Is Ucits suitable for hedge funds?

Most wealth managers now reserve at least part of their clients’ portfolios for outcome-oriented products, those that are designed to produce real world outcomes rather than being defined by the beta of the assets they invest in. The growing universe of such investment opportunities can only enhance the potential to deliver to clients an attractive balance of risk and return by bringing the inherent focus of hedge fund managers on absolute return and preserving capital into a liquid Ucits wrapper.

If there is disappointment among wealth managers invested in the sector it comes from execution rather than strategy.

The Absolute Hedge analysis, compiled by Kepler, shows a return of -3 per cent in the first eight months of 2011 across the universe of Ucits funds, better than equities, but worse than both bonds and offshore hedge funds (the HFRI Composite Index is down 1 per cent).

The fact that the aggregate universe of funds has produced a disappointing outcome this year tells us little about the skill of the underlying managers. The alternative Ucits universe is dominated by long/short equity funds, which have higher correlation to equity markets than many other strategies, so returns are explained largely by the weakness of equity markets. The long/short equity component of the Absolute Hedge index has indeed been one of the worst performing sectors this year.

From the perspective of product providers, alternative Ucits funds have so far been a success. Kepler’s Absolute Return universe contained 219 Ucits funds at the end of August, with total assets of €62bn, implying an average size of about €280m, which incidentally is larger than the average size of Ucits funds as a whole.

While this type of analysis demonstrates the commercial success of these funds, it creates an artificial boundary between alternative funds and the rest of the Ucits universe. Those classified as alternatives make the most extensive use of the tools and strategies that Ucits III liberalised eight years ago.

However, since then these tools have been taken up across the board. Risk in traditional strategies is increasingly being managed in ways formerly confined to hedge funds and there are many successful funds with non-traditional strategies built on the skills of a manager from the long-only world.

Those who buy newly-launched alternative Ucits funds frequently do so on the strength of the track record of an offshore vehicle. In doing so, they should be satisfied the track record achieved offshore could have been achieved within the Ucits restrictions. Investors and fund selectors should not sacrifice potential return for liquidity and transparency.

As with many products, these are ‘horses for courses’ – you don’t use a Ferrari for Motorcross – so I don’t believe that Ucits funds suit many hedge fund strategies.

The Ucits fund was introduced by the EU in 1985, and I think the first one was launched in Luxembourg in 1986. It was and, in its various upgrades to the Ucits IV today, still is a very good retail, long-only investment product. I stress “long-only” because it was not and still is not permitted to go short in a Ucits fund, except for hedging for “Efficient Portfolio Management” – whatever short sales were made must have a clear relationship with the long assets in the fund’s portfolio. Thus you could not hedge your fixed income portfolio by shorting the S&P index.

It is these restrictions that make Ucits unsuitable for most hedge fund strategies. However, since 2008, many institutional investors have found Ucits attractive, largely because they are strongly regulated and have demanded that hedge fund managers launch a Ucits fund, if they want the institution’s pennies. Thus was born the “Newcits” fund – an awful name – referring to a Ucits fund modified to house a hedge fund strategy. Many Newcits were launched despite the restrictions, because many managers of precluded strategies created a complex and often expensive derivative product, which synthesised the short positions. As a result, the Newcits did not exactly replicate the manager’s Cayman fund’s performance.

Furthermore, not only was it more expensive to use a complex derivative to create the short side, but the actual cost of both establishing and operating a Newcits is noticeably higher than the cost of a Cayman, or what I describe as an “IF” fund – ie a Dublin QIF (“qualified investor”), a Luxembourg SIF (“specialised investor”) or a Maltese PIF (“professional investor”) fund.

These costs become penal, unless the manager has distribution and can raise several hundred million euros, to reduce the unit cost. This makes a €50m Ucits very expensive to run. Nevertheless, although a Ucits may not be suitable for many hedge fund strategies, if the strategy fits the Ucits model and the manager has distribution, then it could be just what the institutional investor is looking for.

However I remain sceptical of the wisdom of following the herd in 2009/2010, which was persuaded to start a Newcits, often for the wrong reasons. Even the demand for a Ucits, because it was a “strongly regulated product” was, in my opinion, misguided. After all, not only are the less expensive and less restrictive “IF” funds EU regulated, but also regulation never actually deterred a dedicated crook. Indeed, there were several Ucits funds that were invested with Madoff, with the inevitable result.

People also praise Ucits because they are required to provide liquidity and transparency – both of which any fund can provide if the promoter wishes.

Another problem that concerns many people is that investors who choose Ucits, because they are strongly regulated, may not carry out sufficient due diligence. Similar concerns exist about the potential blow-up of a Newcits fund, which could damage the Ucits brand. Indeed recent press reports that regulators are looking to return the Ucits fund to the simple long-only product it once was, reflect these concerns.

Finally, it has to be said that many managers chose the Ucits fund because Ucits avoided the potentially restrictive AIFM Directive. The decline in the number of new Ucits in 2011 indicates that the fear of AIFM was misguided, especially as it now appears that non-EU managers running non-EU funds can continue to sell them into Europe under the Private Placement Regime.