Appetite still strong for Ucits hedge funds

Despite the introduction of the AIFMD, alternative Ucits vehicles are still attractive to investors, particularly those who like the combination of brand awareness and risk framework offered

Alternative Ucits continues to attract investors

Ucits established itself as the gold standard for retail European investment vehicles, then the international brand moved rather uneasily into alternatives. Hedge funds first started using the Ucits wrapper in earnest after the financial crisis when many investors wanted onshore, regulated vehicles.

In terms of regulatory protection for investors and marketability for fund managers, Ucits was perfect. Its uptake in the hedge fund world has grown since then, although there are some question marks over how popular it will be with the introduction of the alternative investment fund managers directive (AIFMD). AIFMD will provide a regulated onshore alternative vehicle without the constraints on strategies, liquidity and leverage forced on managers by Ucits rules.

Still, Ucits has served the hedge fund community well in the aftermath of the financial crisis. Between December 2008 and June 2011, alternative Ucits funds attracted considerable attention and inflows.

Assets under management (AUM) jumped 330% from $59 billion to $252 billion as the number of funds more than doubled from 392 to 894 over the period, according to Eurekahedge data. The uptake of Ucits hedge funds looked so encouraging by mid-2011 that global investment management and advisory firm SEI predicted alternative Ucits AUM could hit $1 trillion by 2014.

That prediction has proven to be somewhat overly optimistic. By year-end 2011 alternative Ucits AUM had fallen nearly $60 billion to just $195 billion. Although assets have increased, they are rising at a much slower rate and money is concentrated in the larger, more established hedge fund managers and platforms.

“Over the years Ucits hedge funds have attracted significant capital from investors as opposed to non-Ucits European hedge funds,” says Farhan Mumtaz, head of research and analysis at Eurekahedge. “Going by trends over the last few years, claims that alternative Ucits will dominate the European onshore hedge fund industry by 2020 do not seem misplaced.”

According to research by Preqin, just under 25% of all mandates issued by European-based hedge fund investors looking for new investments in the next 12 months include alternative Ucits funds. The majority (62%) of investors seeking to add new Ucits investments over the coming 12 months are funds of hedge funds. A further 14% of asset managers and 8% of wealth managers are also targeting Ucits-compliant hedge funds over the period.

Nevertheless, as a proportion of total hedge fund industry AUM, Ucits remains relatively small, accounting for only 7% of the entire $2.7 trillion market. That could change as the funds gather more assets and longer track records.

A recent survey by research and advisory firm Alix Capital showed around 75% of respondents believed Ucits alternative funds offered an interesting investment proposal for institutional investors. It noted that the proportion intending to increase allocations to these vehicles was at its highest level since 2011.

Institutions slow to allocate
Despite the encouraging numbers, institutional investors have been slow to favour Ucits hedge funds. This should come as no surprise. Many alternative Ucits funds remain under the $100 million minimum AUM most institutional investors want to see before making an allocation.

“The restrictions for some institutions not wanting to represent more than 10% of a fund is more relevant to Ucits funds than offshore funds. We have seen clients that have not been able to invest for that reason,” says Martin Fothergill, managing director in Deutsche Bank’s alternatives and fund solutions team.

Another problem is the lacklustre performance compared with the less constrained offshore vehicles. For many institutional investors the constraints imposed on strategies using the Ucits wrapper reduce potential returns.

Ucits funds are at best able to offer maximum two-week liquidity; most offer daily or weekly. For many institutional investors such a liquidity requirement makes the Ucits strategies less attractive.

“Because the liquidity provided by these funds is generally not required by institutions, who have a longer investment horizon, institutional clients prefer to invest in vehicles with greater flexibility or better aligned liquidity between the fund terms and underlying portfolio,” says Jennifer O’Leary, head of fixed income hedge fund research at investment consulting firm, Towers Watson.

Many investors comparing the Ucits version to the offshore vehicle find significant performance drag, caused by a restrictive framework for what instruments can be used.

“[Institutional investor] preferences will remain the offshore route, especially for big funds as they prefer well-performing diversifiers,” says Ulrich Keller, chief investment officer of alternative funds solutions at Credit Suisse. “Low correlation is important but it has to produce performance.”

So far alternative Ucits funds have been relative underperformers compared with traditional hedge funds. By the end of July 2013, the HFRX Global Hedge Fund Index was up 1.01% for the month and 4.2% for the year to date following a 3.51% return in 2012. Alix Capital’s Ucits Alternative Index Global sub-index showed returns of 0.8% in July, 1.74% for the year to the end of July and 1.63% for 2012.

Drawdowns experienced by Ucits hedge funds in recent years have also been of similar magnitude when compared with hedge funds, according to research from Preqin.

Both structures saw a maximum decline of around 3.3% in 2010. However, in 2011, Ucits hedge funds fell 7.49%, marginally more than traditional funds (down 7.4%). The same pattern occurred in 2012 when Ucits hedge funds declined by 3.03% compared with 2.7% for hedge funds.

Given the lower upside returns resulting from the more constrained framework, Ucits drawdowns are of particular concern as they can prolong loss-making periods. Preqin research shows the volatility of Ucits hedge fund returns was in the range of 5-8% based on three-year rolling average since January 2010, consistently below the 6-10% level of non-Ucits hedge funds and considerably below the S&P 500’s 15-22%. Volatility can be an attractive feature for boosting hedge fund returns

The big problem, however, remains the inability of many hedge fund strategies to fit into the tight Ucits rules.

“Ucits takes away a lot of investors’ key concerns but the additional [strategy] restrictions have a very important impact on the outcome for investors,” says Keller. “If volatility is restricted, then even if a manager is really good, investors cannot expect returns comparable with offshore funds. Volatility of many Ucits hedge funds is just too low, which is why institutions generally prefer offshore funds or are looking for specific Ucits [funds] that meet their target.”

Strategy determines success
Strategies typically invested in liquid assets and employing little leverage, such as equity long/short, macro and relative value, are a more natural fit to the Ucits rules and have fared better, both in terms of performance and demand. Equity long/short, for example, was up 5.68% for the year to the end of July according to Alix Capital’s Ucits Alternative Index Equity Long/Short sub-index. Nearly half of all allocations to alternative Ucits are into equity long/short strategies and the vast majority of Ucits hedge funds also run this strategy.

“The more effectively a strategy can be implemented within Ucits, the less the performance differential should be versus its offshore equivalent,” says Fred Ingham, head of international hedge fund investments at Neuberger Berman Alternatives.

Credit Suisse analysed the performance differential between managers in long/short and event driven. Returns between the long/short manager’s Ucits and offshore funds were consistently similar over time. For the event driven managers, however, the performance differential deviated over time because the offshore fund was able to invest in less liquid assets including bank loans and credit, both excluded under the Ucits rules.

“Some strategies are more suited to Ucits and are drawn to this structure as a natural centre of gravity,” Keller says. “Those funds will continue to grow and attract assets from retail and institutional investors, especially smaller institutions.”

Squeezing in
Not all managers have been acting in the spirit of the Ucits framework, however. Some managers have tried to squeeze ill-suited strategies into Ucits wrappers. “Demand has tailed off over the last couple of years as many funds have pushed into Ucits with strategies that are not a natural fit,” says Peter Herrlin, client executive hedge funds at SEB.

“The vast majority of hedge fund [strategies] do not fit well within this framework and shoehorning them into these structures creates a risk,” notes Towers Watson’s O’Leary.

Forcing strategies into the Ucits framework has been damaging, undermining investor confidence and drawing the scrutiny of regulators.

“Firms need to consider whether they are doing the industry or themselves a favour by squeezing into the Ucits framework,” says Sebastian Schaefer, co-managing principal at SteppenWolf Capital.

The introduction of AIFMD could prove to be a serious competitor to alternative Ucits. The alternative investment fund (AIF) under AIFMD is a fully passportable, regulated structure without restrictions on liquidity or trading.

“AIFs include the best elements of Ucits without the investment and liquidity restrictions that sometimes hinder performance of alternative Ucits compared to offshore funds following similar strategies,” says Donnacha O’Connor, partner at Irish law firm Dillon Eustace.

“Hedge funds will need to have AIF vehicles to be active in Europe in the future. It is important to have an onshore offering as investors want more regulated structures,” says Fabrice Cuchet, global head of alternative investments at Dexia. “The challenge has been to have a wrapper with enough flexibility to deploy hedge fund strategies. AIFs answer that need.”

The less constrained nature of the AIF allows for better alignment of the liquidity preferences between hedge funds and institutional clients, too.

“AIFMD may act as a catalyst for the largest European institutional investors to invest onshore and reallocate to AIFs,” says Nathanaël Benzaken, deputy head of the alternative investments business line at Lyxor Asset Management. Lyxor already runs an alternative Ucits platform and plans to launch an AIF platform in December this year.

Confusion around AIFMD
However, with so many outstanding issues surrounding implementation of AIFMD, “many funds are waiting until next year before deciding which route to take so they can see if there are any changes from a regulatory perspective”, according to SEB’s Herrlin.

It will take some time before AIFs overtake Ucits as the dominant form of onshore hedge funds.

Goldman Sachs’ Hedge Fund Investor Survey 2013 showed 59% of allocators across Europe were investing in Ucits hedge funds with the proportions in France, Italy and Spain significantly higher at 87%, 86% and 82% respectively.

“Many investors are limited outside of Ucits and that will need to change if AIFs are going to be successful,” says Dexia’s Cuchet. “The question of whether AIFs will become as popular as Ucits is linked to the evolution of investor constraints from both regulators and internal policies.”

Some of the biggest European markets have not yet clarified how AIFMD will be implemented. According to KPMG only 12 of the 28 member states had transposed the directive by the July 22 deadline.

Differences exist between the member states. France, for example, has published a stricter version, which the regulator, the Autorité des Marchés Financiers (AMF), says will have some gold-plating compared with the original directive. The UK’s Financial Control Authority on the other hand has said it is not going to gold-plate AIFMD and is taking a much more pragmatic stance on implementation. The Central Bank of Ireland, that country’s regulator, is adopting a similar policy.

On the other hand Ucits has already established itself as a global brand, albeit mainly in the retail area. It is particularly popular with investors in Asia and Latin America.

Goldman’s research shows that 28% of Middle East allocators surveyed are putting money into Ucits hedge funds. This is slightly lower in Asia (24%) and falls dramatically in the Americas (12%).

“Ucits is a great success on a global scale but it took a decade to build a real brand name. The challenge for the European asset management industry is to do the same with AIFs for institutional clients and strategies that do not fit into the Ucits framework. It will take a while for that to happen,” Dexia’s Cuchet says.

Onshore hedge funds will increasingly dominate in future. While Ucits continues to be the gold standard in terms of marketability, AIFMD provides a potentially fruitful alternative vehicle for tapping into institutional demand for onshore products.

“It’s not exactly clear what is going to happen in the onshore hedge fund industry and how it will pan out for Ucits or AIFs. The landscape has changed dramatically even for Ucits and will continue to do so but it will be investors that drive both segments,” says Deutsche Bank’s Fothergill.

 

Tighter rules, fewer strategies

Tougher Ucits rules have already impacted hedge funds trading commodities.

A number of funds closed after the European Securities and Markets Authority’s (Esma) guidelines were updated last year restricting funds from trading indexes made up of multiple assets derived from a single commodity.

Cantab Capital Partners was among those that decided to exit the Ucits arena, closing its $320 million CCP Quantitative Ucits fund. For strategies deploying commodities, it has become very difficult to follow the new Ucits rules, according to Genia Diamond, partner and head of business development. “The regulator is very careful about safeguarding retail investors from access to commodity exposure among other things. What’s to say the regulator won’t decide something else is unacceptable in a few months?”

Funds using total return swaps to import the performance of offshore hedge funds into Ucits vehicles will also have to restructure or close as the February 2014 deadline approaches.

With more changes and clarifications come into place, existing alternative Ucits hedge funds will find themselves unable to comply with the regulations. This could force some mangers to move into AIFs much sooner than they had planned, abandoning Ucits altogether.

Esma could make further changes. It is known to be keen to restrict the use of hedge fund strategies within the Ucits framework. “There is a general move to make Ucits more straightforward and eliminate strategies designed more for the institutional market that may have been paying lip service to the rules, but which were not consistent with a retail-oriented product,” says Donnacha O’Connor, partner at Irish law firm Dillon Eustace. “Esma and the commission are addressing on an ongoing basis the issue of overly complex structures and the de-risking of Ucits further for investors.”

Rather than establishing a dual system within Ucits, as many feared, it looks increasingly likely onshore hedge funds will bifurcate with appropriate and easily fitting hedge fund strategies using Ucits and the others accommodated within the AIFMD structure.