Highlights fromInfovest21’s July Issue of Investor Focus: UCITS funds of funds – a game-changer?

UCITS has been a game-changer in the alternatives space, observes Thanos Ballos of Strategic Investments Group. The firm launched the Active Trading Fund with the Permal Group.

The UCITS III hedge fund industry has grown with lightning speed from about nothing 18 months ago to over 500 UCITS hedge funds today with the pace of expansion accelerating. Estimates are that assets in hedge fund UCITS are about $45-55 billion while Eurekahedge puts assets even higher, closer to $100 billion with close to over 990 funds.

Eurekahedge says UCITS hedge funds account for 7% of total hedge fund assets but attracted 20% of the net inflows in 2010.

UCITS III funds comply with the European Union directive. The acronym stands for Undertakings for Collective Investment in Transferable Securities

The UCITS structure sits very well with institutional portfolios, observes Ballos. “Institutional and family offices investors wanted a regulated, liquid, multi-advisor fund, offered within the UCITS framework, with the added safety of independent risk controls.”

Philippe Dupuy of Alternative Advisors agrees. “UCITS funds offer investors an investment vehicle that satisfies almost all expectations and requirements they’ve been fighting for and struggling to get from offshore unregulated funds - liquidity and transparency.”

The liquidity aspect allows institutional investors to better time their investments according to their macro views, allowing them to tactically allocate.

Dupuy says the nature of the underlying investment is, by definition, more liquid because of strict rules about gating or side-pockets. “Note that side pockets are not allowed in France, allowed only for daily funds in the UK, and negotiated on a case-by-case basis in Luxembourg. In a liquidity crisis, we will get out, though probably not as quickly as anticipated, as gates can be imposed on UCITS funds.”

Bi-monthly liquidity is the minimum requirement but the majority of funds have daily or weekly liquidity.

Chris Rule of Key Asset Management observes that equity long/short is the most developed strategy within the UCITS world. Less liquid strategies such as distressed investing are absent from the UCITS III hedge fund universe and are likely to remain so.

Caution required
Despite the advantages, industry veterans caution investors when looking at new UCITS funds and at UCITS wrapped hedge fund strategies. Not all hedge funds are suitable for the structure. The underlying fund needs to be liquid. Equity long/short and managed futures can fit in a UCITS structure easily while distressed and fixed income arbitrage don’t easily fit.

“Some managers are just surfing the Newcits wave and launching a UCITS even though their core strategy is not transferable, thus moving away from their core competencies,” says Dupuy.

Some strategies are “shoe horned” into a UCITS structure that may not fit well. If so, investor may be buying products that are riskier than they thought. UCITS funds promise liquidity which make it reassuring for investors. A major concern is that the liquidity of some underlying investments may not be sufficient to allow UCITS funds to provide daily liquidity.

A liquidity mismatch may exist between the instruments they invest in and the liquidity they offer investors,” says Dupuy.

Others point out that some managers will change their strategies i.e. reduce leverage or invest in more liquid assets to fit into the UCITS structure.

They argue that negative selection bias exists. Managers who can’t attract assets themselves may rely on big demand for UCITS III funds to attract investors.

Another danger is attracting institutional investors into a retail product as both groups have different objectives. When institutional investors redeem their large investments, it could move prices and hurt smaller retail investors.

Some critics point out that few UCITS hedge funds are larger than $25 million.

Critics also point out that UCITS III hedge funds often underperform hedge funds because of higher fees. UCITS funds tend to have lower margins because of higher operating costs and distribution costs. Operational requirements are higher as daily net asset values are needed rather than monthly.

Eurekahedge statistics show traditional hedge funds outperformed UCITS III hedge funds over the past three years. This is because traditional hedge funds use leverage. Furthermore, event driven and distressed debt that performed well in 2009 are not largely represented in UCITS III funds.

Eurekahedge statistics also show that UCITS III hedge funds performed better than funds of funds.

Argument for UCITS III funds of funds
The argument for the UCITS fund of funds approach is that because there are so many alternative funds either in UCITS, or looking at UCITS, it is difficult to sort out the good from the bad. That makes a very strong case for the multi-advisor fund approach, adds Ballos. The fund of funds as the investment manager is responsible for manager selection, due diligence and asset allocation.

Dupuy adds that a UCITS fund of funds provides a great advantage over the traditional funds of funds. “We can truly act as best-of-breed multi-manager and turn our portfolio around very quickly; something that an offshore funds of funds could not do, having to give sometimes three months’ notice on a quarterly fund. This is valid also for institutional investors.”

“The liquidity and transparency offered by UCITS gives us a lot of flexibility in the way we can manage our portfolio. We can be more opportunistic than a traditional fund of funds would be,” adds Dupuy.

Dupuy points out that the UCITS fund allows the UCITS fund of funds manager and institutional investors the ability to closely monitor what the underlying manager does, the risk he is taking, identify where and why he is making or losing money and enables them to identify style drift, increased liquidity risk, concentration risk, etc.

Outlook
Despite the criticisms and caveats, many are very optimistic about the future of UCITS funds as well as funds of funds. The number of UCITS III funds is expected to skyrocket as tighter regulation of hedge funds occurs globally.

US managers are starting to jump aboard the UCITS trends as it is one way around EU law threatening to freeze US managers out of Europe. York Capital Management’s UCITS fund is up and running while Paulson & Co, Traxis and Peter Schoenfeld Asset Mgt are among those expected to start imminently.

Because EU law requires UCITS managers to be domiciled in the EU, some managers are taking the bank platform route with the likes of Bank of America Merrill Lynch, Deutsche Bank and Morgan Stanley.

“I am convinced that for some strategies, UCITS will replace traditional hedge funds,” Dupuy concludes.

The above is an excerpt from the current issue of Infovest21's Investor Focus which interviews:
• Thanos Ballos of Strategic Investments Group
• Omar Kodmani of the Permal Group
• Philippe Dupuy of Alternative Advisors and
• Chris Rule of Key Asset Management.

Other features include:
Sentiment Indicator: Investors
Overview of UCITS structures
UCITS Indices
Sampling of UCITS funds of funds
Sampling of UCITS platforms
Who’s Who in UCITs