UCITS and NEWCITS: A better mousetrap?

Currently all the rage, UCITS funds, dubbed “NEWCITS,” because they are new launches of UCITS-compliant products, are hedge funds built to follow guidelines on “Undertakings for Collective Investment in Transferable Securities,” a set of EU directives that aim to allow collective investment schemes to operate freely throughout the EU on the basis of a single authorization from one member state.

AllAboutAlpha.com noted the trend back at the start of the year with this report focusing on players such as Brevan Howard, MAN Group and GLG Partners, which have already launched several UCITS vehicles and continue to gather assets.

Indeed, according to a recent survey of fund distributors conducted by London-based KDK Asset Management, the number of NEWCITS funds is exploding, with an estimated 200 such funds making their debut in the last 18-24 months with a collective $35 billion under management. Three different specialized “UCITS Hedge Fund” indices have also been launched.

According to respondents within KDK’s latest survey (you can download a summary of the report for free, or send an email request for a full copy), the benefits of UCITS funds are that they are already regulated and offer the comfort of a trustee or depository bank as holder of the assets. At the same time, they mitigate some of the counterparty risk concerns raised by the role of the prime broker in a typical hedge fund.

Indeed, the vast majority of respondents surveyed by KDK see strong demand for UCITS-structured funds, see chart below.

Source: KDK Asset Management

But there are also drawbacks, in particular on the performance side of things. In fact, according to the survey results, respondents believe that the implementation of the same investment strategy in a UCITS structure impacts performance negatively, reducing the potential for return as compared to the same strategy delivered in an offshore fund.

The order of magnitude of this difference is even expected to be significant (in excess of 3% p.a.) by approximately 10% of the survey participants (see chart below).

Source: KDK Asset Management

Why the discrepancy? According to KDK, managers are facing a certain number of investment and implementation challenges, among them stringent diversification requirements, prohibition on direct investment in certain assets such as commodities and on physical shorting, limited leverage and strict liquidity requirements.

In other words, many managers feel they can get the same or better results for their investors by setting up a non-UCITS fund structure outside the EU.

Source: KDK Asset Management

For funds of hedge funds, the performance concern is even more prominent. For NEWCITS in particular, the survey noted than 90% of funds of funds believe they will have lower returns than their equivalent offshore versions, with a quarter expecting the shortfall to be greater than 3 percentage points a year.

Beyond that, many see the move as mainly being motivated by the ambition to gather more assets from sources that are no longer accessible through offshore funds or managed accounts, thanks to either new or pending regulations.

What it boils down to is whether investors and managers feel there is additional value-added in a UCITS structure versus a separate managed account or offshore vehicle.

According to KDK, the reason why most appear to prefer UCITS over a managed account solution is that real managed accounts are not accessible to smaller investors, and many can’t cope with the operational burdens.

What’s more, UCITS’ perceived main benefits – namely liquidity, transparency and embedded regulatory oversight – are viewed by the majority as well worth the effort and price.

At least for the time being…

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