The relentless German drive for hedge fund regulation has raised the hackles of many over the past few months. The latest to raise concerns about the EU’s AIFM Directive is freshly-minted UK Prime Minister David Cameron, who sees the protectionist slant of German proposals as a threat to London’s hedge fund industry. The protectionist elements of the AIFM Directive may eventually be toned down, but the apparent adoption of UCITSIII as a sort of de facto global stamp of approval may ensure that European policies have extra-territorial implications for years to come.
We’ve covered several industry surveys on the topic of UCITS. But in today’s post, Ahmet Peker, CAIA, of Deka Investments in Germany examines his firm’s proprietary database of UCITS hedge funds.
By: Ahmet Peker, CAIA, Deka Investments
The financial crisis led to changes in the preferences of many investors. Illiquidity, transparency, the lack of regulation etc. are seen as more critical than before. Combined with the political will to have no “grey areas” on the financial markets map, this has forced Hedge Funds to rethink their fund-vehicles. European Managers notably reacted on this by launching UCITS III compliant funds.
But what exactly is UCITS? This was/has been the question many people asked, when the trend kicked-off in early 2009. As readers of this website know, UCITS stands for “Undertakings for Collective Investment in Transferable Securities” and is a directive that standardises the framework for funds across the EU.
A UCITS fund, which was launched in a member country, can be sold in all other member countries. The directive gives certain minimum standards for documentation, marketing, custody of assets and most importantly for the portfolio, like limits for positions, counterparts, liquidity, risk and leverage. It also defines what instruments are eligible for the portfolio.
Equities, bonds, and FX are allowed directly, whereas single future on a specific commodity cannot be bought straight into the fund. It has to be either through an index/basket (existing or “individual”) or through structured products like notes and certificates. Illiquid assets are more difficult from the funds perspective. The other important restriction is the one surrounding leverage. The Manager can (maximum) double the defined Value-at-Risk of the fund, i.e. the benchmark index if an index was chosen. This is more a VaR-limit than an exposure-limit.
Pros and Cons
From an investor’s angle, UCITS funds address many of the problems they have faced during the crisis. A prominent example is that, although many Hedge Funds invest in very liquid instruments, the investor doesn’t normally get a comparable chance to withdraw his shares. Under UCITS, however, funds are required to give at least bimonthly liquidity to their shareholders.
Another example is the security of the assets of the fund. For UCITS funds it is necessary that they are held in a fiduciary account that is not affected by any bankruptcy of the relevant institution. There are other examples, like valuation and side pockets, where UCITS sets a minimum level that would appeal to most investors.
But there are also advantages for Hedge Funds Managers. Besides meeting the new preferences of investors, they have more security about future regulation. Once they have a UCITS, they can also passport the fund into all other EU-countries and market it there also.
Critics say that UCITS-funds will underperform the offshore-vehicles of the same Manager. The main arguments for this are the limits on the portfolio and higher costs for trading/administration. This can be true for some strategies, mainly those that are very illiquid or highly levered. But the majority of hedge fund strategies, e.g. Long/Short Equity, Equity Market Neutral, Global Macro, Managed Futures, can be implemented without many adjustments.
The other argument mentioned is higher costs. In fairness, UCITS funds will probably end up having higher costs compared to offshore funds. After all, the additional layers of security and transparency require resources and don’t come free. Like with managed accounts or other security-oriented vehicles, the investors has to decide, whether the marginal security is worth the costs that can come with it.
Although this trend is the dominating topic in the Hedge Fund-Community (especially in Europe), there is little or no empirical analysis of the current universe of UCITS-Hedge Funds. However, Deka Investments maintains a list of existing funds and analyses them monthly. Here’s what we are finding…
There are currently 270 funds on the list, of which 101 were launched in 2009.
It is expected, that the number of funds will reach 300-350 by year-end. Long/Short Equity is the biggest group within the strategies, followed by Equity Market Neutral. But most of the common strategies are represented.
Most funds are rather small, i.e. half of the funds have less than 50 million EUR. That is mainly due to the fact, that most of them have just been launched.
And the dominant fund domicile is Luxembourg accounting for 43% of the funds.
Clearly, the UCITS-Hedge Funds trend is not a fad. Rather, it is a result of changing preferences with regard to transparency and liquidity. However, it doesn’t replace proper due diligence of an investment – even if it seems to hold the imprimatur European regulators. So before investors around the world get too carried away, they must be aware of its advantages and limitations. The topic of UCITS seems to polarize people. But whether one likes it or not, it has become an issue that cannot be ignored.