Will hedge funds fail the Ucits challenge?

Do hedge fund managers really have the relevant skills to successfully manage regulated, Ucits III products?

The ‘Ucits hedge fund challenge’ admittedly lacks the zing of ‘the Pepsi Challenge’.

But the debate around whether hedge funds are up to running regulated products is as much about liquid products and who does it better as Coca versus Pepsi was.

Few hedge funds foresaw problems running onshore, Ucits III-compliant products.

Marshall Wace, Brevan Howard, Gartmore, Cazenove Capital Management and Majedie Asset Management were among many hedge funds which launched Ucits-compliant portfolios, and all could justifiably trumpet their short selling skills.

It was their long-only peers who had to play catch up on this skill.

Banks, sensing prospects of replacing business from struggling hedge fund clients, offered long only managers courses on derivatives, short selling and risk-managing short books to bring them up to speed.

Nothing, some hedge funds said privately, replaced hands-on experience of shorting markets for years.

Then, earlier this month, fund of Ucits-funds manager Collins Stewart Fund Management threw the cat among the pigeons.

Mike Brown, its head of sales, said: “Managing a fund with certain regulatory restrictions on types of investments as well as daily or weekly liquidity requires a very different skill-set to one which has a longer liquidity profile [and] lock-ins.”

Brown’s first point is open to debate. Managing investment restrictions should not cause competent hedge fund managers problems.

Using derivatives based off a security to sell short, rather than borrowing the security itself, is no big deal for hedge fund managers running Ucits.

Majedie, for example, used derivatives to go short well before it transformed its hedge fund into a Ucits vehicle last year.

Brown’s point about liquidity, on the other hand, is valid – and hedge funds’ hand may not be strong.

Ucits funds must let investors in and out at least fortnightly. For hedge funds, 135 days is standard, one or two year lock-ins are not uncommon.

To satisfy stricter liquidity, surely hedge funds will simply invest accordingly?

Recent history suggests they have struggled to do so.

About one third of hedge funds completely gave up on managing liquidity to meet redemptions during the crunch, according to Credit Suisse/ Tremont, and chose instead to bolt their exit door shut.

Those mentioned above did not, and lost assets as a result during the crunch.

Some funds who locked investors in at least cut charges for investors to stay put.

Veteran US hedge fund investor Sandra Manzke, locked unwillingly into one prominent London-run fund when most of her peers traded loyalty for fee cuts said at the time.

“They have to give me my money back, it is not theirs to keep,” she says.

Many exits remain closed, and even 11 months later data provider Credit Suisse/ Tremont says about 11% of hedge fund investments remain ‘impaired’ – for this, read ‘too illiquid to sell’.

If a repeat of 2008’s fourth quarter recurs, hedge fund managers will not be able to gate their Ucits products.

Kate Hollis, global head of fixed income and alternatives fund research at Standard & Poor’s, predicts assets in them will grow, as does data provider Hedge Fund Research – which estimates $35bn is already in them.

Growth will be partly thanks to people like Jean Keller, chief executive of 3A, which manages both a fund of hedge funds and a fund of Ucits funds.

Hedge fund managers that can launch either type, he says, should choose Ucits.

The longer-term questions will be not if hedge funds follow his advice.

One will be whether, when market shocks happen again – and they will – investors pull money en masse from their most liquid investments including Ucits funds.

If hedge fund managers see their Ucits funds drained in a matter of days, will they remain committed to running them? Not least if the alternative is keeping money safely for at least 135 days in their hedge fund?

David Walker is a senior asset management correspondent on Investment Week