitate the launch of such vehicles is a further indication that we are in the presence of a solid and sustained trend.
A case for managed accounts
UCITS and managed accounts are usually jointly named as the solutions to address the type of issues investors faced in the 2008 hedge fund crisis. In a UCITS fund of hedge fund distribution survey conducted by KdK Asset Management (“KdK”) in February-March 2010, fund distributors were asked whether they consider either of these approaches as a superior (or a more appropriate response) in the light of their own investors’ concerns; 50% of the respondents were of the opinion that UCITS is a better response while only 19% disagreed with this statement; 22% considered that the propositions are not comparable and 9% have no opinion. These results are a bit surprising at first sight: don’t managed accounts offer the highest degree of transparency and unconstrained liquidity?
There is some published research that suggests the renewed interest in managed accounts is mainly a consequence of recent negative liquidity experiences such as gates and side pockets, as well as the impact of some high profile fraud cases. Investors now believe they are better off investing in a portfolio that they control themselves rather than being co-mingled with other investors and thus vulnerable to their behaviour. In addition to liquidity concerns, requirements for more transparency and better risk management have also contributed to this shift towards a managed account structure.
The ability to impose investment guidelines is seen as a further significant advantage of this approach. In short, managed accounts constitute a valuable opportunity to (1) improve liquidity terms, (2) mitigate operational and fraud risk and (3) get a better visibility over the risk exposure of an investment. The (probably) most important advantage of a managed account is the isolation of the investment management role from all other activities related to the management of the investment (administration, risk monitoring, reporting, etc), in order to increase transparency and control. We note that this is by and large also a given with UCITS.
Consequently, we think that the reason why a majority of the survey respondents prefers UCITS over managed account solutions is due to the fact that they think as distributors. (Real) managed accounts are not accessible to smaller investors and many can’t cope with the operational burden nor are they sophisticated enough to deal with the information that is generated. Large investors (pension funds and funds of funds) are expected to be the main users of a (individual) managed account approach, whereas UCITS seems to be a more suitable solution for wider distribution.
Adequate regulatory framework
With assets in excess of €5.3 trillion at the end of 2009, UCITS have proven to be successful and are widely used by European investors. UCITS account for 75% of the total fund management industry in the European Union. UCITS is a global brand, attracting investors from the EU, Switzerland, South America and Asia.
KdK’s UCITS Fund of Hedge Funds Distributor Survey confirms the distribution potential of UCITS; 90% of the respondents consider that a UCITS wrapper is adding potential in terms of distribution, as shown in Figure 1. The relevant EU directives are outlining the requirements for the set-up, the management and oversight of UCITS. Amongst others, they provide guidelines for fund organisation, custody, risk management, asset eligibility, liquidity, diversification, leverage, etc. Since 2002, the UCITS framework has offered extended financial instrument scope, which has triggered a convergence of the hedge fund industry with the long-only fund industry. Investment managers are allowed to use a broad range of (derivative) instruments to access different types of exposures, which are generally associated with managers generating ‘alpha’. The gap between hedge funds and UCITS compliant funds is arguably narrowing.
The growing popularity of UCITS hedge funds with end users is due to their appeal in terms of liquidity and the (perceived) additional security provided by the regulatory framework. As far as distributors are concerned, the biggest selling points of UCITS hedge funds as compared to offshore hedge funds are better liquidity terms, regulatory oversight and transparency, as shown in Fig.2.
• Liquidity: A UCITS must provide liquidity at least twice a month. It is also worthwhile pointing out that it is more difficult to gate a UCITS (although not impossible notwithstanding a widely held assumption to the contrary) or to organise side-pockets. Therefore, one can assume that managers should be more careful about liquidity mismatches.
• Regulatory oversight is perceived as a true advantage of UCITS. Assets are to be held in a segregated account and placed under the responsibility of the custodian.
• Transparency and reporting are seen as significant advantages of UCITS over offshore funds. Mandatory reporting, however, is limited to the production and filing with the regulator of (audited) annual accounts and (unaudited) semi-annual accounts. In terms of transparency (i.e. the type of information disclosed), the norm for UCITS is probably not more valuable to investors than what the average offshore hedge fund provides.
• Risk management framework: The UCITS requirement for the implementation of a risk management process is seen as mildly positive. Actually, the fact that a hedge fund manager will typically have to perform more complex transactions than in an offshore fund fully justifies some additional safeguards.
• Lower due diligence costs are seen by the survey respondents as a marginal advantage. Indeed, UCITS only partially protect against fraud. When it comes to the assessment as to whether the manager or the different service providers have the experience, the capabilities and the adequate set-up to fulfil their tasks, the client still has to perform his own analysis.
There are substantial benefits of operating in the UCITS framework. However, the benefits come at a price: the manager will have to comply with some organisational requirements and most probably alter the way he has traditionally managed assets. In the following we look at some of the main challenges.
The UCITS regulations require a manager to have a real substantial presence in the country where the fund is domiciled. Ensuring the standards of compliance and risk management under this regime may add a significant cost as compared to running an offshore fund. The managers are basically facing the choice of whether to set up a UCITS on their own or through a so-called platform. Such platforms are generally run by investment banks or asset managers. Recently a few independent platforms have also been launched in Ireland and in Luxembourg. Current active players are Merrill Lynch-Bank of America, Deutsche Bank, JP Morgan, Schroders, Luxembourg
Financial Group, Merchant Capital and Decision Analytics. In order to take a decision there are several key factors to consider.
Timing: A platform (established umbrella SICAV, ICVC) will generally have a shorter time to market. Setting up an independent fund (may) take more time, although one should be aware that investment banks have a thorough internal approval process for each transaction, which may negatively impact time to market. The use of a platform also impacts flexibility: the hedge fund manager is no longer in control of the pace for fund launch, registration timeline or country passporting. Product development plans may be influenced by decisions made by the platform provider or other managers using it. Platforms are quoting lead times of 4 to 6 weeks. However, there is some anecdotal evidence suggesting that 4 to 6 months might be more realistic in some cases.
Costs: Platforms promote their offering as cheaper than an independent approach. Due to economies of scale, established relationships, etc. it is true that costs can be reduced significantly. However, platforms may charge an ongoing fee which exceeds the higher set-up and maintenance costs of an independent set-up (legal, administration and “substance” costs).
Choice of service providers: Platforms usually impose constraints on structure and service providers. This reduces the ability to negotiate fees, to seek competitive derivative pricing, etc. It also prevents the potential to replicate partially the existing operational framework such as the relationship with the fund administrator, some aspects of the prime brokerage relationship, etc.
Flexibility: The platforms offer no scope to change the legal structure, or the service providers. Some platforms (especially those run by investment banks) require the fund to trade exclusively with them as the derivative counterparty.
Distribution: Platforms, and in particular investment bank platforms, come with a brand name and a distribution network. Usually, the hedge fund strategy becomes directly also “eligible” for in-house indices and structured products. In some cases, banks may even provide seed capital (although this is becoming rare). The flip side is that the brand may in some cases negatively impact distribution potential. Platforms may sometimes require exclusive distribution rights and may require disclosure of the hedge fund manager’s investor list. It is also worth highlighting that it is a misconception that partnering with a large universal bank comes automatically with distribution through their private banking networks. Independent or asset manager run platforms also provide only a limited assistance in terms of distribution.
Investment management challenges
From an investment management perspective, the main challenges can be summarised in the following areas.
Diversification: UCITS are required to maintain a significant spread of their investments. This is known as the “5/10/40” rule, which requires that any UCITS cannot be exposed in excess of 10% to securities issued by the same body (with an exception for issues guaranteed by a government), and that the sum of the exposures exceeding 5% have to remain below 40% of the scheme’s net assets. Further risk spreading requirements apply to cash deposits, derivatives or investments in other funds.
Flexibility: Prohibition on direct investment in certain assets such as commodities and on physical shorting. This may limit a hedge fund manager in delivering its investment strategy in full.
Leverage: A UCITS is not allowed to borrow for investment purposes. It can however obtain leverage through derivatives. A UCITS global exposure through derivatives is in principle limited to 100%, which means it is theoretically limited to 200% gross exposure (100% on balance sheet plus 100% off-balance sheet). There is some flexibility in calculating this exposure in accordance with a valuation methodology and risk monitoring framework acceptable to the UCITS home regulator (Value at Risk approach).
Liquidity: the maximum redemption period for a UCITS is fourteen days and redemptions must be made in principle at the fund’s net asset value. Therefore, the ability of managers to take positions in illiquid assets or illiquid strategies may be limited, restricting again the manager’s ability to deliver its investment strategy in full.
Note that some challenges can be overcome with the use of derivative instruments. Provided certain conditions are met, short positions, leverage and even exposure to ineligible assets will be possible through the use of financial derivative instruments. Most of the prime brokers offer synthetic prime brokerage services, which usually take the form of portfolio swaps. In such a relationship, the nature of the relation with the prime broker is very similar to the relationship in a traditional offshore hedge fund set-up. For some strategies, such as long/short equity funds for example, where extensive leverage is not used, the UCITS can even be run without such a synthetic prime brokerage relationship. Instead, the fund just faces derivative counterparties to implement short or leveraged positions.
Impact on performance
When compared to its sister offshore hedge fund, a UCITS hedge fund may end up underperforming to a certain extent. The main (known) sources of differences in performance are investment and counterparty restrictions, liquidity, and operations.
Investment restrictions: In terms of regulatory guidelines, we are tempted to say ‘less is more’. Restrictions are reducing the opportunity set and consequently reducing the performance potential. This, of course, only holds if we assume that the manager is effectively generating alpha.
Liquidity: UCITS are required to provide at least semi-monthly liquidity. In practice, UCITS hedge funds have weekly or even daily liquidity. If used on an investor level, this calls for more transactions and potentially a higher portfolio turnover on a fund level (compared to offshore funds). The higher the costs, the lower the performance.
Operations: A practical aspect often neglected by product developers is related to operations. A poor handling of executed transactions generally requires the attention of the manager. This unnecessary use of his time may prevent him focusing on generating performance.
Counterparty restrictions: A substantial proportion of the fund’s economic exposure may have to be acquired through derivatives. This highlights the need for negotiation power, absent of which, the fund could end up paying inflated prices for each transaction. UCITS hedge funds are generally restricted to a few counterparties (due to the necessity of having a contractual framework in place with each derivatives counterparty). Moreover, when a transaction has been entered into with a designated counterparty, it has to be closed with the same counterparty, which may constitute an issue in terms of best execution.
Consequently, managers should carefully analyse the different alternatives to best deliver their investment strategy and to build a sustainable UCITS business. A particular focus should be given to flexibility and independence of the approach chosen. If it is decided to go for a platform solution, one should clearly assess the quality of the proposed operational framework and obtain assurances or even hard commitments in terms of distribution.
A vast majority of the respondents of the KdK UCITS fund of hedge funds distribution survey expect UCITS hedge funds to underperform in comparison with non-UCITS peers. This outcome is quite unsurprising given the fact that the survey was filled in by investment professionals aware of the cost impact of the UCITS regulations.
The potential for distribution is dramatically higher for a UCITS hedge fund than for an offshore hedge fund despite the expected underperformance. Hedge fund managers have been used to letting the performance talk. In other words, a good investment process, solid and consistent performance were the ingredients of successful distribution. In the UCITS world, this is clearly not enough.
There is a widespread belief that a hedge fund just needs to launch a UCITS to see dozens of pension funds, insurance companies and private banks pour money into it. It is needless to say that this view is largely overstated. Hedge fund managers will need to understand what investors want. In order to fully exploit the UCITS potential, a manager will need to set up his fund in the right jurisdiction, provide for adequate liquidity, charge an adequate level of fees, pay trailer fees, etc.
As an example, depending on where one wants to distribute, the choice of the domicile of the UCITS can be important. The preferred domicile for UK distributers, based on our survey, was Luxembourg with 36% of the votes and Ireland with 21%. The preferred domicile for UCITS from Spanish and Italian distributers were 60% Luxembourg and only 10% Ireland. The level of management fee, performance fee, liquidity features, minimum denomination, etc. will all have some degree of significance and distribution potential will be affected by the choices taken. The UCITS framework is a regulatory standard but not a marketing standard.
There is growing concern among industry organisations that such funds are being sold to retail investors that do not understand them. UCITS may provide investors with a false sense of security and this should be carefully addressed. UCITS hedge funds are not necessarily more risky than traditional long-only UCITS. In fact, it is probably even the other way round. UCITS hedge funds will have a more controlled risk profile, usually referred to as an asymmetric risk profile, which aims at protecting investor capital in a downward market.
The risk lies in the complexity of the exposure. The counter-performance of a long-only US equity fund is easy to explain when the S&P 500 Index is down. However, negative performance becomes more difficult to explain in the case of an absolute return fund falling in a negative market environment. Communication is key. This means that promoters of UCITS hedge funds should be careful in targeting their audience and make sure that the risks associated with investments in their vehicles are well understood.
UCITS look very much like a new market reality. The migration from an exclusively offshore business model towards a model including a UCITS offering seems to be a logical evolution. However, hedge fund managers need to understand that UCITS is not an asset management tool but rather a distribution wrapper. The main challenge lies in the fact that UCITS asset gathering is a fundamentally different exercise from the methods they have used to raise assets until now. It is not rocket science to set-up a UCITS fund but it is—potentially—an art to do it in such a way that flexibility, independence and potential for performance are preserved.