Tue, 29/07/2014 - 12:36
By Ian Swallow – A framework, not an endorsement: The popularity of the UCITS ‘brand’ is beyond question and this continues to be one of the fastest-growing segments of the fund-management industry. Indeed, our own anecdotal experience suggests that investors outside of Europe often prefer to invest in a fund under the UCITS banner.
One of the issues associated with the ability to label a product as UCITS-compliant is that this status alone can influence the perspective of investors over its potential suitability. For example, a risk-averse investor may incorrectly consider that each and every UCITS vehicle is effectively approved by local and international regulators as being suitable for all.
The UCITS framework should indeed ensure that the relative risks undertaken by investment managers are commensurate with their published strategy and that the potential returns justify the absorption of such risk. However, the regulations do not aim to ensure that all UCITS-compliant products have the same risk/return objectives or offer similar levels of downside limitations.
A separate but related point is that some strategies that are not specifically excluded under the UCITS directive are not wholly compatible with it. This means that there is a moral responsibility – that may not always be strictly adhered to – on the part of providers to only wrap appropriate strategies within a UCITS format.
Consequently, we believe that a perception that all UCITS funds are made equal has led to some strategy or provider-specific issues being afforded myth-like status and blanketed across the entire universe. Clearly, objectivity demands that the following commonly quoted myths are dispelled.
UCITS funds carry a performance drag
Some investors believe that the performance of an alternative UCITS fund will, by definition, lag that of the offshore strategy on which the offering is based because significant re-engineering of the portfolio is required in order to satisfy the UCITS directive. However, the rationale behind a number of alternative product offerings being made available under the UCITS banner is that the underlying offshore strategy is largely, or even completely, aligned with UCITS regulations. Consequently, where no major modifications are required, the offshore and UCITS funds will often trade pari-passu.
A liquidity mismatch could cause redemption difficulties
Liquidity mismatches arise when the terms of redemption offered are different to the rate at which the portfolio could be unwound in the event of a flood of redemptions. Some investors fear that where the redemption terms of the offshore product differ from that of the UCITS offering, managers will not be able to provide the advertised liquidity.
It is true that some hedge fund strategies, such as certain offerings falling within the event-driven category, require additional time to unwind a portfolio because the underlying assets themselves are relatively illiquid. However, many hedge fund providers stipulate a longer redemption period in their non-UCITS offerings than that specified by the UCITS directive simply because they have a small number of very large investors. Consequently, in the event of a significant redemption, they wish to protect the interests of other investors by unwinding positions over a longer period to avoid slippage. It is often the case that the assets could, in practice, be crystallised in line with the UCITS specifications.
A large number of alternative strategies are not replicable under the UCITS provisions
A number of investors have noted that, for example, the Eligible Assets Directive (EAD) prohibits the holding of physical commodities. Consequently, strategies that harness commodities-related earnings streams, such as Managed Futures and Global Macro, are not fully replicable.
Clearly, there are a number of issues related to the holding of physical commodities, such as storage, potential damage, insurance and transport costs. However, alternative UCITS providers can gain commodities exposure through (for example) index options, which are highly liquid and meet other UCITS rules relating to diversification and collateralisation. Consequently, the ability to deliver commodities-related return streams is not only highly desirable for investors seeking investment performance that is uncorrelated to traditional assets, it is also perfectly permissible under the EAD.
UCITS rules prohibit short selling
A popular misconception is that some of the best hedge-fund strategies are not available in a UCITS format because they rely on short selling, which is not permitted under UCITS regulations.
Clearly, short-selling is one of the most powerful tools in the armoury of a hedge fund manager, as it allows investment professionals to express a negative view on an asset. This provides a further potential source of alpha and the short book can also be used to hedge the performance of the long positions. However, the practice has often come under the scrutiny of regulators because it can be dangerous if not conducted prudently. Consequently, stock exchanges have periodically banned ‘naked’ short selling, which is a form of speculation that involves selling stock that is not owned with a view to buying it at a lower price in time for settlement.
Under the terms of the UCITS directive, even ‘covered’ (where stock is legitimately borrowed before selling) shorting is prohibited. However, synthetic shorting can be achieved through the use of cash-settled derivative instruments, which are perfectly permissible. As such, the regulations are not a barrier to operating a long/short strategy that is aligned with its offshore counterpart.
It is expensive to bring an alternative UCITS strategy to the market so fee loads are greater
The costs associated with structuring a UCITS offering are very much dependent on both the scope of the issuer and the compass of the strategy offering. There is no doubt that economies of scale apply and some small alternative investment houses could find that any or all of the following points are barriers to cost-effective implementation for both manager and investor.
• Platform size (fixed costs can be large for small platforms)
• Complex compliance monitoring requirements can be difficult to monitor and are thus labour intensive
• Production of additional materials (eg. KIID)
• Passporting/registration, upfront and ongoing maintenance costs (including translation costs)
• Maintenance of or contracting with an onshore management company to manage the funds
• Lack of experience in dealing with regulators (both directly and via legal counsel)
The last point is not a question of expense in monetary terms, but it can be a drain on human resources and regulatory inexperience frequently leads to unforeseen delays in proposed launch dates (and thus fee-income accumulation).
Resources and innovation
As is often the case with myths, there is usually some substance to the misconceptions that are frequently applied to alternative UCITS strategies. However, these issues may be specific to either the issuer, the specific approach pursued or both. It is unquestionably the case that some of the most popular UCITS products, such as managed futures and equity long-short, are naturally aligned to the liquidity provisions of the UCITS directive.
Consequently, adhering to the principles of the offshore strategy on which the offering is based and producing returns that are closely aligned to it within a UCITS framework is seldom a barrier. This is especially the case for large-scale players who are able to devote, time, expertise and resources to uncovering innovative methods of mirroring the offshore strategy within the UCITS regulations.
Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). These opinions are subject to change without notice, are for information purposes only and do not constitute an offer or invitation to make an investment in any financial instrument or in any product to which any member of Man’s group of companies provides investment advisory or any other services. Any forward-looking statements speak only as of the date on which they are made and are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. Unless stated otherwise this information is communicated by Man Investments AG which is regulated by the Swiss Financial Market Authority FINMA. In the US, distributed by Man Investments Inc. which is authorized and regulated, but not endorsed, by the US Securities and Exchange Commission, the Financial Industry Regulatory Authority and the Securities Investor Protection Corporation. CH/14/0424-P
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