Ucits no guarantee of immunity from risk

The growing proliferation of hedge funds in Ucits III structures has been partly driven by investors’ increased demand for higher liquidity, transparency and regulatory oversight, which so-called ‘Newcits’ supposedly offer more than their offshore or lightly regulated versions. After all, suspensions and gates imposed by hedge funds during the financial crisis and the Madoff fraud are still very fresh in people’s minds.

But ironically the risk is now that the Ucits stamp may lead selectors and distributors alike to lower their guard.

Reassurance

After the Madoff fraud, some of the largest hedge fund allocators in the world have decided to use Ucits III vehicles to get the comfort and reassurance they needed, to be able to sit back and say “we have done their due diligence and risk management work”, says Marc Denogent, managing director at HFR Asset Management based in Zurich.

“People tend to forget that the Ucits vehicle is not different to any other vehicle, from a structural perspective. The safeguards that are being promoted by Ucits III don’t necessarily match up with the reality,” he says.

For example, Ucits III funds are required to offer at worst two-weekly liquidity, and at best daily liquidity, but there are increasing concerns that the liquidity of the underlying investments may not match the liquidity the Ucits structure is supposed to offer.

According to recent research from consultancy Strategic Insight, there are worries in the distribution community that hedge funds, driven by business pressures and uncertainties about the European Union’s impending Alternative Investment Managers Fund Directive – which may impose some restrictions on the marketing of offshore hedge funds to European investors – are offering strategies less suited to the Ucits format, which might not provide sufficient liquidity during times of stress.

“Your investments will only ever be as liquid as the actual instruments themselves. If the underlying assets that are held within the Ucits vehicle can’t be traded, it does not matter what their framework is,” warns Mr Denogent.

“If you look in the fine print of any Ucits III fund, you will see that they can basically suspend redemptions in case of market disruption events. Ucits III does not necessarily guarantee liquidity and it is not because of Ucits III that investors are necessarily going to be safer,” he adds.

The potential liquidity mismatch between what the European Ucits directive in theory guarantees and the underlying investments is the major risk to consider when investing in Newcits, believes Nicolas Campiche, head of Pictet Alternative Investments.

“There are already a number of institutions that are playing with fire, creating Ucits funds using quite sophisticated swap structures, which are not liquid enough,” he says, explaining that in the $8bn (€6.5bn)fund of hedge funds operation he heads there are no investments in Ucits compliant funds yet.

“We are still analysing this emerging industry. Ucits is a fantastic brand name but it may be misleading to a number of investors, as to what the real risks embedded in a Ucits hedge fund are,” says Mr Campiche.

“We like to invest in products that have been tested over time and many Newcits are coming out just as an answer to some of the problems that were raised during the crisis. Should we decide to move in that direction, we will do so very carefully,” he says, explaining that, nevertheless, client demand is something to take into account and regulated long short or CTAs, which are the only two strategies that can really be successfully replicated in Ucits, can enhance liquidity in a fund of funds portfolio.

“There are only around 40 “real” Newcits hedge funds available and the only way to analyse them is very much through qualitative due diligence, because there is no track record yet,” says Mr Campiche.

Hedge Fund Research estimates there are now 400 Ucits compliant funds launched by hedge fund managers available on the market, which have gathered more than $35bn (€28bn). These include both regulated versions of existing hedge funds (Newcits) as well as new Ucits funds. Most of the strategies are predominantly in the equity long short space, which is the most conducive to the Ucits structure (see chart).

Also, there are some concerns that hedge fund houses are failing to meet the levels of transparency offered by traditional fund houses, including basics such as prospectuses, legal documents and details of performance, according to Strategic Insight.

“There seems to be full security that just because the fund is Ucits, it has much better risk management, transparency, and reporting than your offshore counterparts, but I don’t think this is necessarily the case,” says Ana Haurie, group managing director at marketing and distribution group Dexion Capital.

Ana Haurie, Dexion Capital

Dexion, which currently offers the Newcits AHL Diversity fund managed by Man Investments, is looking to add other Ucits compliant funds on its platform soon.“We have a lot of demand for Ucits funds across different types of investors, which is due to the regulatory stamp they have on them and the liquidity terms they offer,”she says.

“That is a reaction to the lock ups, the gates, and the lack of liquidity that hedge funds went through during the crisis. Ideally we would like to work with a well established manager, who has an established track record and strong robust infrastructure,” says Ms Haurie, explaining that as Ucits work only with liquid strategies, Dexion offers illiquid hedge fund strategies in closed end fund structures listed on the stock exchange to meet investors demand for liquidity.

While large managers such as Schroders and Deutsche continue to add Ucits funds on their platforms, funds of hedge fund managers are also increasingly attracted by this powerful distribution wrapper.

Signet, a London based fund of hedge funds, is exploring the opportunity to launch a Ucits product within the next few months, mainly to meet investors’ demand but also to edge the risk related to the evolution of the regulatory landscape, explains Heath Davies, co-portfolio manager at the firm.

In addition to looking at those few hundred of Ucits funds available, the firm is also engaging in talks with all the individual hedge funds in which it currently invests and that run liquid strategies, about the possibility of them launching Ucits products.

“If we are invested in those managers in our offshore products, we believe that they are the top class managers, and therefore we would also want top class managers in our Ucits products,” says Mr Davies.

If liquidity and transparency are benefits of Ucits strategies, those characteristics alone are not driving investors to switch from offshore hedge funds to their regulated versions, believes Bill Malconado, head of alternatives at HSBC Global Asset Management

“The growth in Ucits funds is not due to the difficulties that hedge funds experienced over the last few years. Investors are not driven by fashion or short-term factors, these are long-term institutional type investors. Most of these institutions were not invested in hedge funds before, and therefore did not suffer from these problems,” he explains.

“Perhaps they were unable or unwilling to invest in offshore hedge funds. Or maybe illiquidity and opaqueness were part of the reasons why some investors have been historically on the sidelines. They were looking for means of investing onshore, and Ucits provides that means.”

This is also shown by the fact that the demand for offshore funds has picked up again, as risk appetite has increased. “Some people are able to invest in offshore funds, and they choose to do that, equally there is a universe of people who are not able or not easily able to invest offshore, and they like the Ucits route, and I think that trend will continue,” says Mr Malconado.

Debate revolves around how closely the performance of Newcits can mirror the performance of their existing offshore versions. There are a few notable examples in the market - for instance, the Ucits III compliant absolute bond plus fund by Brevan Howard, which failed to generate investors’ interest and is being restructured to make the strategy more appealing – which support those who believe that investors necessarily need to accept a trade-off between fund performance and higher regulatory protection.

“I don’t think it is true that Ucits funds don’t perform as well as offshore hedge funds. For some strategies it may be true, but across the board it is a very difficult assertion to make,” explains Mr Malconado.

The number of Ucits III hedge funds is still too limited, compared to the very large universe of 9,000 offshore funds, to be able to make any valid conclusion. “Statistically it is a very difficult comparison to make, I don’t believe evidence supports that assertion,” he says.

Ucits III funds, in general do bear more expenses than offshore funds, and the added fee layers within the Ucits III structure will obviously detract from performance.

However, Ken Heinz, President at HFR Research says “it is not clear what investors’ expectations should be, because there are instances where the Ucits vehicle is launched under different risk parameter than the original non Ucits fund,” he says. He adds that they are however, for the most part, calibrated in a very similar manner.

Ucits not the only way to liquidity and transparency

There is a strong demand for safer products in terms of operational framework, but Ucits III funds are only one of the ways to ensure a certain level of protection, says Christophe Baurand, global head of sales and marketing of alternative investments at Lyxor. Another way is through the managed account platform that Lyxor has developed over 10 years, which enjoys better liquidity, transparency and risk management, states Mr Baurand.

“We have seen a very strong rise in managed accounts demand over the past 18 months, because of the liquidity crisis on one hand and the Madoff effect on the other. Our managed account platform protects the investors from operational risk more efficiently than Ucits vehicles. Also it allows investors to gain access to a much wider range of strategies that are not suitable to the Ucits wrapper.”

However, like many asset management firms, Lyxor too has a Ucits III fund of funds product ready on its launch pad, with a view to broaden its distribution. “We have a lot of investors who simply from a regulatory stand point are not allowed to invest in the traditional funds of hedge funds, including our funds of managed accounts,” says Mr Baurand.

Lyxor already offers a Luxembourg-domiciled, diversified multi-strategy UCITs fund of fund, which allocates dynamically, via swaps, and according to a top down methodology, to the 15 Hedge Funds strategy indices into which the $11bn (€9bn) Lyxor managed accounts platform is divided.

Lyxor’s next Ucits III fund of fund product is going to be a more concentrated, bottom-up driven portfolio, investing in around 20 positions from the universe of existing Ucits hedge funds.

At the same time the French firm is going to launch Luxembourg index trackers of these 15 alternative investment indices, which will have weekly liquidity and will allocate money via swaps to the managed accounts of the Lyxor hedge fund platform. In order to achieve appropriate diversification, the new Ucits III funds of hedge funds will allocate approximately 20-25 per cent of the portfolio to these index trackers to gain exposure to hedge fund strategies that are traditionally not suitable to the Ucits III criteria. These index trackers will be available to third-parties too.

“We are seeing a lot of appetite from other funds of funds providers for our hedge fund index trackers, because they are aware of the limitations in the strategies available in the Ucits III space,” explains Mr Baurand. Lyxor is able to offer the hedge fund index approach as it has the largest liquid managed account platform in the world, where funds have a weekly liquidity, he says.

“We expect these products to have slightly lower returns than the very traditional offshore fund of funds. But the risk linked to liquidity or operational issues in gereral are very strongly reduced when investors use managed accounts or Ucits III framework, so this is a benefit that should not be underestimated.”