Is UCITS 3 driving the convergence between hedge funds and long-only funds and what are the challenges?

Since the transposition of the first UCITS Directive (85/611/EC), the Investment Fund Industry has been subject to continuous changes in the tax and legal frameworks, booming investor demand for investment funds and increasing pace of financial product innovation. The latest amendment of the UCITS framework issued in 2002, referred to as UCITS 3 ¹ , paved the way for these trends to enter the UCITS passport world.

After full embracement of the Directive by the asset management industry, the number of highly sophisticated UCITS products increased strongly over the past two years. The reasons to this are investor demand as well as clarifications given by Member State regulators with regards to the application of local UCITS legislations.

So, is UCITS 3 contributing to the convergence?

At first glance, the increased interest in alternative investment strategies of the mutual funds space and the subsequent waves of UCITS funds using absolute return strategies and 130/30 strategies are a reaction to the interest of investors in mass-market mutual funds replicating hedge fund strategies driven by performance and risk diversification reasons. But, in some countries, other considerations such as tax benefits have led to a shift towards alternative fund strategies. In Germany for example, fund promoters are actively replicating structured products (e.g. bonus certificates) in UCITS funds, because retail investors benefit from a tax waiver on capital gains if they are invested in such funds before 2009.

A recent study conducted by the EU Commission investigated the potential change in risk levels and volatility of UCITS products since the introduction of UCITS 3 (observation period from 2002 to 2006) ² . Similar to the trends that have been observed in overall within financial markets, there has been a marked increase in the use of structured financial instruments, especially OTC (over-the-counter) derivatives and in UCITS portfolios (for example use of Swaps has increased by more than 110% over a period of 5 years when viewed as a percentage of total portfolio). Furthermore, the level of leverage taken by the fund managers remains stable at about 1.3, although specific risks linked to OTC transactions are increasing (e.g. liquidity risks, counterparty risks).

The convergence of the alternative industry with the long-only funds industry is thus linked to the extended eligible instrument scope of UCITS 3. Yet, this convergence itself is part of a general market trend towards the overlapping of long-only fund and hedge fund market segments that is also underway in the US.

Dipping your toe into alternative strategies

The main innovation in UCITS 3 is the full eligibility of OTC derivatives . Subject to certain instrument diversification and counterparty limits, all OTC instruments in the market can be purchased by a UCITS fund, if the underlying is eligible as a direct investment.

This product evolution allowed for example “130/30” strategies into the UCITS space, which include 30% synthetic long and short positions via OTC-derivatives such as contracts-for-difference or total return swaps. Many argue that these products are merely a stepping-stone towards far more innovative strategies (e.g. “convertible arbitrage”). At present, long-only asset management companies disposing of in-house hedge fund management capacities promote most of those funds.

The success of the new UCITS strategies is mitigated. The 130/30 strategies are a huge success in the US with assets surging to USD 53bn in September 2007 from just USD 30bn in April 2007. The success in Europe is less significant, which is partly due to the less active marketing. Also, the launch timing in the wake of recent extreme market situations led to some alternative strategies such as for example “absolute return” struggle.

In addition, the trend is for regulators to loosen the UCITS restrictions even further. An example is the Irish Financial Services Regulatory Authority (IFSRA), which under certain conditions recently gave regulated investment funds the green light to perform direct physical short sales of assets, effectively removed one of the few remaining absolute restrictions within the UCITS framework. Other countries are likely to follow.

Faced with the dilemma between the breakneck pace in financial instrument innovation and the quality of a UCITS as a mass-market, retail investor product, the EU regulator has adopted a principle-based approach in terms of risk management of a UCITS. The portfolios making broad use of derivatives and replicating hedge fund strategies are usually referred to as “sophisticated”. In such case, the measurement requirements in terms of leverage and risk management exceed the traditional UCITS investment restrictions and are much more similar to risk measures used in the institutional asset management industry (e.g. value-at-risk), thus further narrowing the gap between the market segments.

One other driver contributing to the change in the UCITS industry is the growing institutional investor base. Traditionally, the UCITS has been designed for retail investor needs. Faced with the prospect of smaller stock market returns, institutional investors are looking for ways to enhance their portfolios return. Even more, with the current stock markets turmoil and credit market squeeze, large pension funds and insurance companies are looking for a diversification of their risks by strategy and asset manager. As shown in a recent study ³ , the interest is growing, with planned future investments of more than EUR100bn into alternative strategies such as hedge funds, private equity and real estate over the coming two to four years. This trend also benefits the investment in UCITS products replicating alternative strategies. Such products represent an entry door to the alternative industry, or as others put it: “it’s dipping your toe in the hedge fund water, but without jumping the whole way in”.

New strategies trigger also new challenges

The emergence of alternative strategies in a standardized UCITS world creates nevertheless certain challenges.

Firstly, from a distribution and marketing point of view, sophisticated UCITS that are distributed to retail investors are required to be branded with an adequate risk profile. The recent implementation of MiFID ⁴ has increased the requirements with regards to the adequacy of the product sold to a particular investor. Thus, the public placement of alternative strategy UCITS requires reasonable market segmentation in order to limit reputation and regulatory risks.

Then, on the operational dimension the replication of hedge fund strategies within open-ended regulated investment funds is creating several challenges, as for example:

• Investments in OTC and in other less liquid instruments may create an imbalance with the fund liability towards investors arising out of mostly more frequent capital movements (open-ended funds). In the hedge fund sector such issue is often smoothened by using “side pockets”, a technique that is not authorized in UCITS;
• Pricing of OTC instruments may also be an operational challenge for fund administrators, who are more used to deal with exchange traded investments in UCITS. This is even more challenging in the context of daily NAV and daily redemptions, which means implementing or reinforcing pricing policies around non-listed/illiquid investments;
• Competing with alternative funds often also means replicating the fee structures of such products, i.e. performance fee computations. Faced with daily capital movements, “undue fees” or “free rides” can only be avoided via a complex automated performance fee equalization functionality either in the Transfer Agency legacy system or an application supporting crystallization;
• The use of prime brokers and of collaterals shifts roles and responsibilities from the traditional custodian banks towards other actors. The risks linked to a lack of transparency in the combination of prime brokerage services with the traditional custodian bank role, the reconciliation of off-balance positions and less standardized workflows are often significant.

The recent past has been characterized by the launch of more complex investment strategies in a UCITS 3-compliant format. Although “foot has been taken off the gas” in the wake of last year’s summer crisis, the overall trend towards more investments overlap, strategies and investors seems to be deep-rooted.

Perhaps the major factor supporting the trend is the potential of the huge UCITS investor market accessible via the UCITS passport. The alternative UCITS products could be the ideal “entry product” for alternative strategy managers or investment banks to hook clients and draw them into higher margin private placement products.

At present, mainly long-only asset management houses have identified this opportunity. But the hedge fund industry and investment banks could launch another wave of innovation that will see a broader range of strategies made available to retail investors, not just in the EU, but also in other countries accepting the UCITS brand, such as South America and Asia. The commercial success will largely depend on the performance and the risk diversification of the strategies, especially in terms of de-correlation from the equity markets.

Finally, the impact of such shift in styles and strategies on future UCITS regulations and the image of the UCITS brand in non-EU countries remain to be seen. Especially, the quality of risk management procedures is at the heart of the regulators’ agenda both in the EU and abroad.