The adoption of Ucits III by absolute return managers has coincided with a period when confidence in offshore investment funds has never been lower, writes Merchant Capital's George Cadbury.
One of the asset management industry’s major focal points this year has been the rapid increase in hedge fund managers implementing the Ucits III fund structure for their own offshore investment vehicles. The adoption of Ucits by absolute return managers has coincided with a period when confidence, in what are regarded by some as opaque investment funds, has never been lower.
A recent survey carried out by Kepler Partners, an independent fund marketing and research adviser, estimates approximately $30bn is invested in hedge fund strategies that sit within a Ucits III structure. Official figures from the European Fund and Asset Management Association show the total global Ucits market stands at about $7trn. When you compare these overall market figures to the offshore market, where there are over 10,000 hedge funds competing for a capital pool estimated to be a little above $1trn, it is clear why hedge fund managers are starting to take Ucits seriously. These figures, twinned with the fact investing institutions and retail investors are increasingly turning to Ucits as they seek the lower volatility and higher return characteristics of hedge funds, show there is great growth potential at this nexus point between alternative and ‘traditional’ investment.
Madoff and Nadel
The Madoff and Nadel sagas prompted governments to explore new ways of clamping down on hedge fund activities; with Ucits there is a structure already in place that addresses many governmental concerns. Although to some extent the hedge fund industry has been used as a political scapegoat and the ‘survival bias’ is an argument funds that came through the recent turmoil are carrying the crosses for those that did not, there is still a need for the alternative investment industry to mature as it moves into the mainstream.
With this trend in mind, it is unsurprising swathes of managers are exploring the possibilities of launching one of their products within a Ucits structure. However, dangers lurk for managers and investors alike when it is their intention to simply replicate a strategy that may have served them well as an offshore structure.
If a manager decides not to launch a cell (a version of an offshore strategy in an onshore framework within a Ucits platform) such as those run by Merchant Capital or Merrill Lynch, and instead do it themselves, this can be an expensive proposal. A Ucits III fund offering weekly liquidity with indicative daily pricing, compared with monthly pricing and quarterly liquidity for a typical offshore fund, will incur higher administration costs alone, placing upward pressure on the Total Expense Ratio.
Additionally, methods of investor protection that limit gearing, particularly within non-sophisticated funds, could curtail a manager’s ability to match their performance in the offshore fund. Due to the very nature of Ucits III and its liquidity constraints, private equity, real estate and distressed debt are not compatible as strategies with the structure. Investors should therefore be wary of managers who have had to make significant changes to their portfolio in order to ‘fit into’ Ucits. Although the directive’s guidelines are flexible, they are likely to continue to encourage participation predominately by equity long/short and global macro funds.
Infrastructural support
Aside from the considerations of a specific strategy, it is important the proper infrastructural support is in place to ensure the diversification mechanisms, embodied by the 5/10/40 rule (a Ucits structured fund may invest no more than 10% of its net assets in transferable securities or money market instruments issued by the same body, provided that the total value of transferable securities or money market instruments held in issuing bodies in each of which it can invest more than 5% is less than 40%), and again this can be expensive.
This brings us onto what the regulators state is the most important component of managing a successful Ucits fund – the risk management process (RMP). The global financial crisis exposed significant weaknesses in the risk management practices of many funds and investors are now demanding that funds implement stronger RMPs. At Merchant Capital we have employed a global professional risk and valuation services firm – Kinetic Partners.
Related to this, if a fund does not have a sophisticated pre-trade compliance tool and an experienced compliance officer in place, there is not only an inherent risk borne by the company, but also an opportunity cost due to time spent by the fund manager ensuring their weightings are correct. The fund’s performance will undoubtedly be affected if the manager is perpetually concerned about position sizes. Far better for the investment specialist to be able to concentrate their expertise where it is best applied, knowing that the necessary systematic support and personnel are in place.
In addition to performance attribution, value-at-risk (VaR) analyses and stress testing, regulators want to address issues such as OTC valuation, liquidity, leverage and counterparty risk, all areas that in some cases were conspicuous for being inadequately monitored recently. To do so, managers must implement an internal framework if they are to stand up to regulatory due diligence. It would be impossible for a fund to launch a Ucits fund without these systems in place and managers must be cognisant of the costs involved.
A growing audience
Greater transparency, improved liquidity terms and counterparty exposure controls are becoming more important as features of the maturing absolute return fund industry. There is a growing audience that believes the Ucits directive, which lays greater importance on these features, can re-invigorate the investment community’s interest in these strategies.
Nonetheless, although the Ucits liquidity, transparency and diversification requirements offer much more protection than their offshore counterparts, investors would be wise to look out for warning signals from managers who struggle to match the performance of their existing offshore funds or have not fully adapted to the Ucits world. In saying that, we expect the majority of managers to thrive under the Ucits umbrella by offering institutional and retail markets the greater returns they are so keenly seeking now with appropriate risk management.
George Cadbury is director at Merchant Capital
