STEP UP THE UCITS III WAY

When talking about the most advanced techniques employed in fund management, the European Ucits III legislation is what comes to mind first. By allowing the use of a wider range of investment instruments, the new regulations have enabled asset managers to offer more sophisticated products to retail investors, who have for the first time been able to gain access to techniques traditionally reserved for the institutional segment.

Derivatives can now be employed in funds for investment purposes, rather than just efficient portfolio management. Those managers who have derivatives expertise are well placed to make the transition to offering these more advanced types of funds.

In addition to investment banks and hedge fund managers, it could be argued that bond fund managers are generally well positioned, having tended to use derivatives for their institutional accounts for liability matching strategies.

Managing separate accounts has been very similar to the way Ucits III has evolved, say Kevin Kuhner and Michael Thompson, co-heads of European institutional remarketing at Pimco. “We have been using many of these instruments in our portfolios for many years, so that when Ucits III came into effect, we were more than ready to be able to use the increased powers in Pimco’s range of funds in Dublin,” says Mr Thompson. There is a total of 32 fixed income funds in their Dublin range, all using the full Ucits III toolkit, say the two Pimco managers.

In terms of new trends, there has been an increasing focus on delivering returns with Libor as a benchmark and moving to a space which is not traditional but a possible alternative, says Mr Thompson. “The whole concept is being able to port alpha from different sectors into Libor space. Although this cannot be classified as a new development, products in that area have become a lot more available.”

“We have been running portable alpha strategies for the last 20 years,” adds Mr Thompson. “But Ucits III definitely has allowed that concept of total return funds to grow and flourish.”

Multi-assets funds have developed a lot more significantly. “But even in the more core traditional fixed income space, investors’ expectations are much greater, wanting their existing core allocation to work a lot harder,” says Mr Thompson, making reference to the concept increasingly becoming a cliché in the industry of the importance of “really making your assets sweat”.

Freedom to capitalise

The 130/30 fund, a type of structure that is making the most of powers enabled by Ucits III, is quickly gaining momentum in European distribution. The product, which can also assume different ratios (such as 140/40), takes a 100 per cent long position, while giving the manager the freedom to take a 30 per cent short positions in those stocks on which they have bearish view, this way providing the ability to capitalise on downward markets. Under the Ucits III rules, the 30 per cent short is provided by derivatives.

“A proliferation of these products is beneficial to the whole industry”, says Nick Phillips, head of global partners at Goldman Sachs Asset Management (GSAM), EMEA. “There is a lot of education required, to explain the sophistication of these products and how they are appropriate for an individual’s portfolio. As that education process goes on and on, as there are more entrants in the market, these products will tend to become more acceptable and normal within a client portfolio,” he says.

The 130/30 products use hedge fund techniques and skills, in that they are able to identify short positions, but they are not trying to achieve the same objective as hedge funds, explains Mr Phillips. Hedge funds are seen as an absolute return vehicle, whereas these are directional vehicles, aiming to outperform a particular index.

Criticism of 130/30 products revolves around the fact that along with the possibility of increasing returns, there is also the chance that if bets go wrong, with shorting there are no limits on the downside.

Whether it would be a 130/30 or long-only product, those managers who are positioned correctly will perform well, while those who have taken more risk will have a greater variance of return, he says. “I think it is down to the quality of the stock and the position the manager takes.” And if the possibility to short gives no limit on the downside, the opposite is also true. “If you have a strength in identifying shorts, you are going to create alpha for clients from their short positions,” says Mr Phillips.

GSAM’s Core Flex strategies, which follow the format of 135/35 and come in European, US and Japanese equity versions, have a tracking error between three and a half and six, depending on the region. Flex is a beta one product. There are long-only products with tracking error targets higher than that, explains Mr Phillips. “In order to take more risk, the tracking error needs to be higher to get higher returns, whether long-only or 135/35.”

JP Morgan Asset Management has also joined the fray, launching 130/30 products, two in the United States and two in Europe and currently looking at a global one, explains Luke Costanzo, associate, product development Europe at the American firm.

In general, says Mr Costanzo, apart from 130/30 products, the use of derivatives has become much wider spread since Ucits III regulation came out, and the wider range of strategies in a larger range of investment structures allows to control risk and return within a portfolio in a much more efficient manner.

“The vast majority of the products that we have issued in the past 12 months have had a sophisticated nature to them or have got some form of derivative element built into the structure,” he says.

“In general, we have seen more movements towards incorporating hedge fund strategies in our suite of funds, looking at quantitative approaches and increasingly looking at how hedge fund type structures can be employed in the Ucits environment,” says Mr Costanzo.

JP Morgan AM already employs hedge fund firm Highbridge Capital Management, in which the firm has a majority stake, as a sub-adviser to some of their funds.

The idea is to distribute these funds on a larger scale, says Mr Costanzo.

“Highbridge run their investment strategies within the (JP Morgan) Luxembourg Sicav and we help them to adapt their investment strategies to the Ucits environment so that they can run the funds in line with the regulation,” he says.

“The hedge fund strategies they use in a Sicav are different from what they would do with hedge funds. They are getting more experienced and we are also learning,” says Mr Costanzo.

Daily liquidity of these more sophisticated structures is the key benefit, if compared to hedge funds. While in the hedge fund market daily liquidity is pretty limited, using these more advanced techniques in a Ucits III environment means that you can liquidate your portfolio on a daily basis if necessary, says Mr Costanzo.

“From a hedge fund manager perspective, this is not necessarily the greatest thing, because if there are immediate reactions, people can liquidate quickly,” he adds. If this does not allow hedge fund manager to deploy their strategy fully, on the other hand it allows them to access the market in terms of greater distribution, he says.

Case for a multi-manager

Product complexity is an additional issue that argues for the case of multi-manager structures, says Robert Burdett, who co-heads the multi-management team at UK-based asset management boutique Thames River.

“Product performance is subject to a wider range of influences now,” says Mr Burdett. “Rather than just buying stocks, you also have to be able to strip the influence of derivatives, the influence of new benchmarks, and the influence of different investment styles that can be developed with these wider powers. The analysis needs to be sophisticated, but it probably plays into the hands of investors via multi-manager, as long as multi-managers have or develop those skills.”

For multi-managers themselves, the most important change under Ucits III is the ability to mix open-ended vehicles with listed or transferable securities, or shares. This has opened new possibilities in terms of access to new products. For example, it is possible to buy exchange traded funds to get exposure to physical asset classes, such as wheat, whose prices are currently going up. There are not any mutual funds which give exposure exclusively to wheat, says Mr Burdett.

These new possibilities, opened up by the legislation, fit in well with the trend toward multi-asset class solutions. In multi-management now you can use a wider range of assets than in the past. There are funds which advertise for investing in wine, art or other asset classes, says Mr Burdett.

“Often these areas tend to be available through unconventional vehicles, such as investment trusts or structured products, which might not have been impossible to use before Ucits III.”

	‘Ucits III definitely has allowed that concept of total return funds to grow and flourish’ - Michael Thompson, Pimco
	‘Rather than just buying stocks, you also have to be able to strip the influence of derivatives, the influence of new benchmarks and the influence of different investment styles’ - Robert Burdett, Thames River
	‘The regulations are up to interpretation from each asset manager, who will interpret the legislation as they see fit... From our point of view, it is working well’ - Nick Phillips, GSAM
	‘It is our task as a portfolio manager to use all the instruments that we are now given. Our toolbox is bigger than before and we can build and manage products differently from before’ - Dirk Degenhardt, Deka

In terms of new developments, the use of derivatives for efficient portfolio management is also growing in multi-management. “One of the aspects of multi-management is that you tend to invest in products that are priced once a day or once a week,” explains Mr Burdett. “But you may want to get the exposure to that market before the fund you are dealing in values, so you could buy derivatives to cover that exposure in that market and hold the derivatives until the valuation point of the funds you originally traded, and then unwind the derivatives immediately after that valuation point.”

Specific resources are needed to do that, says Mr Burdett, mentioning that half of the $12bn (?8.4bn) of total assets managed by Thames River is in hedge funds. “We have in-house expertise in trading derivatives and in their administration, that is a key advantage to us in this business,” he says.

What to expect next?

It seems there is a long way to go before Ucits III shows its full potential in terms of more sophisticated products, both from the asset managers’ and distributors’ point of view.

This is only the beginning, says Luke Costanzo of JP Morgan Asset Management. “At the moment we are still in a growth phase and we are learning more about what we can and cannot do. The potential of Ucits III has not been maximised because there is not full understanding of instrument types and how they can be used, both from the asset manager and distributor view point,” explains Mr Costanzo. There is always scope to become more flexible and provide greater opportunities in the market place, he says.

There are, for example, areas they would like to explore, but legislation does not allow it yet. “The one area we would like to move into is commodities,” says Mr Costanzo. “You can use index-related commodity derivatives but being able to select specific baskets of commodities is not something that we could do under the current rules, but one would hope that this will change in the future.”

One of the challenges that comes with implementing new products under any new regulation is that guidelines tend to be quite loose and down to interpretation of single regulators and single asset managers.

Mike Hemming, managing director of Skandia Global Funds, the Dublin-based sub-advised platform, currently employing 17 sub-advisers, blames the slower than expected uptake of derivative content in Skandia’s fund range on the lack of clear guidelines on Ucits III.

“In the Dublin fund range we haven’t really gone much into the Ucits III arena yet,” admits Mr Hemming. “I think partly there has been a degree of confusion around what you can achieve under the Ucits III rules. We expected very clear guidelines on what we could do within Ucits III. I think the various organisations have been slow to lay them down,” he says.

Mr Hemming observes that there is more an expectation that the funds providers will present concepts to the regulator and the regulator will decide whether they fit the rule. This is not uncommon, as the rules are new for the regulator as well, he says.

The next generation products that are likely to be more successful in the retail market are the products that can creatively generate income, without eroding the capital, says Mr Hemming. “They will be the bulk of the market in five to 10 years’ time in Europe,” he says. And if there are managers in the industry delivering this type of products, leveraging on the new powers offered by Ucits III, it is difficult to find those who can deliver consistent returns, says Mr Hemming.

“In the short term, the benefits of using derivatives have been mainly on the fixed income side, because the fixed income managers have struggled to deliver yield or differentiate themselves without the capacity of using derivative instruments. Over the long term the benefits will be seen in terms of investor returns.”

Risk awareness

But the challenge is to demonstrate that managers know what they are doing in terms of risk control and that they can understand the risks inherent in what they do.

The evidence with credit default obligations over the last couple of months has demonstrated that even the larger institutions have a tendency sometimes to invest without understanding the inherent risk. The exposure to subprime mortgages has demonstrated this, says Mr Hemming.

“It is a conundrum to generate income which is significantly higher than base rate and that is provided consistently without eroding capital, because you want consistency rather than volatility. It is difficult to find a manager who can do it consistently,” he states, adding that Skandia’s problem is no different from the problem of a man in the street who wants to buy an income product. “We are just doing it on a wholesale basis rather than retail basis.”

But Mr Hemming also accepts the slowness of the process. “I think any significant change in the structure of an industry has to be delivered slowly and with thought. If it is done quickly, there is the danger that the client misunderstands. In my mind, slow development is good development.”

He also states that a lot of these products have been available on individual country markets for some time but the development of the cross-border market for these products has to be much slower. “That is in everybody’s interests, including the clients’, and I think that is why the regulator responds slowly.”

To this regard, asset managers think quite differently, seeing the process of developing new products as a necessarily interactive one with the regulator, which is giving a successful outcome. “The regulations are up to interpretation from each asset manager, who will interpret the legislation as they see fit. Within each and every product that is launched involving innovative strategies, asset managers would go back to the regulator and the regulator will say if that is appropriate or not,” says Nick Phillips, managing director at GSAM. “From our point of view it is working well.”

Dirk Degenhardt, head of product management at Deka Bank, believes it is very important to distinguish between the role of asset managers and distributors when it comes to offering sophisticated products.

“Most of the financial advisers don’t even know what Ucits III is, and they needn’t know. What is important is that they are able to offer fund products that meet their customers’ needs,” he says.

“But it is our task as a portfolio manager to use all the instruments that we are now given. Our toolbox is bigger than before and we can build and manage products differently from before.”

For example, a recent product that the German bank launched is a flexible duration policy bond product. This gives fund managers the possibility to invest with a maximum duration of seven years, with the option to go short, selling bond futures, if they think that the interest rate will increase. “Investors can participate on increasing and decreasing interest rates,” says Mr Degenhardt, “and this is very innovative.”

In this case, what retail customers need to understand is not necessarily how the engine of the fund works, but the possibilities they have in terms of returns. “They don’t have to worry about active duration management, because the fund manager does it for them.”

The situation in Germany

But the real problem in Germany, to which Ucits III is no solution, says Mr Degenhardt, is the fact that investors only want to invest in money market and guaranteed products that have a low risk and no duration or equity risk. Because of the credit market crisis over the last two months, investors do not want to have credit risk in their portfolio either.

“This means that the structure of our sales is very much money market and guaranteed fund oriented.” Mr Degenhardt hopes Deka can change this trend and achieve higher inflows in equity and bond funds in the future. New structured funds, investing in discount and bonus strategies, are also on their launch pad, making the most of the popularity in discount and bonus certificates, which, together with guaranteed products, are most in demand.

Another point of view on the German retail market comes from Markus Krebber, responsible for product development in the private client business at Commerzbank.

New Commerzbank funds in the Ucits III arena have taken the form of 130/70 structures. On the equity side, one-third of the fund volume that the German bank sold this year was in these new types of investment funds, says Mr Krebber. But he is keen to make clear that if these new products had not been available, they would have sold the old products. “These new products using derivatives are a positive development and it is a must for the asset management industry, but I don’t see it as a major innovation from the perspective of the retail investors. These new products are not an add-on for the asset management industry, there has been full cannibalisation,” he says.

The average retail investor in Germany cannot tell the difference between a simple equity long only fund and 130/70 fund, he says. What these 130/30 (or whatever the ratio) will show in the future are the capabilities of the asset managers. “The gap between the bad and good managers will increase,” says Mr Krebber.

That opportunities on the long-only market are intact and these more advanced range of products are complementary to the existing range of products is something asset managers are keen to stress.

“Ucits III opens the spectrum from a lower risk to a higher and there is a lot to talk about concerning the new generation products,” says Mr Phillips at GSAM. “But we mustn’t forget the old generation, the Ucits I products, the good stock picker that is able to manage portfolios and deliver returns for clients,” he adds.