Who would have thought a year ago, in the immediate aftermath of the credit crunch, that there would now be such a large number of UCITS hedge funds, encompassing almost the full range of investment strategies. There are not only relatively simple long/short equity funds but also an increasing number of more complex macro, arbitrage and commodity vehicles.
After two years of decline in Europe’s asset management industry, such growth is welcome. The new UCITS hedge funds are a genuine response to investor demand and, by all accounts, are attracting new assets under management. According to fund of hedge fund managers, there are now more than 300 UCITS hedge funds and the number is growing weekly. Demonstrating the size of the market, funds of hedge funds managers now judge the market large enough to sustain properly diversified funds of UCITS hedge funds.
Yet, there is a tension between welcome innovation and the need to provide suitable protection to UCITS funds’ retail investors. When the UCITS III Directive was amended to allow investment in financial derivative instruments in 2001, no one imagined that this would introduce such a wide range of strategies into UCITS. Now, the regulatory authorities have to strike the right balance between promoting growth of the highly successful UCITS brand and ensuring that they have anticipated any threats to investors.
“What the hedge funds are bringing to the UCITS area is a great deal of what we would call product innovation,” observes Grellan O’Kelly, Senior Regulator with responsibility for the Derivatives and Risk Management Policy Group at the Irish Financial Services Regulatory Authority. “We are familiar with most of the assets that are traded, but the manner in which they are managed to gain alpha is something new for us.
“I believe that the rules are strong enough and flexible enough to cope with this innovation. As ever, however, hedge funds are pushing at the boundaries of gaining exposure to asset classes that you would not normally be able to gain exposure to in UCITS.”
Act within the Spirit of the Rules
We believe that hedge fund managers need to be careful to act within the spirit of the UCITS directives. There is some flexibility within the rules governing eligible assets and risk management, for example. If managers are not sensitive to the regulators’ intentions, there is a danger of further regulatory clarification at some point in the future in the form of a new UCITS directive or amendments to existing directives.
Hedge fund managers are responding to demand from institutional-type investors, such as funds of hedge funds, private wealth managers and small pension funds in the wake of the 2008 market crisis. The equity market collapse reminded investors of the advantages of absolute return investments. Even though many hedge funds experienced losses and were sometimes more correlated with markets than expected, most performed far better than equities. While the FTSE 100 Index, for example, lost more than 40% between its July 2007 high and its lows in November 2008, hedge funds tended to lose far less.
Yet, hedge fund investors were disenchanted by the methods that hedge fund managers chose to prevent fire sales of less liquid assets. Many were prevented from disposing of portions of their investments, imprisoned within gates, side-pockets and other special purpose vehicle solutions. There were also some instances of style drift, where hedge funds supposed to employ a particular strategy used another, with consequent losses.
The UCITS regulatory framework reduces the likelihood of these things happening. The UCITS III Directive allows funds to use leverage within certain limits and to short sell through derivative instruments. Funds may also invest in a wider range of instruments, including commodity and hedge fund indices. Set against such freedom, however, the UCITS rules have strict parameters. Among other things, funds must publish their top holdings; allow investors to redeem at least fortnightly; limit leverage (through use of a value at risk calculation); and implement stress testing.
Many hedge fund managers will now find that an increasing amount of demand for their product comes through UCITS vehicles. In addition to those institutional investors who are investing in UCITS through choice, others can only get access to hedge fund strategies through a UCITS fund due to the restrictions of their home country regulations.
When the Alternative Investment Fund Managers Directive is finalised, set for July 2010, this could provide further impetus for UCITS hedge funds. Currently proposed rules suggest that it might become more difficult for managers based outside the European Union to market offshore funds within its member states.
Areas of Risk
As the number and variety of UCITS hedge funds has grown, so has concern that innovative strategies might lead to investor protection issues, even a hedge fund blow-up. Addressing some of the critical areas, the Committee of European Securities Regulators launched a Level 2 Consultation focusing on risk management in summer 2009, examining issues such as the global exposure rules and counter-party risk.
For the industry as a whole, the greatest areas of doubt surround liquidity and the suitability of some more complex UCITS hedge funds for retail investors. Some industry participants question how many of the UCITS hedge funds currently being launched could hope to provide fortnightly liquidity in a future crisis, considering that the credit crunch rendered even some money market funds illiquid. Additionally, there are concerns that retail investors could have little chance of understanding the more complex strategies in which they might choose to invest. This is especially pertinent at a time when the UCITS IV Directive is introducing the Key Investor Information Document specifically to improve investor understanding.
“The AMF considers UCITS with leverage of close to two might not be suitable for less aware retail investors and should be reserved for institutional investors by imposing a minimum entry ticket of, for example, €100,000 – this is the French approach,” explains Patrice Berge-Vincent Head of the Asset Management Policy Department at France’s Autorite des Marches Financiers, which was the primary architect of the sophisticated UCITS framework that allows derivatives.
“When a UCITS hedge fund with leverage this high enters the French market, we recommend to the distributor to limit their distribution to professional investors. Or we recommend to them to explain the risks to retail investors so that they fully understand.”
There is little doubt that the UCITS hedge fund universe will continue to grow. Hedge fund managers would be wise to follow some simple guidelines, however, to ensure that the level of innovation is appropriate.
- Set a minimum investment appropriate to the type of strategy and investor. More complex strategies aimed at institutional investors should have high minimum investments to deter retail investors.
- Make sure you can clearly explain the investment strategy to retail investors within the two-page Key Investor Information Document – strategies that cannot be explained might not be suitable for UCITS.
- Ensure that the proposed investment strategy can provide fortnightly liquidity, even in difficult markets.
The current proliferation of UCITS hedge funds is bringing alternative investments into the mainstream as never before. This is a great opportunity for hedge fund managers, yet one that they need to grasp with sensitivity for the spirit of the UCITS directives.
This article is an abridged version of a PricewaterhouseCoopers point of view on UCITS hedge funds, drawing on interviews with European regulators.
This article first appeared in the Asset Management News of PricewaterhouseCoopers Ireland (March 2010). For more information, please go to www.pwc.com/ie.