UCITS III appears as the gold standard, strict enough to give investors comfort and flexible enough to accommodate a large number of traditional and alternative strategies. However, in the UCITS market, one size does not fit all. The UCITS framework is heterogeneous – shoehorning strategies is a threatening practice and therefore, the label does not exempt investors from performing thorough due diligence.
UCITS III: The Gold Standard
The first UCITS Directive was adopted in 1985 with the aim of integrating the EU market for investment funds by offering both greater investment opportunities to investors and greater business opportunities to the asset management industry. Proposals to amend the original directive were adopted in December 2001 and are generally referred to as UCITS III. One of the main amendments to the original framework is the broadening of eligible assets to financial derivative instruments not just for hedging purposes. These amendments opened the way to manage different absolute performance strategies within the UCITS III framework. These new absolute return UCITS III funds are sometimes referred to as Newcits.
Newcits Benefited from the Crisis
The 2008 financial crisis highlighted the liquidity issues and the lack of investor protection of some unregulated hedge funds. Investors were frustrated with the methods some managers chose to prevent fire sales of less liquid assets. Gates, side pockets, and frauds coupled with the Lehman collapse, focused attention on the safekeeping of assets. While sophisticated investors called for more regulation for hedge funds, others are simply forbidden to invest in offshore vehicles anymore: the UCITS III regulatory framework seems to offer answers to both groups. UCITS products have enjoyed outstanding success over the past 25 years and have been the catalyst for development of the European investment fund industry. In addition to this, UCITS has developed into a global brand recognised in Asia, Latin America and the Middle East. Although almost inexistent two years ago and still small compared to the overall UCITS industry, the Newcits industry is developing at a fast pace. Almost all major hedge fund players have already launched UCITS III vehicles. Several investment banks have set up platforms of UCITS III funds and dedicated indices have been released.
UCITS Means 'Transferable' Securities
The original UCITS focus was in transferable securities, meaning liquid, negotiable instruments, whose risks are adequately captured by risk management and whose valuation is regular, accurate and comprehensive. It has evolved to accept derivatives, providing that the underlying assets are interest rates, currencies or UCITS-eligible assets and in the case of an OTC derivative, that the counterparty is subject to prudential supervision and that valuation is reliable and verifiable on a daily basis. Derivatives on indices are also deemed eligible if the latter are sufficiently diversified and are considered good representative benchmark published in an appropriate manner. Through derivatives, the list of eligible assets is broad; liquidity, valuation, and risk management remain the main criteria for inclusion. This means that illiquid investments such as private equity and real estate are excluded. Physical commodities or derivatives that may lead to actual delivery of such physical commodities are also prohibited. In terms of liquidity, UCITS funds must offer redemption facilities at least every second week. This prohibits from investing in illiquid securities and in strategies that need time to realise value - notably strategies in the credit space.
UCITS Prohibit Short Selling
Selling securities short is not allowed. However, equity short positions can be taken through equity swaps (eligible as derivatives on eligible assets). Brokers adapted their systems in order to offer the possibility to settle trades through swaps in a transparent way, opening the way for true equity long/short strategies to fit in the UCITS III framework.
UCITS Imposes Diversification Rules
Diversification has been one of the cornerstones of UCITS since the introduction of the original UCITS directive. This has been enshrined in what is commonly known as the 5/10/40 rule, which means that a UCITS III may invest no more than 10% of its net assets in transferable securities issued by the same body, provided that the total value of transferable securities held in issuing bodies in each of which it can invest more than 5% is less than 40%. The diversification rule may be an issue for concentrated portfolios (global macro bets, some high-conviction equity or fixed income strategies).
Leverage: Sophisticated UCITS III Funds vs Non-Sophisticated UCITS III Funds
The framework for leverage appears more complex since the European Commission introduced the differentiation between sophisticated and non-sophisticated UCITS III funds. As borrowing is limited to 10% of NAV, leverage can only be accessed through the use of eligible derivatives. For non-sophisticated UCITS III funds, the leverage should be measured using the commitment approach and may not exceed the net asset value. Therefore, the global exposure, including cash securities and potential leverage through derivatives cannot exceed 200% of NAV. Sophisticated UCITS III funds are required to use an advanced risk measurement methodology to measure global exposure. The different regulators recommend the use of the VaR method and require that the VaR model employed by the UCITS III funds meets certain quantitative and qualitative criteria and is calculated using an acceptable proprietary or commercially available model.
However, the rules on VaR calculations vary from one country to another. The general guidelines (99% VaR with one month holding assumption) are adopted by most, with a maximum limit of 20% in Ireland and Luxembourg for example. France, by contrast, requires a 95% confidence interval on a one-week period with a 5% maximum VaR limit. An interesting study from EDHEC shows that 85% of live hedge funds (as of November 2009) would pass the VaR requirements. On the other hand, a non-sophisticated strategy, such as a 200% exposure to the S&P 500 would not pass the VaR requirement, with a 99% VaR on one month of 21.4% as of June 2010. Sophisticated UCITS III funds are perceived as being more dangerous; their risk is, in fact, more tightly controlled through VaR models.
Some Strategies are More Equal than Others
Equity long/short strategies are available in UCITS III funds. The main change from a hedge fund setup is the necessity to take short exposures through equity swaps, which has operational and counterparty risk consequences but does not modify the strategy. Front office just needs to flag a settlement through equity swap rather than cash equities. However, this is time-consuming for the middle/back office as written confirmations need to be signed through an ISDA agreement.
Another consequence is the need for an active collateral management. As counterparty risk is limited to 10%, the management company needs to adjust the collateral amount posted with the equity swap counterparty on a regular basis. The management company also needs to adopt client money protection for the remaining collateral (deposit spread between different banks). Strategies which involve less liquid equities (micro caps) or need time to realise value (eg, deep value investing) may not be adapted to the UCITS III format. Most leveraged equity market neutral strategies meet the VaR criteria, but they need to be diversified enough to satisfy the diversification rule.
CTA strategies are highly liquid and involve eligible derivatives except for the commodity derivatives with physical delivery. Managers need to remove or modify their exposure to commodities (using, for example, commodity index derivatives) to comply with UCITS rules.
The impact on performance is proportional to the weight of commodities in the original hedge fund strategy, if any. Event driven strategies focusing on equities look very much like equity long/short strategies regarding UCITS III eligibility. However, diversification rules may be more difficult to meet as portfolios are usually more concentrated. Strategies with a focus on distressed securities will not be eligible due to the illiquid nature of underlying securities. There is no formal obstacle for convertible arbitrage to enter the UCITS III space.
However, managers will have to focus on the most liquid part of the market resulting in a 'safer' profile with fewer opportunities. Fixed income arbitrage looks more difficult to implement as it is not easy to build synthetic short exposure to non-equity instruments. Diversification rules are also difficult to meet as leverage is high and therefore, positions often represent more than 5% of NAV.
Adapting Strategies Entails Costs
The adaptation of hedge fund strategies has consequences either in terms of costs or risk return profiles. The more the strategy is distorted to fit into the UCITS III framework, the higher the tracking error between the initial strategy and its UCITS III version. Effects of leverage reduction for high-octane strategies are easy to predict, whereas the cost of diversifying a concentrated portfolio is hard to estimate. But as liquidity appears among the main constraints, the main detractor to performance could be the cost of abandoning a liquidity premium, if any. On the cost side, most of the provider costs are either the same or lower. Wider competition between a larger number of providers in a bigger market places downward pressure on fees for UCITS funds.
In addition, the disclosure of fees is more efficient in UCITS funds. For example, in France, management fees include custody, administration, and audit fees, and the management Company is responsible for paying those fees directly to the providers.
The use of derivatives instead of cash instruments in order to comply with UCITS III rules has a cost. It largely depends on whether the strategy uses listed and plain vanilla OTC derivatives or requires customised derivatives. In the case of classic equity swaps on baskets of equities, the cost is minimal and may even be offset by a better tax efficiency. This is not the case if the UCITS fund swaps its performance against a customised basket of instruments as the counterparty will not easily spread the costs of this new structure across several funds.
The authorisation to apply sophisticated risk management techniques to UCITS III funds is granted to management companies which demonstrate their ability to operate relevant VaR models on a daily basis. If large hedge fund companies already use upper end techniques, smaller players will definitely need to enhance their operations and risk management.
UCITS IV Should Further Facilitate Pan-European Distribution
On the distribution side, despite the theoretical European passport, registering UCITS III funds in other countries than the original is still a long and expensive process which only big players are able to realise. In addition, the tax treatment is still a moving area. In the end, smaller investment firms are only able to distribute their product in their home country. The new UCITS IV rules are expected to simplify the pan-European distribution of all UCITS funds by replacing the actual cumbersome country-by-country registration process with a mere notification.
Beware of the UCITS III Supermarket
The UCITS III offer is today much wider than the original purpose of offering pan-European distribution to liquid funds. Institutional investors have adopted the legal framework (60% of UCITS investors according to EFAMA), and investment managers have brought many innovations.
As a consequence, the UCITS III supermarket is now far more complex than anticipated. In fact, while initial UCITS funds were traditional funds, many innovations entered the UCITS III framework since 2005.
130/30, ETF, Hedge-Like Strategies are under the Same Umbrella
The so called 130/30 funds, which are long equities for 130% of NAV and short for 30% were among the first non-traditional UCITS funds. Although they are still traditional as they provide 100% equity exposure, they open the door to short exposures through swaps or derivatives. The fall in equity markets in 2007/2008 called for the launch of funds with lower net exposure.
As long as their gross exposure does not exceed 200%, those market neutral or low exposure equity long and short funds are still considered as non-sophisticated. At the same time, in the more traditional space, a myriad of exchange traded funds (ETF) replicating all kinds of indices were launched within the last two years. In comparison, few levered equity market neutral funds have been set up as sophisticated UCITS III funds and their risk profile is rather conservative. As far as other asset classes are concerned, the combination of the eligibility of derivatives and the measure of risk through VaR models allowed traditional global macro, currencies and fixed income strategies to fit into the UCITS III format.
Only in the last two years did managers start to launch alternative strategies using the same toolbox.
The Mistake of One May Be the Curse of All
Should managers use the UCITS III toolbox to shoehorn undesirable strategies, their UCITS III funds may share some of the same bad press as hedge funds even if they are regulated and risk-constrained. There is no doubt that the attractiveness of the successful UCITS III brand will further lead some investment managers to make any effort to fit their strategies into UCITS III whatever the risks and the costs involved. The frontier between innovation and disguise is thin. It is then the responsibility of all players, investment managers, custodians, administrators, auditors and regulators to control the implementation of strategies in order to preserve the brand from excessive risks. While there is no doubt that from a legal point of view and from our experience that the UCITS III supermarket is more regulated than offshore funds, it is also clear to us that it is not exempt from the risk of accidents occurring. From a distribution and marketing point of view, all UCITS funds that are distributed to retail investors are required to be branded with an adequate risk profile. There are voices who further call for a minimum investment in excess of €100,000 for UCITS III funds with a leverage close to or higher than 2. The question is whether retail investors should be protected based on sophistication or level of risk or both?
Our Two Cents' Worth: Do Your Homework
Despite an awkward wording, we believe that sophisticated funds do not present greater risk of serious losses. Some non-sophisticated funds may actually have higher VaR. As for any investment, extensive due diligence should be done by any investor allocating to a UCITS III fund. Alternatively, the investor can hire a fund of UCITS III funds manager to do the due diligence. Funds of funds groups have a key role to play in order to direct assets to UCITS III funds which truly fit its philosophy of liquidity and risk management. For investors who do not have the ability to perform such due diligence, funds of UCITS III funds are an elegant way to benefit from the UCITS III advantages while covering the necessary checks.
This article first appeared in swissHEDGE magazine (2nd Half 2010 issue, Pages 20-24). For more details, please go to www.swisshedgemagazine.ch