Gaming the Good Housekeeping Seal of Approval

Hedge Fund Regulation 14 Oct 2010

For over 100 years, consumers have relied on The Good Housekeeping seal of approval to reassure their product-purchasing decisions. It’s not a stretch to say the term “seal of approval” came from the folks that ordained all kinds of consumer products “as promised.”

Unfortunately there is no such thing in Hedgistan. There have been attempts over the years, to be sure, but finding a way to definitively rubber stamp a hedge fund product continues to be impossible – if for no other reason than hedge funds really aren’t much alike and can’t be painted with the same brush.

As we reported yesterday, UCITS-compliant hedge funds are the hedge fund industry’s latest attempt at trying to get a nice, neat seal of approval that will provide investors with reassurance. A stringent set of government-contrived guidelines, setting up a UCITS structure has become all the rage for hedge fund managers looking to attract investor money, particularly so for funds of hedge funds (FoHFs) who after a couple of bad years are more in the market for luring investors into their fold than others.

Along these lines, a report from London-based KDK Asset Management published back in July recently caught our eye, partly due to its focus on whether FoHF managers can add value in the UCITS space but equally because of more recent discussions on the conference circuit, in academic circles (click here for some of AllAboutAlpha.com’s coverage of UCITS research) and even among regulators concerning whether some hedge funds are bending the rules to get the UCITS rubber stamp.

The report, “Can funds of hedge fund managers add value… in the UCITS space?” (click here to download), examines whether FoHFs can actually add value in UCITS form.

It covers a variety of litmus tests to determine whether the adherence to UCITS criteria actually provides value-added, after-fees returns to investors.  But more importantly, it also looks at various approaches FoHFs have adopted to deliver multi-manager UCITS performance: a “restricted direct approach”, an “unrestricted direct approach”, an “index approach” and a “structured approach.”

The “restricted approach” refers to FoHFs that invest exclusively in UCITS hedge funds; the “unrestricted approach” refers to FoHFs that invest in both UCITS hedge funds and closed-end and regulated non-UCITS funds, as well as delta one notes linked to hedge funds or managed accounts.

The “index approach” is where FoHFs get exposure to offshore funds / strategies through a hedge fund index. To be UCITS compliant, however, they have to be sufficiently diversified, published in an appropriate manner, follow predetermined rules and objectives criteria, receive not payments from index components and conduct no backfilling.  Finally, the “structured approach” involves entering into a derivative transaction that provides indirect exposure to a portfolio of offshore hedge funds.

The chart below shows the results of a survey of fund distributors (conducted by KDK) on the “potential” of each of these four different investment approaches.  As you can see, more than two thirds of respondents felt that a UCITS fund of funds “investing exclusively in UCITS (funds)” or “investing in UCITS closed end funds” would have a positive impact on fund distribution.

In fact, previous KDK survey results available here show that most UCITS distributors plan to launch UCITS funds of funds that invest directly in underlying UCITS-compliant hedge funds.  By contrast, a small proportion of them plan to launch products that track an index of hedge funds.

Still, the so-called “tracking and index” and “structured” approaches to UCITS HFoF creation is garnering the attention of regulators and trade associations like the Alternative Investment Management Association, who are increasingly worried that hedge funds are agreeing to the rules and regulations that govern UCITS, but are actually engaged in much more complicated strategies – strategies which aren’t even UCITS-compliant.  These concerns are compounded by the possibility that some hedge fund funds might alter their liquidity policies just to earn the UCITS label – putting investors at risk.

Despite all that, the number of UCITS-compliant funds continues to mushroom (see yesterday’s post), with another 125 funds launched in the first five months of 2010, with total net inflows standing at US$12 billion, according to its latest report. That compares to 200 such funds counted by KDK in its last report on the space a few months earlier (Read AllAboutAlpha.com’s “Hedge Funds: Wrap it up UCITS and put a bow on top“, for more analysis on the UCITS phenomenon).

The moral of the story: Many hedge funds are transparent, liquid and sufficiently risk-managed but, by definition, are not UCITS funds.  Just because a product gets the Good Housekeeping Seal of Approval doesn’t mean it’s a great product or does exactly what it’s supposed to.  Investors should note what happened to the ubiquitous Seal of Approval when some of its recipients tried to game the system.  According to Goodhousekeeping.com:

“…in May 1941, the FTC issued an order directing Good Housekeeping to cease and desist from the use of seals declaring that its advertised products had been tested and approved. It declared that, while tests were made by Good Housekeeping, such tests were generally not sufficient to assure fulfillment of the claims made for such products.”

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