So marveled J.C. Hall, founder of Hallmark Cards, in his autobiography “When you care enough.” He was talking about the new invention he had stumbled upon one Christmas: wrapping paper.
Nearly a century later, a new kind of wrapping is being invented that seems poised to kick-start – or at least re-invent – an entire industry: the UCITS III wrapping.
The EDHEC Risk Institute released the results to a survey on the topic recently entitled, “Are Hedge Fund-UCITS The Cure All?” (click here to download the full report). The report focuses on what is pushing investors, particularly institutions and funds of hedge funds, to seek out, and in many cases demand, UCITS-wrapped hedge fund strategies.
The 86-page report is full of various reasons and responses for the ongoing swell of interest, ranging from the Lehman Brothers’ collapse and a new-found appreciation for counterparty risk to Madoff and concerns of restitution risk – i.e. getting sued for being ensnared in someone else’s fraud.
Topping the list though is the Alternative Investment Fund Managers Directive, AIFMD, for short, which is currently being pushed through the European Union parliament and could be enacted in some yet-to-be-fully-disclosed form by summer (see two charts below).
Part of the reason for the attraction to UCITS funds is that both investors and managers alike feel it will cover off any unforeseen rules that the AIFMD will ultimately put in play. Among the biggest concerns of investors and managers at the moment isn’t so much the Directive itself but the lack of information about what form it may ultimately take (click here to read the Alternative Investment Management Association’s latest response to the Directive).
Beyond the uncertainty of the Directive, however, respondents to the EDHEC survey noted that the UCITS framework actually makes it easier to promote and distribute hedge funds – particularly since right now each country / jurisdiction has so many different types of rules, many of them conflicting, that makes it difficult to market and sell. Some 90% of sellers, managers, and distributors agreed “somewhat” or “very much” that the UCITS framework makes it much easier to promote and distribute hedge funds.
Indeed, UCITS are the sole vehicle eligible for pan-European distribution at the moment. According to EDHEC, once an investment has earned the UCITS designation in its home country (or is registered in a host country if it is a foreign fund), it can be marketed and distributed in other European countries, in keeping with the directives on the single market. In addition, a UCITS designation may also be the only passport for distribution to institutional investors (with the exception of pension funds).
Further, the study notes that UCITS is now an internationally-recognized label, with UCITS funds sold worldwide: Some 40% of UCITS are sold outside of Europe. The U.S. doesn’t recognize UCITS as the equivalent of its domestic regulated funds.
According to EDHEC Risk, a wave of hedge-fund UCITS is on the way, driven by both supply and demand. Slightly more than 60% of investors in investment funds plan to ask promoters or managers to restructure hedge fund strategies as UCITS. Likewise, the chart below shows that 70% of fund managers plan to restructure their strategies as UCITS.
The attitudes of institutional investors depend on whether they are subject to investment restrictions. Most pension funds, generally exempt from investment restrictions, show no interest in having hedge fund strategies packaged as UCITS, while institutional investors, funds of hedge funds and insurance companies are much more keen. Insurance firms in particular are subject to investment restrictions and plan to ask promoters or managers to restructure their funds as UCITS.
Following the UCITS path isn’t easy. Article 34 of the UCITS directive states that “A UCITS must make public in an appropriate manner the issue, sale, repurchase or redemption price of its units each time it issues, sells, repurchases or redeems them, and at least twice a month.” Those are harsh terms for a hedge fund.
But the real stumbling block: cost. Some 80% of respondents expressed concern over not only the cost of structuring a hedge fund under the UCITS banner, but running it (due to the higher cost of leverage, higher cost of reporting and a higher cost of liquidity). Many felt it will actually impede their ability to produce positive alpha, particularly in a world of fixed fees.
Nonetheless, in a world where transparency has already become the new norm, sticking to UCITS rules doesn’t seem such an onerous thing, particularly when, as the study notes, most investors see it as a kind of “seal of approval.”
Bottom line: Like it or not, UCITS-compliant hedge funds are here to stay. Expect more hedge funds to wrap them up as UCITS and put a bow on top, and more investors cooing “Ah! You shouldn’t have!…”