April 2011

IS THIS THE GENUINE ARTICLE: Ucits compliant hedge funds

DiamondThe Ucits-compliant hedge fund world is growing and multi-manager structures have emerged. But Angele Spiteri Paris finds providers are concerned how their regulated products compare with unregulated structures...

Critics of single-manager hedge funds that are compliant with Europe’s Ucits directive say these funds provide investors with less potential return than similar unregulated products yet command fees similar to a proper hedge fund.

In view of this, how much more questionable are Ucits-compliant funds of hedge funds (FoHF) made up of these vehicles? An issue that critics, such as investment consultants, have with Ucits FoHFs is the size of the universe of underlying single managers.Actual numbers for single-manager Ucits hedge fund strategies that are available to FoHF providers are debatable. Those quoted by a variety of market experts range from 40 to almost 1,000.

 According to research consultancy Strategic Insight, there were 472 Luxembourg-domiciled alternative-style Ucits funds as at September last year. This includes some 40 funds of funds with around €1.5bn in assets.

 In all domiciles, the firm found that there were 1,044 alternative Ucits funds, of which 172 were structured as funds of funds.

Although the numbers are not miniscule, alternative strategies only account for 4% of assets in all long-term Ucits, excluding money market and liquidity funds. 

 Craig Stevenson, senior investment consultant, hedge fund research, at investment consultancy Towers Watson, says: “There is a growing but, at this stage, a still relatively restricted universe of Ucits hedge funds and one of the key elements that makes a good fund of funds is a wide choice of as many sources of alpha as possible.”

Defenders of Ucits FoHFs are quick to emphasise that although the market is still small, the Ucits hedge fund world is growing.

Chris Rule, an investment director at Key Asset Management, says: “The Ucits hedge fund universe is smaller than the offshore universe, but it is rapidly growing.

”Dexia Asset Management thought the universe big enough to launch its own strategy in November 2010. Fabrice Cuchet, head of alternatives, says: “The Ucits hedge fund universe is now more diversified. You have more strategies available. There aren’t many but we believe the market has come to a point where the diversification is sufficient for us to launch a Ucits FoHF.”

Werner von Baum, partner and head of investment programmes at LGT Capital Partners, which manages a Ucits FoHF, says: “There are many ways of constructing a Ucits FoHF, which means that one may be more flexible on what is included [in the underlying strategies]. Also, the number of single-manager Ucits hedge funds is increasing.” 

 Liquidity challenges

Even if the alternative Ucits world is developing, there are still other inherent issues behind the practice of stuffing a hedge fund strategy into a regulated framework, such as a liquidity mismatch between the liquidity demanded by Uctis funds and what fund managers can actually deliver. This was a problem for the unregulated FoHF industry at the time of the sub-prime collapse.

Eric Bertrand, director for Schroders global alternative investor access Ucits platform, says: “Some strategies are not adequate for the Ucits framework. Long/short equity and CTAs [commodity trading advisers] can be adapted to the Ucits wrapper, but fixed income and relative value are more difficult to do in this space.”

Von Baum says credit and relative value strategies are not appropriate.

George Cadbury, director of funds at Merchant Capital, says: “It’s true that for some strategies the liquid framework is problematic but the majority of strategies, such as global macro, foreign exchange and long/short equity strategies should comfortably comply with these liquidity terms.”

But despite the difficulties outlined, fixed income Ucits hedge funds have been brought to market. Therefore, it is up to the FoHF manager to filter out any strategies with a potential liquidity mismatch.

Some funds in the Ucits Hedge Funds Fixed Income Index, created by Swiss firm 2n20.com are: Baring Absolute Return Global Bond Trust and Threadneedle Absolute Return Bond Fund. 

 A major question for Ucits FoHF managers is whether they will step up and provide liquidity if any of their underlying managers are unable to do so.

Stevenson says: “This is the $64,000 question. Investors are accessing these vehicles in the expectation that there is liquidity; however, there is no guarantee that this will be available in a time of crisis. This does relate back, therefore, to the FoHF managing their asset/liability profile according to the fund level. Though not strictly a Ucits issue, history – that is, 2008 – does show that the industry more broadly does not always do this well.”

Von Baum says providing liquidity when an underlying manager cannot would be difficult. “It will depend on the magnitude of the allocation to this manager and its effect on the overall portfolio as well as on the options, which the Ucits FoHF prospectus would define.”

Alpha-liquidity trade-off

Having sufficiently liquid strategies in a Ucits FoHF is important. But that liquidity is a double-edged sword since the Ucits FoHF offers investors lower potential returns.

Stevenson says: “The type of strategies that are put into the Ucits framework suit those that are more liquid. However, investors should expect a trade-off between alpha generation and an ability to provide a high level of liquidity. So, to a certain extent you’re starting off on the wrong foot in terms of performance expectations.”

Managers say that as long as the prospective client is aware of the product’s return profile, it does not matter that Ucits FoHF do not offer as much alpha.

Bertrand says: “Illiquidity is a source of alpha, a source of risk, and a source of return. So the fact that the hedge fund strategies in Ucits are more liquid does mean that an offshore fund will probably perform better. But as long as this is clearly articulated to the prospective client, then it doesn’t matter.”

But others argue that the difference in performance between a Ucits-compliant FoHF structure and an unregulated offshore hedge fund is largely dependent on the way the manager structures the portfolio and on the filters in place in both investment processes.

Rule says: “Ucits hedge funds have evolved such that in many cases the anticipated risk/return profiles of the offshore and onshore vehicles are pretty similar, as is the underlying strategy choice. 

 “There remain certain strategies that we are positive about but are largely absent from the Ucits universe, such as distressed. However, we have always avoided strategies that are more prone to liquidity stress and are not interested in seeking out illiquidity premium, so the difference between our investment universe is less than you might assume.”


Another bone of contention is that in some cases, the fees on the onshore FoHF vehicle have not been discounted.

Stevenson says: “Standard fund of fund fees are one and ten [1% management fee and 10% performance fee] and we haven’t seen evidence that this has been in any way significantly reduced in a Ucits structure.”

There are some cases where this is true.

Von Baum says: “We haven’t reduced our fees in the Ucits framework. We believe our structure is already competitive.”

But it is not the same across the board. In some cases the fee for the Ucits vehicle has been trimmed.

Bertrand says: “Our headline fee for our Ucits FoHF is lower than that of the offshore vehicle. It’s 50bps compared to 1%. Also, the performance fee on our offshore fund is 10% above Libor while for the onshore product it is 10% over Libor +2.”

Managers who retain the same fee for FoHF, be it onshore or offshore, say this is because they do the same job despite the domicile of the funds they select.

Rule says: “It doesn’t make much difference whether an HF is a Ucits fund or not. The Ucits badge doesn’t prove safety in itself and, therefore, the due diligence an FoHF manager should conduct is the same as for any other investment.

“The fees of the offshore FoHF and the Ucits FoHF are very similar. There are some differences, but these are not due to us doing a different job. They are more the result of the channels into which the two funds have been targeted and the relevant market practice.”

But Stevenson says: “Because you have less alpha generation and return potential a Ucits FoHF may not really be worth the fees it commands.”

Cadbury says: “There will always be investor chagrin about fees in the fund of funds world. In 2007/2008, some FoFs did not cover themselves in glory where some fundamental due diligence requirements were not met, which has not helped the cause of the FoFs industry as a whole.”

©2011 funds europe