Critics question long-term appeal of ‘Newcits’ funds
Even as the growth of ‘Newcits’ funds in the marketplace accelerates, concern has been growing about their limitations and potential dangers. These fears cover issues such as the potential for investment by retail customers that do not understand the products or for whom they are unsuitable, the possibility that investors may be disappointed if returns fail to match those of offshore hedge funds, and the need for higher volumes of assets under management to meet increased set-up and servicing costs.
But most potent is the fear, expressed by a number of prominent representatives of the asset management industry, that any hedge fund-style blow-up could cause long-lasting damage to the reputation of Ucits, built up over more than two decades, as a trustworthy fund vehicle for retail investment.
They include Jean-Baptiste de Franssu, chief executive of Invesco Europe and president of the European Fund and Asset Management Association, who recently described Newcits as “a traffic accident waiting to happen”. Speaking to a conference organised by the Association of the Luxembourg Fund Industry (Alfi) earlier this year, he argued that the Ucits structure was not designed for funds aimed at sophisticated investors and that hedge fund managers had taken advantage of rules defining eligible assets for Ucits in ways not intended by the legislation’s authors.
“It is a great concern,” De Franssu said. “These funds are pushing the Ucits rules on eligible assets to extremes. Can we afford to let Newcits develop? They could damage 20 years of work and success up to now. This is an opportunity for the industry to demonstrate we are ready to call for action when past legislation – in this case the rules governing Ucits eligible assets – has gone too far.”
Claude Kremer, a partner with Luxembourg law firm Arendt & Medernach, chairman of Alfi and vice-chairman of Efama, has also warned that the offering of more sophisticated and risky strategies through Ucits could endanger the acceptance of EU-authorised retail funds by regulators elsewhere in the world, such as Asia. “There is legitimate concern about the scope of the European regulation,” Kremer said. “Asian countries are not bound by European rules. We need to be aware of the issue and ensure that the Ucits brand, which has been highly successful in Asia, is not damaged.”
Brian Kelliher, a partner in the asset management and investment funds unit of Dublin law firm Dillon Eustace, adds: “The danger is the Ucits brand could be tarnished if something went wrong. We’ve seen that as a result of the Lehman crisis, the Hong Kong regulator has become very cautious about alternative funds, even domestic ones. If Ucits funds are open to potentially very high levels of leverage, not to mention volatility or market risk, it may be difficult for these funds to be registered in non-European jurisdictions.”
Olivier Sciales, a partner with law firm Chevalier & Sciales in Luxembourg, notes that Newcits come with drawbacks as well as advantages compared with other alternative fund structures. “Ucits is quite a complex product, which some smaller promoters may not be aware of, and it’s often more costly than a SIF. Except in the case of a self-managed Ucits, you need a management company that currently needs to be approved and regulated in Luxembourg. You also need a promoter with at least EUR8m in net assets on its balance sheet, unless the regulator agrees to a lower amount.”
He observes that the scope of Newcits may be constrained in the future by action on the part of the continent’s regulatory authorities. In fact the Committee of European Securities Regulators helped to pave the way for the growth of Ucits funds using alternative investment strategies in 2004 when it introduced a distinction between sophisticated and non-sophisticated funds.
Recently, however, senior regulatory officials in France and Ireland have expressed willingness to re-examine the way sophisticated Ucits funds are dealt with under European legislation, and in particular whether they should be treated as complex rather than non-complex products, as is the case currently for all Ucits. Under the EU’s Markets in Financial Instruments Directive, while non-complex products can be sold on an execution-only basis, the distributor of a complex product must ensure it is being sold appropriately, which in practice tends to mean with advice.
Dermot Butler, chairman of Custom House Administration, is an avowed sceptic about the qualities of Ucits as a structure for hedge fund strategies. “I’m none too convinced it’s anything but a short-term fad,” he says. “People seem to be setting up Ucits because they think they’ll get better distribution, because the investors perceive that they’re better protected because they’re regulated, and because it helps avoid the AIFM Directive, which will apply to non-Ucits funds. I think there are fallacies with all of these.
“A Ucits fund may be open to a broader band of investors, but you’ve still got to sell it to them. That requires distribution, and the average hedge fund manager doesn’t have retail distribution. If you’re a Marshall Wace or Brevan Howard that can conjure up USD300m in seed capital for a Ucits fund, you’d be stupid not to do it. If a big pension fund manager offers you USD100m for a Ucits structure, you’ll open one up the following day. But many managers are launching funds with less than USD50m, and some funds are already being closed because they have failed to attract a sufficient volume of assets.”
Butler cautions that it would be a grave error for investors to skimp on their due diligence into the manager just because the fund is a Ucits structure. “I fear that some investors may be relaxing their due diligence efforts because Ucits are widely touted as being strongly regulated,” he says. “That may mean they are not looking closely enough at the actual manager of the money. There’s nothing regulation can do to stop an incompetent manager, and regulation wasn’t much use to the investors in Ucits feeder funds that invested with Bernie Madoff.”
Finally, he argues, the extra costs involved may represent a significant drag on performance. “A Ucits costs a lot more to set up than European Cayman-style funds such as a QIF in Dublin or a SIF in Luxembourg or Malta,” Butler says. “The structure costs a lot more to operate because you must have a custodian, compliance with the regulations is expensive, and you will always have a quarterly bill from a lawyer for attending board meetings because the laws and EU regulations change so often.”
But he concedes: “If the cost of operating the Ucits fund doesn’t crucify its performance in comparison with the group’s offshore Cayman vehicle, or if investors are happier to be in a Ucits and are prepared to pay the extra cost, that’s fine.”
John Sergides, head of business development and strategy for alternative fund services in Deutsche Bank’s Trust & Securities Services business, points out that Newcits are often more complex, and therefore more costly, to administer than long-only Ucits structures or indeed offshore funds. “Managers may not be aware of the differences in technology needed to do this and how much work will be involved,” he says. “When you try to make a hedge fund into a Ucits, unless the assets are substantial, your servicing costs are increased, not decreased.”
Kelliher suggests that the cost issue might be mitigated if smaller managers join existing platforms – one of the most prominent is operated by Deutsche – rather than setting up their own schemes. “Platforms have been developed by certain promoters with existing administrators and custodians, where the fund is already up and running with a number of sub-funds, and they are adding third-party asset managers to it,” he says.
“That could enable start-up hedge fund managers to gain experience and develop commercially until they have an established track record as a Ucits manager and may then be able to set up their own structure. An important factor is that these platforms may have existing distribution networks that new managers can avail themselves of.”
The jury is still out on how Newcits performance matches up with offshore funds run by the same managers according to the same strategy, mostly because few alternative Ucits have a long enough track record to offer a meaningful comparison. A recent survey suggested that in the second quarter of this year many Newcits strategies only narrowly lagged equivalent offshore hedge funds, and equity long/short, global macro and event-driven Ucits actually outperformed their offshore counterparts.
“There are certain things in an offshore fund which, for all the obvious eligibility, liquidity and concentration of risk reasons, should not and cannot make it into a Ucits,” says Simon Hookway, managing partner of MAG Consultancy. “Unless you have correctly tested what your portfolio would have been under those conditions and how it would have performed, you don’t know what the tracking error will be between the offshore fund and the onshore regulated Ucits, because when there is position-level disparity there will be tracking error.
“A number of firms that have rushed into this area haven’t necessarily gone through all these steps. This isn’t as serious a problem as a blow-up, but it still gives Ucits a less than shining image in the eyes of investors if they think they re getting an exact replica of the offshore fund when in fact they are getting something different. It should be obvious why this is, but if it is not explained correctly to investors it still comes as a shock.”
According to a recent survey conducted by the Edhec-Risk research centre, asset managers fear that structuring hedge fund strategies as Ucits will distort strategies and diminish returns, because many strategies need to be altered to comply with the Ucits regime, and liquidity requirements would put the liquidity risk premium out of reach. Sixty-nine per cent of participants in the survey believed that the liquidity premium of hedge fund strategies would disappear and performance would fall when strategies were structured within Ucits.
Sergides suggests that smaller Newcits managers may not see the same level of support in terms of subscriptions that the larger managers are getting from institutional investors. “Managers are certainly looking for that money, but how much of it has actually materialised to date?” he asks. “The big shift for pension funds is in their allocation to alternatives. They’ve always had a huge allocation to long-only structures, but it’s their allocation to the alternative space that is increasing.
“On the whole the institutional investors we talk to seem to have gone with institutional managers. People are looking for transparency, fiduciary responsibility and oversight of what’s going on at the asset level by investing via managed accounts. In the alternative space Ucits have been outweighed by managed accounts so far.”
However, managers who have been successful in developing Newcits business believe that some of the concerns are overblown. For example, Hans-Olov Bornemann, manager of the SEB Asset Selection Fund, counters the argument that Newcits could endanger the Ucits brand by noting that the regime emerged with its reputation intact from the stock market meltdown at the beginning of this century.
“Some Ucits funds investing in internet stocks dropped in value by 90 per cent without having a major impact on the brand,” he says, adding that long-only investments offered through Ucits funds in many cases carry significantly higher risk than hedge fund strategies. “You can invest 100 per cent of your money in Russian equities, and with leverage have 200 per cent exposure to Russia. Ucits can and do lose lots of money at times.”
He believes that these losses do not attach a stigma to the brand because they are attributed to the behaviour of the market rather than any inherent riskiness in the way the funds have been managed. Managers who proclaim their objective is to deliver absolute returns are more exposed, Bornemann argues, because investors harbour unrealistic expectations that such managers can and will make money in all market conditions. “People with that sort of expectation will be disappointed, no doubt about it,” he says. “But the important thing about a Ucits fund is that its liquidity enables investors to take their money out immediately if the fund starts to underperform.
“The potential risk to the reputation of Ucits lies in certain strategies, notably long credit and short volatility, especially if asset managers fail to explain the risks of the fund adequately. If they are too greedy and put on too much leverage, it may blow up in their face. Historic risk in such funds may not provide a good indication of future risk, because it’s a very fat-tailed kind of risk.
“This is a valid concern, but it shouldn’t result in investors being forbidden to use these tools. Instead there should be limits on how much leverage managers can use, and there must be proper disclosure to investors. If you explain how higher-risk products work, some investors will want to put their money in while others will shy away from them. That’s exactly the way it should be, both for traditional Ucits and for Newcits.”
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