The alternative UCITS environment remains a compelling option for institutional investors but there are signs that the strong annual AUM growth seen over the last five or six years has slowed in 2018. Investors have decided to exercise caution in 2018, holding back on allocations while they wait to see how the markets will fare. Combine this with poor performance, leading to natural compression of AUM, and the alternative UCITS sector has failed to ignite this year.
Kepler Partners publishes a quarterly review on the alternative UCITS market. In last year’s Q4 quarterly report, Kepler Partners placed total industry AUM at GBP284.5 billion, equivalent to an 8 per cent growth rate. In their most recent Q3 2018 quarterly report, AUM was GBP286.6 billion.
Having had a good start to the year, there has been a noticeable slowdown in activity in the second half of the year.
“We have tracked fewer new launches, and assets under management have remained broadly flat this year,” says Georg Reutter, Managing Partner, Kepler Partners LLP. “Demand from allocators remains strong, although investors are rightly becoming more selective when selecting their managers. There have also been some high profile funds struggling for performance this year, which isn’t helping.”
He says that the winners have tended to be managers with established track records of delivering uncorrelated returns. There have been notable successes in the Event Driven space, particularly Merger Arbitrage funds, where returns have been strong recently. Macro remains a hot topic and any strategy offering some form of ‘tail risk’ protection.
“We have recently launched an Asia-focused Macro strategy on our UCITS platform. The KLS Arete Macro fund launched in July and has enjoyed significant interested thanks to its unique approach to macro investing and strong track record,” suggests Reutter.
Some of the top performing funds this year, to date, include Odey Swan, an equity long/short fund up over 28 per cent, BlackRock Emerging Markets Absolute Return, a market neutral fund up 15 per cent, MontLake North MaxQ Macro UCITS, a macro strategy with gains of 14 per cent, and GAM Star Alpha Technology, another equity long/short fund, up 12.5 per cent.
As with every aspect of investing, there are always strong performers that stand out from the competition across strategies, even if the broader strategy indexes are a sea of red.
Looking at the Absolute Hedge (AH) UCITS Index, every strategy is in negative territory YTD. The AH Global Index is down -3.2 per cent compared to +3.6 per cent in 2017, while the AH Equity Long/Short Index is down -2.5 per cent compared to +6.9 per cent in 2017. AH Managed Futures Index is by far the worst performer, down -8.9 per cent YTD.
Moez Bousarsar, Deputy-Head of Hedge Fund Selection, Lyxor Asset Management tells Hedgeweek that a few funds on its Alternative UCITS Platform have generated good returns in 2018. The Lyxor/Tiedemann Arbitrage Strategy, a merger arbitrage strategy, is up 4.36 per cent YTD, he says, adding that Lyxor / Sandler US Equity, a US equity long/short variable bias fund, is up almost 3.65 per cent.
“We have a couple of other funds that have weathered the market volatility and have managed downside risk very carefully,” says Bousarsar. “One is a credit long/short fund managed by Chenavari, up 1.43 per cent and the other fund is the Lyxor Epsilon Global Trend Fund, a CTA programme which is only down -2.76 per cent YTD. That is quite impressive compared to its wider CTA peer group.”
Bousarsar admits that at a broad industry level performance has been challenging. One of the key asset gathering strategies last year was alternative risk premia but this year these strategies have struggled badly. “Global macro and CTAs have found it challenging and even some equity long/short strategies have been adversely affected by market rotation and increased volatility. There was quite a severe drop in equity markets in October so people have been more cautious to allocate to these strategies.
“We cherry pick the best managers that we think can offer investors steady returns, capability to preserve capital and mitigate downside risk. If funds do not offer those characteristics, they will not have succeeded in attracting new inflows; or at the very least they would have been more muted,” remarks Bousarsar.
Short-term CTAs seem to be managing the markets well and some discretionary macro managers that were positioned for market disruption a couple of years ago have also done well – e.g. the MontLake North MaxQ UCITS fund – but equity and fixed income managers have found it tough.
This would ordinarily be one of the strongest times of the year for raising assets, as mid-Sep to mid-November is when a lot of institutions make decisions as to what their allocations will be for the upcoming year.
Not that this has been a problem for ML Capital, an independent UCITS and AIF platform operator and provider of management company services.
“From our perspective, 2018 is proving to be a strong year. We had already surpassed 2017’s full-year asset raising targets by the end of Q2,” says Richard Day, Partner and COO, ML Capital.
The ML Capital Group oversees in excess of USD7 billion in total AUM and has evolved into one of the industry’s leading names in European fund structuring and distribution.
Even if 2018 turns out to be a flat year for alternative UCITS, it is hard to argue against just how far the space has come in the last decade. Granted it is still largely dominated by equity and fixed income-related strategies that fit easily within the confines of the UCITS rules, but there is now a far wider array of strategies, some of which are quite complex UCITS funds, such as multi-factor UCITS, CLO-related UCITS, credit long/short UCITS and so on.
“We have seen a shift in investor appetite in response to changes in the market,” remarks Philip Lovegrove, Partner in law firm Matheson’s Asset Management Department. “A decade ago, we would have worked on many more funds taking significant commodity exposure through UCITS-eligible indices but there hasn’t been a push to make those products available, given how commodity markets have fared in the last few years. The fixed income space has become more active and multi-factor strategies have proven popular as people find new ways to extract value out of equity markets.
“I think once managers get into the UCITS space, put in the initial expenditure, get comfortable operating in that space and understand from a distribution perspective what the potential is, they will continue to launch products. For institutional investors, it’s just much easier for them to complete their due diligence on UCITS than it is for an offshore hedge fund. We find that a large majority of UCITS are sold to institutional investors, although they are manufactured in compliance with retail investor standards. This makes life a lot easier for fund managers when it comes to marketing UCITS.”
Ongoing complexity of product universe
This point about alternative UCITS largely being sold to institutional investors is interesting because the automatic response to UCITS is retail. This is true of traditional long-only products, but not alternatives and in some ways the regulators probably didn’t anticipate so much complexity being introduced into this carefully constructed regulated fund regime; one that has investor protection at its heart.
“UCITS is ultimately a regulatory framework that is designed with retail investors in mind,” says Reutter. “In the alternatives space it is however used predominately by institutional clients. It is this intersection that causes issues, and regulators have a difficult time getting the balance right.
“It is not only the definition of eligible assets that should be considered, but there should be enhanced focus on the liquidity of the underlying instruments, including those behind swap structures.”
One such complex product is alternative risk premia products, which use sophisticated factor models to build a vast array of index products, ETFs, and of course alternative UCITS products.
“We certainly see a lot of them, it has been a clear trend over the last three to five years,” affirms Lovegrove. “Some are multi-asset, some are multi-factor.”
Setting up one of these funds is not necessarily straightforward for those coming from a hedge fund background where the levels of disclosure in their offering documents and regulatory rules that they need to comply with are significantly lower than in the UCITS space.
“That can challenge us as lawyers in terms of understanding the strategy when preparing the offering documents. Local regulators, such as the CBI, require detailed disclosures in terms of the descriptions of the product, the assets, the levels of risk and so on, all have to have be described to a standard that is understandable by a retail investor.
“It can be done, and in a manner that is appropriate for a UCITS product, and we feel comfortable that ARP strategies meet the regulatory requirements. What becomes a further challenge for the manager is how such strategies are going to be sold: who will they be targeting? I think there is an understanding that these products may not always be suitable for broad distribution to retail investors, but that certainly shouldn’t preclude them from being set up as UCITS.”
Establish a clear risk framework
At ML Capital, Richard Day expands on the liquidity point made earlier by Reutter. He says that there are certain alternative fixed income strategies, for example, that simply don’t fit within UCITS because of the need to match underlying liquidity of the strategy with that offered to investors, at all points of the investment cycle.
“People come to us and ask if a particular strategy will fit in a UCITS wrapper. Our Risk Solutions team will help guide managers on the rules and constraints that UCITS places on an investment strategy and ultimately assess its suitability for UCITS,” says Day.
Ultimately, when someone is thinking of launching a less liquid strategy, they should have a clear risk framework around the underlying portfolio to meet liquidity terms offered to investors in a worst-case scenario.
This is something that ML Capital has most recently helped Highland Capital with. The big US CLO fund manager operates the Highland Flexible Income UCITS Fund on MontLake UCITS. It invests in US and European structured products through a combination of fundamental security analysis and dynamic allocation across ratings categories. Understanding the liquidity aspects of safely operating a CLO UCITS fund was integral at the pre-launch phase.
Diversified products for different markets
Goldman Sachs Fund Solutions has a comprehensive platform solution that straddles alternative risk premia products and more traditional hedge fund strategies. The platform provides investors with access to unique internal strategies via regulated funds (UCITS and AIFMD-compliant funds), unregulated funds, as well as managed accounts. In addition, it offers investors access to carefully selected external alternative fund managers; referred to specifically as the Third Party Managed (UCITS) Platform.
The Goldman Sachs’ team can launch either passive risk premia products or work with asset managers to provide solutions where they selectively pick Goldman Sachs’ risk premia products and manage them on an active basis.
A good example of this is Aberdeen, who are managing a portfolio of risk factors in two funds with different volatility levels on the platform.
“We have a team who develop indices and systematic trading strategies and sit within the Securities Division. We are not a fiduciary so the way we deploy those strategies in funds is either through a passive fund structure, which tracks a strategy or a portfolio of strategies and automatically rebalances, or by working with an external asset manager to allow them to build bespoke portfolio solutions using our menu of indices,” outlines Camilla Haux, Executive Director at Goldman Sachs.
Ben O’Bryan is Executive Director and Head of Fund Solutions, Goldman Sachs. He says that “alternative risk premia strategies and alternative UCITS are viewed with equal importance”.
“It is important to offer clients a diversified range of products for their different needs and for different points in the market cycle so we do not emphasise one platform over another. Some clients are looking at and investing in both whereas some are only investing in hedge fund UCITS because they feel they are not yet ready to invest in alternative risk premia, or vice-versa.
“This funds platform within the Securities Division at Goldman Sachs is an important part of our business mix. We want to make sure we remain cutting edge not just as a platform provider but also in terms of the way the products are developed and structured.”
The platform choice conundrum
One of the key considerations for institutional investors is determining how best to access alternative UCITS funds. There are plenty of good platform choices in the marketplace but what are the criteria to consider before allocating to funds on one platform versus another?
“I think the first consideration should be, ‘Is this a platform with a robust infrastructure and risk management, compliance and due diligence framework’? suggests Andrew Dreaneen, Head of Liquid Alternatives, Schroders. “Secondly, does the platform have managers that the investor wants to invest in? In some cases you may like the manager and not the platform and vice-versa.”
On the margins some platforms have restructured and retreated, while some new platforms have emerged. Indeed, bank-owned platforms such as those operated by Merrill Lynch and Morgan Stanley, have vacated the space.
Asset managers such as Lyxor have a different philosophy to banks, as they invest in the funds they launch, alongside their investors. “We have all of the set-up in place in terms of legal, compliance, financial engineering, risk and distribution to serve the needs of investors and satisfy the regulators, without any type of conflict of interest,” says Bousarsar.
“The platforms you see on the prime brokerage side were very successful but they have reached a difficult time where they need to make a decision. They need to meet a lot more regulatory requirements (including MiFID II) and they need to operate completely separate from the PB business, which includes investing in more people, systems and technology to get in line with what regulators are looking for.
“I think it has become very challenging for some banks to continue operating that business model because the level of investment in people and infrastructure to be made presents a high barrier for them to continue. Some would prefer to focus on running their profitable prime brokerage business and work with managers in that capacity, rather than run platform and distribution services.”
If funds on bank platforms were to self-launch or move to another platform and grow to USD1 billion, for example, and still use the bank’s prime brokerage service, then that’s still a very healthy commercial relationship they can have with alternative UCITS fund managers.
“Perhaps some banks are realising they can still be just as close to these hedge fund managers even if they launch their fund on other platforms; particularly independent platforms that use an open architecture, which gives managers flexibility as to the service providers they use.
“The fact we’ve seen a number of banks retreat at the same time is intriguing, part of the rationale may relate to the increased costs and complexities of operating an asset manager within an investment bank and a focus on more core business lines. As the alternative UCITS industry has matured banks no longer need to operate these platforms as a defence mechanism given they can still provide structuring and prime brokerage services to most fund managers without needing to provide the actual UCITS platform,” suggests Dreaneen.
In the current environment, the complexities of running a UCITS platform business have arguably risen in response to increased regulation. Going forward, even if there are fewer bank-owned platforms for investors – and indeed fund managers – to consider, these institutions will still participate in the growth of the alternative UCITS industry through their prime brokerage arms, offering swap contracts and bespoke solutions rather than necessarily having to host managers on a platform.
Platform ecosystem continues to support managers
For fund managers wishing to break in to the alternative UCITS space, one of the key questions they should ask themselves, in relation to platforms, is: ‘Do I launch my own standalone fund, or do I set up a sub-fund on a platform?’ The answer to this will largely depend on scale. How much does the manager genuinely think they will raise in assets? If they are a small manager with fewer resources, who expects to raise a modest amount of assets, then the platform solution is a faster, more cost-effective way to get a UCITS fund to market.
“If, on the other hand, you have sufficient scale yourself as a fund manager to put in place compliance and manager oversight resources as a standalone UCITS ManCo or self-managed investment fund, or you have good expectations for the product, you might lean towards setting up your own standalone fund because over time, a product might have sufficient AUM such that paying for a third party platform service may not be the best option for that fund.
“It is also possible for managers to transfer products which have been set up on third party platforms to become their own standalone funds. I think that platform providers understand this are generally happy to facilitate it – they have an appreciation that their platform services may not fit everybody over time and they can frequently continue to support managers who set up a standalone fund by other means,” explains Lovegrove.
UCITS ManCos have done a very good job of providing an easy access point into Europe for managers who would not ordinarily have been able to do so on their own, given the costs involved.
It can be an expensive undertaking and there is a lot of knowledge involved in establishing a UCITS fund; a lot of registered requirements to meet, rules to understand. By using a plug-and-play model, a fund manager does not need to know the complexities of the local market.
Ultimately though, it will depend on the manager’s own individual expectations of having a UCITS product as to how they use a platform over time.
“Some managers with funds on MontLake UCITS want to partner with us on a broader basis,” explains Day, in relation to active distribution support.
“In these instances we are more than happy to talk with them because they are a known quantity to us and we are always looking for new high quality funds to introduce to our investor base. This concept of just running around distributing third party funds we have no fiduciary role over is not something we want to do, or ever have done. But people do need help and we feel we are well placed to support them with our 6 person strong distribution team.”
At Schroders, Dreaneen and his team are speaking to hedge fund managers of all sizes across a variety of investment strategies to seek out the best propositions for its client base. As is the case with ML Capital, Lyxor and Goldman Sachs, the approach is highly targeted and discerning. It is about building quality not quantity. These platforms want total confidence that the managers they work with will succeed, both in terms of performance and fund raising.
This could make it more challenging, going forward, for managers to get on to third party platforms but one way that Schroders has tweaked its value proposition is to launch the GAIA II platform to support AIFMD-compliant funds, alongside its GAIA platform for UCITS-compliant funds.
“There are questions as to whether there should be more harmonisation between UCITS and AIFMD and our view is that UCITS works very well, it is a gold standard and we are not advocating change. Under AIFMD, however, there is full flexibility to structure funds as this is manager-focused, not product-focused regulation.
“Therefore, having an AIF platform alongside our UCITS platform gives us the ability to create all types of hedge fund strategies.
“Another part of the rationale behind launching the GAIA II platform was that if there was a correlation in the more liquid end of the market when the next market downturn happens, then investors may want to look beyond UCITS to harvest returns from certain strategies which may be concentrated, highly levered or less liquid and therefore unsuitable for UCITS (there has been a 1.4 per cent per annum give-up between investing in UCITS versus the average hedge fund over the past 10 years) they might look to increase their allocation to AIFs. Not to say they would turn their backs on UCITS altogether, but perhaps look to rotate a portion of their alternatives allocation into AIFs,” explains Dreaneen.
There is already one AIFMD-compliant fund on GAIA II and over time, more will be added. Thereby giving Schroders the ability to respond to the supply/demand dynamics as investors look for more sophisticated, customised ways to access ‘liquid alternatives’; including AIFs as well as alternative UCITS. ML Capital and Lyxor both also offer AIF platform solutions.
Reutter offers the following concluding thought on what may lie ahead for the alternative UCITS marketplace: “We continue to believe that alternatives play an important role in investor portfolios, especially in times of heightened uncertainty.
“Alternative UCITS has established itself as the premier access point for both managers and investors and allows for strategies to be offered in regulated and liquid format. This has to be a good thing for investors, and as such we believe the sector will continue to grow.”
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