Over the past year, the market has been flooded by a great number of UCITS regulated funds managed by hedge fund managers. UCITS hedge funds are said to manage nearly US$ 100 billion with 980 funds globally. Another 125 funds were launched in the first five months of 2010, with total net inflows standing at US$ 12 billion1. According to Eurekahedge, UCITS hedge funds now account for 7% of the total hedge fund universe of US$ 1.5 trillion but have attracted 20% of the net inflows into the industry YTD 2010. Numerous hedge fund managers are considering UCITS as a potential instrument to regain assets from private banking clients and high-net-worth individuals who have not returned to alternative investments yet. These so-called Newcits have become one of the key topics in the hedge fund industry. UCITS are a set of EU Directives, which establish a common regulatory regime for collective investment schemes and enable a Europe-wide distribution of such products. Even beyond the European Union, UCITS enjoy a high level of recognition; it has become the gold standard of investment funds, leading to a proliferation of products with total assets under management in excess of €5.6 trillion at the end of the first quarter of 20102.
The market for UCITS hedge funds is growing rapidly in terms of number of funds and in terms of assets under management. Institutional investors have been the early adopters of the concept, but it is the private banks, which are likely to bring this to the next level.
Investor demand is strong, fuelled by concerns about transparency, risk management and liquidity. An increasing number of investors are looking for UCITS to add to their hedge fund portfolio. As a result, funds of hedge funds are also entering massively in this space, with more than 50 multi-manager UCITS funds of hedge funds launched to date3. The fact that the investment universe is still relatively small used to be an impediment to the development of such offering, but this issue is getting smaller every time a new UCITS hedge fund is launched. A significant number of private banks are keen on having a UCITS fund of hedge funds offering rather than a single-manager UCITS offering. The main reason for this is their general reluctance to take single manager (selection) risk.
The Funds of Hedge Funds Business Case
By definition, UCITS hedge funds are alpha-generating strategies or skill-based strategies as opposed to market-based (or beta) strategies. Such funds are characterised by the fact that the managers barely are restricted in the choice of their investment strategies and that they target consistent absolute returns rather than the outperformance of a designated benchmark.
The dispersion of the returns of UCITS hedge funds is much higher than with traditional, long-only UCITS funds. A wide dispersion means that the worst performing fund of a specific category will do much worse than the fund which performs the best. For investors in this type of vehicle, this is a risk. At the same time, it constitutes a tremendous opportunity for an asset allocation specialist or a fund selector. UCITS hedge funds are, in general, more complex products than long-only funds. The investment strategies applied go far beyond the traditional investment concepts such as value or growth investing. Asset allocators or fund selectors have arguably a strong value proposition, provided that they can demonstrate that they are able to derive advantages from a better understanding of the strategies and the instruments or techniques used by these Newcits.
The Funds of Hedge Funds Value Proposition
Funds of hedge funds have historically been successful in selling their products by highlighting the following advantages: diversified exposure to value-added investment strategies, superior portfolio construction (tactical/strategic asset allocation), successful manager selection, access to closed funds, lower minimum investment, enhanced liquidity and superior risk management. If we assume that this is true, the question remains as to whether this is still valid within the UCITS framework?
We distinguish four main methods to deliver a multi-manager hedge fund performance in a UCITS:
- Restricted direct approach: Plain vanilla approach, the UCITS FoHF invests exclusively in UCITS hedge funds.
- Unrestricted direct approach: Plain vanilla approach, the UCITS FoHF invests directly in UCITS hedge funds, closed-end hedge funds or regulated non-UCITS hedge funds, delta one notes linked to hedge funds or managed accounts (investing exclusively in eligible assets).
- Index approach: The exposure to offshore funds/strategies is obtained through a hedge fund index. For this to be UCITS compliant, such index has to be sufficiently diversified, considered to be an adequate benchmark and published in an appropriate manner. Furthermore, the index has to follow predetermined rules and objective criteria for the selection and rebalancing of the index components, and there can be no backfilling and no payments from index components. The exposure to such an index is obtained through a performance swap (or total return swap).
- Structured approach: The UCITS enters into a derivative transaction (structured swap), which provides it with indirect exposure to a portfolio of offshore hedge funds. Such approach allows for obtaining one-to-one exposure to an offshore fund of hedge fund. The exposure to the offshore fund of hedge fund is obtained through a performance swap transaction.
In a survey conducted by KdK Asset Management at the end of the first quarter 2010, UCITS hedge fund distributors were asked for their opinion about the potential in terms of distribution of each of these approaches.
Figure 1: Opinions about Investment Methods
Click on the image for an enlarged preview
Clearly, there is a strong preference for the “direct” approaches. More than two-thirds of the respondents state that the perception of their clients with regard to the structure is positive when the UCITS invests directly in eligible assets. Structured (or swap-based) approaches are considered less suitable for distribution. Some respondents said that their clients were not open to purchase a vehicle that invests in assets which are unrelated to the sought investment exposure.
Transparency in terms of portfolio allocation has become a key attribute of any fund targeting distribution. In addition, the intervention of swap counterparties is perceived as costly and as resulting in a substantial increase in risk, (operational and counterparty risk) and the regulatory robustness of such approach is questionable. Regardless of the nature of the investment policy, we see the main challenge as being the access to quality managers, in particular, to those who have not yet launched a regulated vehicle, and the liquidity of the underlying hedge fund strategies. Even if we assume that swap-based approaches may address these issues to a certain extent, the lack of investor appetite for these solutions is leaving the fund sponsors with an intact challenge. The pure or direct investment approaches are thus more likely to attract investors.
However, in the aftermath of the 2008 liquidity crisis, and recent disappointing performances, investors are critical and need to be convinced of the value added by funds of funds managers. In this respect, an important challenge for funds of funds managers resides in some (unfortunately widely accepted) misconceptions. It is generally assumed that UCITS hedge funds are liquid, transparent, and accessible. The UCITS label is also providing for a sense of security, diminishing therewith the requirement for risk management. As a result, much less value is recognized to due diligence processes. In addition, the lack of depth of the current investment universe (UCITS hedge funds only represent between 5% and 10% of total hedge fund assets) negatively impacts the perceived information advantage of funds of hedge funds managers. The funds of funds value proposition is certainly much weaker if we assume all of the above to be correct.
Nothing, however, is Less True
UCITS hedge funds are only as liquid as their respective underlying strategy; it is the access window that has changed as compared to traditional hedge funds.
Funds of hedge funds managers still have to make sure that the underlying managers can satisfy all redemption requests. The transparency of a UCITS hedge fund is very limited. Actually, because of the extensive use of derivatives, accounting reports or other periodical publications are no longer sufficient to provide for a good representation of the fund’s risk exposure. Having a good understanding of the true nature of any UCITS hedge fund still requires an in-depth analysis of its systems and processes. Nothing prevents a manager to bar the access to his fund. As an example, MLIS Blue trend, one of the first UCITS hedge funds on the Merrill Lynch Bank of America platform is now closed to new investors. In addition, a significant proportion of the existing Newcits have minimum investment requirements in excess of US$ 1 million. Investing in regulated funds still requires one to go through a proper due diligence process and decide to take the risks one should - not the risks one should not. Despite its current modest size, the underlying investment universe is incredibly complex and subject to a rapid evolution. This information inefficiency is providing the (good) fund of hedge funds managers with an edge. Constructing a value-added portfolio with this investment universe requires significant experience and specific skills.
When it comes to UCITS hedge funds, let us not forget that most of them have no or only a short history, which means that only little information can be derived from their track records. Knowledge of the manager and of the investment strategy is certainly of great value, but the analysis should take UCITS particularities into account. When compared with its sister offshore hedge fund, a UCITS hedge fund may end up underperforming to a certain extent. The main (known) sources of differences in performance are:
UCITS Investment restrictions: In terms of regulatory guidelines, we are tempted to say that less is more. Restrictions are reducing the opportunity set and consequently reducing the performance potential.
Instruments and management techniques: The UCITS framework leads to differences in the implementation of an investment strategy. The traditional prime brokerage model is no longer applicable since the assets of UCITS hedge funds cannot be re-hypothecated. A UCITS hedge fund is not allowed to borrow for investment purposes and short positions have to be implemented through derivative transactions, implying higher costs.
Liquidity: UCITS funds are required to offer at least bi-monthly liquidity. In practice, UCITS hedge funds have weekly or even daily liquidity. If used on an investor level, this calls for more transactions and potentially a higher portfolio turnover on a fund level (compared to offshore funds). The higher the costs, the lower the performance.
Operations: A practical aspect often neglected by product developers is related to operations. A poor handling of executed transactions generally requires the attention of the manager. This unnecessary use of his time may prevent him to focus on generating performance.
Counterparty restrictions: A substantial proportion of the fund’s economic exposure may have to be acquired through derivatives. This highlights the need for experience, skills, and negotiation power; absent of which, the fund could end up paying inflated prices for each transaction. UCITS hedge funds are generally restricted to a few counterparties (due to the necessity of having a contractual framework in place with each derivative counterparty). Moreover, when a transaction has been entered into with a designated counterparty, it has to be closed with the same counterparty, which may constitute an issue in terms of best execution, and impact performance negatively. Therefore, one should not assume that a UCITS hedge fund performs exactly like its offshore counterparty. Furthermore, one could argue that analyzing such products requires even more discipline and skills.
Given that UCITS hedge funds are complex instruments and that relevant information about them is often difficult to obtain or to analyse, we believe that funds of hedge funds managers potentially can add a significant value and present a real and strong value proposition. Their experience in constructing multi-manager portfolios is another source of value added. Investment strategies can be accessed in various forms, (UCITS, closed-end funds, delta one notes, managed accounts, etc) and it is therefore crucial to investors to know what to look for.
The UCITS hedge funds universe is currently too small for the creation of top quality funds of hedge funds but if such a portfolio is completed by other instruments, we are of the view that a valuable proposition is in the cards. Investors considering an investment in a UCITS-compliant fund of hedge funds should therefore search for those managers who understand the underlying hedge fund strategies, understand the instruments and techniques used by UCITS hedge funds, and understand the implication of the regulation on these strategies and instruments. In addition to this, the managers have to know how to complete a UCITS Hedge funds portfolio with alternative instruments to make it a superior portfolio and have their interests aligned with the investors.
Furthermore, if we consider the fact that multi-manager products in the long-only space already are widely spread and successful, we believe that the fund of hedge funds model surely is not yet dead; it is well alive, particularly in the UCITS world.
This article first appeared in swissHEDGE (Pg 13, 2nd Half 2010 issue). For more details, please visit www.swisshedgemagazine.ch
1 Eurekahedge, June 2010
2 EFAMA Quarterly Statistical Release N°41 (First Quarter 2010)