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Magazine Issues » March 2011

FALLING INTO LINE: the growth of alternative Ucits

Falling_into_lineThe growth of alternative Ucits funds has thrust some asset managers into an unfamiliar world of compulsory checks and limits. Nicholas Pratt looks at how compliance management systems are helping them meet regulatory requirements

The migration of alternative managers from unregulated fund structures to the regulated framework of Ucits funds has been one of the notable trends of the recent past. Investors are seeking a clearer demonstration of good governance and more prudent risk management, even from alternative managers, and what better way to illustrate this than launching an alternative that promises to provide all the innovation of a hedge fund but within the regulated framework of a Ucits fund.

An uncharitable view of this approach may be that alternative managers are attempting to attract as much institutional investment as possible by using the Ucits framework as a cloak of compliance respectability. These managers have to wrestle with the tension of attempting to generate as high a return as possible but still staying within the confines of the framework and are, therefore, looking to use compliance systems that will allow them to skirt as closely as possible to any imposed limits on counterparties, concentration or exposure.

Fabrice Cuchet is head of alternatives at Dexia Asset Management, which has the majority of its €5bn in alternatives assets under management invested in alternative Ucits funds, the first of which was launched in 1996. The idea that the role of compliance systems is to enable alternative managers to skirt as close to the limits as possible so as to ensure as much innovation as is legally permissible, does not resonate quite so much with him.

“Yes, you have constraints and are not allowed to do everything but there are still plenty of chances for innovation,” says Cuchet. “For example, we have developed Ucits funds that have been using risk-driven arbitrage, credit funds and long/short equities for more than ten years and there is a wide range of derivatives that can be used within the Ucits framework.”

Of more importance is having the infrastructure in place to manage the daily compliance requirements of the framework rather than the more irregular and less compulsory risk management measures that come with non-Ucits alternative funds, he adds. “This does not mean that non – Ucits alternative managers are not using any systems to track their portfolios, but with Ucits there are stated limits on concentration, leverage and counterparty exposure and they are compulsory. And you have to manage these limits every day.”

It has not always been easy to find the most suitable systems for managing Ucits compliance, says Cuchet. “We have developed our own system rather than using external software. With alternative Ucits funds we are often using derivatives and many of the existing compliance systems are not able to cover new instruments.”

That said, Cuchet acknowledges that many of the vendors are currently enhancing their offerings and Dexia Asset Management is reviewing a number of third-party options with a view to replacing its own in-house compliance system. “The flexibility and openness of the system and the ability to adapt to new instruments and best-practice for collateral management will be key in choosing a new compliance system.”

Cuchet is looking to the established risk management application vendors (such as Sophis and Murex) to provide its new compliance system, which is a logical choice given the close relationship between risk management and compliance, the shared functionality in terms of alerts, reports, limits management and exposure analysis, and the fact that most risk applications have bolstered their compliance functions in recent years.

Another source of compliance management systems is the world of order management systems and trading platforms that have compliance as a featured module. Increasingly though these platforms are making Ucits-specific enhancements in recognition of the rise of alternative Ucits funds. For example, ConvergEx’s Eze Castle Software, an order management system for both traditional and alternative asset managers, released version 5.7 of its order management system, the Eze OMS, last year which contains expanded functionalities for Ucits funds in its compliance module.

“The key value is allowing managers to check the Ucits limits at the time of trade entry so that they are preventing a problem before it happens," says Pete Adams, director in product management at Eze Castle. “You can also run checks in a batch mode before the trading day begins so that you can get a report on where you stand versus the Ucits limits. For example you can see if your exposure to a single counterparty is approaching 5% before you even begin trading.”

The compliance enhancements of version 5.7 are mostly concerned with updating the various templates and regulatory libraries within the system so that upon entering a derivatives trade within a Ucits fund, the trader will be told all the relevant limits and potential violations. “That pre-trade aspect is a big selling point for a compliance system,” says Adams.

Although Ucits IV is soon to come into force, the regulatory environment is largely consistent, he adds.

For alternative Ucits funds, the big changes came with Ucits III which allowed for the greater use of derivatives as well as more aggressive trading strategies such as synthetic shorting and the use of contracts for difference. Consequently, the existing rules around counterparty exposure, concentration risk and issuer exposure will remain in place even though the actual size of these limits may vary. The moving parts are really the positions of the funds and the funds themselves rather than the rules that govern them.

The biggest challenge facing many alternative managers, especially those new to the Ucits world, is moving to one where limits checking and position management is not only compulsory rather than voluntary but daily rather than monthly, something which raises operational and organisational issues. “The majority of hedge fund managers would not have had to deal with pre-trade compliance in the past so there are some workflow issues and interventions in the trading life cycle that were not there before,” says Trevor Headley, global product strategy and delivery manager at Tradar, a UK-based compliance systems developer.

Essentially, says Headley, hedge fund managers are looking for a compliance system with a lighter footprint and fewer of the operational overheads that come with the systems used in the major institutional space. They are also looking for a system that takes into account the specifics of Ucits requirements but can also be used across the firm’s fund range.

“A number of alternative managers operating in the Ucits market will adopt pre-trade compliance practice for their other non-Ucits funds because of the shift in investors’ mood and their demand for more assurance. The investors are now more institutional than high-net worth, they have more stringent risk management requirements and pre-trade compliance certainly comes into that.”

The ability to demonstrate that you have always stayed within your guidelines may be increasingly important to investors but there is also the more explicit cost of a compliance breach, whether that be through a fine, having to correct a trade or even having to unwind a position. “For example, if you go over your 10% concentration limit, you may be unwinding an otherwise profitable trade with various commissions being paid out. So there are significant losses involved with noncompliance,” says Headley.

Enhancements The key, says Headley is to have a single, integrated compliance engine that can monitor real-time P&L and use those same numbers to manage exposure limits and check portfolios against the Ucits limits. Like many other compliance system developers, Tradar has undergone a number of functional enhancements to cater for the increase in alternative Ucits funds.

“We have developed extensions to the data retrieval process and the data quality checks have been tightened. All securities are fully tagged by issuer, by counterparty and by security type. There are active alerts and a manual override and a constant focus on improving end-end workflow and producing compliance reports.

The small staffing levels at many hedge funds means that there is not usually a dedicated compliance officer and it is more likely that a CFO or similar figure will take on compliance as an extra responsibility, therefore the ability to quickly and easily generate regular reports is of particular importance in a compliance system. “This is where a compliance system comes into its own,” says Headley. “Like all systems, it needs to be managed but we try to help them do more with less.”

As useful as the compliance systems are in “doing more with less” and lightening the load of a sparingly staffed boutique hedge fund, this is not to say that managers can expect the technology to take care of it all and not themselves be familiar with the various Ucits II restrictions.

“The systems provide a first line of defence at the trader level and indicate where a limit has been or might be breached. This does not, however, remove the need for front-line trading staff to be aware of the requirements,” says Amelie Snape, senior associate at Bovill, a UK-based regulatory and compliance consultant.

The risk management and compliance functions also have a role to play in ensuring that any breaches or potential breaches are fully investigated and properly escalated and reported. Regular compliance monitoring is essential and high-quality management information needs to be produced by the risk and compliance functions,” she says. “Compliance will also have an important role to play in providing training to fund management and other staff on the regulatory requirements applicable to the business.”

And it is also essential that senior management encourage a risk aware and compliant culture and that they provide effective oversight and control over the business, says Snape.

“Where more complex strategies are employed then it is critical that senior management fully understand these strategies. They will need to be receiving regular management information that enables them to assess the risks being taken and to ensure that these are well managed and controlled, and are consistent with the investment strategy set out in fund documents such as the prospectus.”

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