By James Williams – The last twelve months have done a lot to consolidate peoples’ views of alternative Ucits. Fund managers have started to wake up to the obvious benefits of having an onshore vehicle and the value that the Ucits structure can bring.
Every month new funds are being launched, transforming a sector that was once the preserve of equity l/s strategies into one populated by more diverse, complex strategies including event-driven, global macro, credit and CTAs. The emergence of John Paulson, Barton Biggs of Traxis Partners and York Capital illustrates the depth of hedge fund talent embracing Ucits.
Net inflows into Ucits, YTD, are EUR51billion. Total industry AUM is EUR5.88trillion, but “Other Ucits”, including alternatives, still represent a tiny portion of the market: 6 per cent, equivalent to somewhere between USD300billion and USD400billion.
There are roughly 400 funds, growing in response to institutional demand for regulated hedge fund-lite products. “In the last two quarters 50 per cent of net inflows into hedge funds came from institutional investors and this trend is growing. They have a preference for regulated structures,” comments Olivier Laurent (pictured), Head of Hedge & Structured Fund Group, RBC Dexia.
One of the catalysts behind this growth is a desire for managers to circumvent the AIFMD which, in 2018, will make it difficult to market offshore funds as private placement regimes. “It’s difficult to imagine European institutions going for Cayman funds because it won’t be possible to do active marketing. Over time, regulation will be a key driver for the growth of regulated structures,” adds Laurent.
Peter de Proft, Director General of EFAMA, thinks the hype surrounding alternative Ucits is cooling down: “There’s a much bigger rise in ETFs so things need to be kept in perspective. The growth of ETFs is much more important than alternative or AR Ucits, call them what you will.”
“Absolute return funds use derivatives and are certainly not a new product consideration. They’ve been around for a long time,” adds Gary Palmer, Chief Executive, Irish Funds Industry Association (IFIA).
The size of alternative Ucits, relative to the offshore funds they seek to replicate, remains surprisingly small. Paulson & Co, a multi-billion dollar fund manager, launched its DB Platinum IV Paulson Global Fund with around USD100million: tiny in comparison to the Paulson Advantage fund.
Assets remain modest for two reasons: firstly, overall performance is flat. The Alternative Ucits Global Index has returned 0.17 per cent this year, while hedge funds are up 1.96 per cent: a significant 10-fold performance swing. The same was true last year. Secondly, although “Newcits” are being snapped up by retail investors, big institutions and their chequebooks remain largely in the shadows.
“It’s reassuring to have the protection of Ucits but they didn’t go for it before because it’s not what they needed. Some say that ideally they wouldn’t invest in Ucits but they have constraints that push them to do so,” comments Samuel Sender, Applied Research Manager at EDHEC-RISK Institute, whose research is sponsored by CACEIS as part of the research chair “Risk and Regulation in the European Fund Management Industry”.
Some worry that strategies are getting too complex. De Proft confirms that a recent meeting of the European fund classification working group was held at EFAMA to assess the different types of funds within the Ucits framework. The French regulator AMF proposes to classify them into complex and non-complex Ucits.
“The important phenomenon right now is that regulators are paying attention to investor protection, particularly retail investors. They’re assessing what type of funds are being sold to them, that the strategies are not too complicated to understand, and I think that’s very important,” says de Proft.
ESMA is currently looking into the issue, something EFAMA welcomes. “We have excellent relations with ESMA,” adds de Proft. “We have confidence they and national regulators will continue to enforce Ucits requirements for all Ucits managers in an adequate manner and maintain a level playing field.”
Fund centres like Ireland and Luxembourg are benefiting from the way the industry is evolving, and will continue to so under the Ucits IV directive, which will encourage even more efficiency and transparency.
The evolution of the Ucits framework has allowed Ireland to develop into a well-established domicile for internationally distributed investment funds, both in the Ucits and more flexible QIF structure. According to Palmer, unrivalled depth and breadth of expertise and experience are the hallmark of its industry, not to mention innovation: it was the first jurisdiction to introduce regulation for alternative investment (QIFs).
“We’re always looking to anticipate the next wave of industry requirements, whether that be thought leadership in the servicing of funds, or in the legal, regulatory and tax frameworks for product development,” explains Palmer, citing the development of its legal framework to provide tax certainty for Ucits funds as a recent example.
The Association of the Luxembourg Fund Industry (ALFI) is pleased with the growth of Ucits funds according to Deputy Director General, Charles Muller, although he admits some are more risky and less adapted to the needs of retail investors. “We believe that if these funds use the “Ucits brand”, it’s because there’s currently no alternative providing a European passport,” explains Muller.
Luxembourg is the leading centre for cross-border fund distribution. According to Lipper-PwC figures, it’s home to over 75 per cent of “true” cross-border funds. “Luxembourg is truly international both in terms of asset management companies and workforce; half are foreigners. A quick implementation of Ucits IV last December demonstrated our leadership role,” adds Muller.
With 80% of Ireland-domiciled funds being Ucits, Palmer expects the increased attractiveness of Ucits IV to provide a “significant opportunity”: “We’ve been working with our Central Bank colleagues to ensure the requirements under Ucits IV are well understood. The industry over the last two years has been working towards that.”
De Proft thinks the KIID document is the key provision in Ucits IV: “It’s a clear document that will hopefully be the standard for all retail products.” He admits that it is too soon to decide how well the master/feeder provision will work, stating: “Co-operation between regulators is key and is already well established.”
The danger with alternative Ucits is that fund managers may be jumping on the bandwagon. The risk, moving forward, is that low quality managers will sell Ucits products with a high hedge fund fee structure. Although robust enough to protect against blow-ups, the possibility remains that the global recognition Ucits enjoys could become compromised. “The risk is that good quality guys remain unregulated hedge funds while those not able to survive could go for something that is easy to sell,” opines Sender.
De Proft is unconcerned about a blow-up because as gatekeepers of the Ucits brand “we’re looking at what’s going on in the market on a daily basis with ESMA and the regulators. We want to avoid possible accidents, that’s why all these exercises are being done.”
One emerging trend is fund managers using total return swaps (TRS) to replicate offshore strategies, rather than investing directly in the underlying securities. A recent report by Alix Capital found that 63 per cent of investors had reservations. A TRS is one of the methods of getting around Ucits limitations, given that managers are restricted by the assets they are allowed to invest in.
Unlike the flexibility of hedge funds, Ucits present two sorts of limitations: firstly, not all strategies (e.g. distressed debt) can be packaged in Ucits; secondly, managers cannot directly access assets like commodities, nor can they directly short sell. They therefore rely on derivatives, which creates an added layer of costs.
“Some Ucits restrictions such as short-selling can be avoided with the use of derivatives. You can package a lot of things that way, but it comes with additional fees,” explains Sender. This isn’t altogether ideal for investors as it impacts on fund performance.
With the AIFM Directive looming large, another interesting trend is emerging: QIFs and SIFs being preferred to Ucits. RBC Dexia, in their last report, found that 77 per cent of fund managers who don’t yet have a Ucits would consider these alternative structures. Laurent says he was a little surprised by the percentage, but it could be that managers want to perfectly replicate their offshore strategies, which is possible with a QIF.
Tracking errors under Ucits are unavoidable given its limitations, but Laurent believes that one of the key advantages “Newcits” has over QIFs and SIFs is the ability to sell to retail investors. In jurisdictions like France, pension funds are restricted from investing in these non-Ucits structures. “For hedge fund managers it might make more sense to have a QIF, but the distributor may try to convince him to go for a Ucits structure instead,” says Laurent.
“In 2010 there was a 33% increase in the value of assets in Irish QIFs. If one looks forward and with the anticipation of AIFMD, it’ll provide a passportable non-Ucits product. Maybe in a number of years’ time we’ll be talking about an AIFMD non-Ucits product framework in the same way and with the same success as Ucits,” says Palmer.
The industry will likely see managers choosing co-domiciliation as the regulatory environment evolves, maintaining their offshore Cayman vehicles whilst at the same time running an onshore Ucits or QIF.
“Where I’m a little worried regarding sustainability of the Caymans model is for mid-sized hedge fund managers as they try to grow their onshore and offshore funds,” says Laurent. He concedes that some of these managers might move completely onshore to control costs. Alternative Ucits are set to dominate the industry as a portfolio diversifier, but they won’t eclipse the offshore market.
“In 2010 there was a 33 per cent increase in the value of assets in Irish QIFs. If one looks forward and with the anticipation of AIFMD, it will provide a passportable non-Ucits product. Maybe in a number of years’ time we’ll be talking about an AIFMD non-Ucits product framework in the same way and with the same success as Ucits,” says Palmer.
