UCITS and the rebirth of hedge funds

Hedge funds as a whole have struggled to perform in the last couple of years, with mediocre returns dragging down the average, despite decent returns from a few standout funds. In 2015, hedge funds delivered their worst performance in years, with the Preqin All-Strategies Hedge Fund benchmark returning just over 2%, and Preqin reports that 40% of fund managers and 33% of investors believe performance objectives were not met during 2015.
UCITS stands for Undertakings for Collective Investment in Transferable Securities. It is a fund structure developed by EU regulators in response to calls for better regulation and transparency of alternative investment managers. Funds complying with UCITS can be sold to any investor in the EU. To protect consumers, a UCITS fund can only invest in eligible assets, must follow certain risk controls, and must be liquid and open-ended. UCITS III rules expanded the range of investments in which UCITS funds could invest to include derivatives, paving the way for hedge fund-style liquid alternatives funds. Following a difficult period for many hedge funds, UCITS alternatives funds have come in to their own as attractive options for retail investors wanting access to hedge-fund style investing in a more liquid, closely regulated format.
However, the Hedge Fund Marketing Association says it is not helpful to lump every hedge fund together, because they follow a wide variety of investment strategies (with differing degrees of success). It notes that although hedge fund gains in 2015 fell “far short of investor expectations”, significant numbers of hedge funds are currently “achieving outsize gains, in many cases, doubling, tripling or even quadrupling the gains of the wider industry.” Pension funds and high net worth individuals have long relied on hedge funds to deliver outperformance and protect their capital from losses, but with many funds failing on both counts, the pace of inflows has fallen. Investors pulled a net $34bn from global hedge funds during the first half of this year, Preqin data shows, as underperformance led to two consecutive quarters of net outflows. In contrast, the growth in liquid UCITS alternatives funds has been “prolific”, according to a 2015 report by PwC and the Alternative Investment Management Association (AIMA). PwC’s survey found that 81% of firms managing UCITS funds reported rising assets under management, while 87% of US managers of liquid alternative funds said assets were rising in these strategies. “With greater transparency, a strong regulatory environment, appealing liquidity terms, often lower fees and the ability to access a range of alternative strategies, growth in liquid alternatives is unsurprising,” the report said. Morningstar reports that liquid alternative assets recorded a compound annual growth rate of 50% between 2008 to 2014, to $304bn. The number of funds grew by 226% during that time to 1,569. UCITS alternatives funds are as varied in style and strategy as hedge funds. Indeed, many offshore hedge funds have their own spin-off onshore versions packaged in a UCITS format. In today’s investment environment, investors have to cast their net wider to find alpha, and these ‘hedge fund lite’ strategies seem to fit the bill, especially as traditional hedge funds disappoint. James Calder, research director at City Asset Management, said there is enough choice now to make UCITS the best option for investors wanting to access hedge fund strategies. “UCITS is the way forward. As retail investors, we cannot buy the offshore limited liquidity vehicles without onerous and continuous suitability requirements. This does preclude us from some limited liquidity strategies such as event driven, but there is plenty of choice in equity long/short and market neutral, global macro discretionary and CTAs.” As well as the benefits of choice, investors can also take comfort in the strong, tried and tested regulatory structure that is UCITS. It aims to protect investors by preventing funds from investing in some of the more esoteric, risky and illiquid assets out there. But this benefit could also be considered a downside, with critics saying the restrictions UCITS places on the investment universe naturally limit performance. Another potential issue is that UCITS funds may also offer less diversification than hedge funds would, because they tend to be more closely correlated to equities. Cost is also a factor – hedge funds tend to have complicated, layered charging structures, and will usually charge a performance fee for delivering alpha above a certain level, although downwards pressure on fees is increasing across the industry as a whole. There is a perception that UCITS funds with a similar investment strategy will be cheaper, but this is not necessarily the case. One fund researcher I spoke to said: “The UCITS rules means the manager usually has to operate with a restricted opportunity set and therefore has reduced alpha potential, but they still charge hedge fund-like fees. Maybe retail investors are being conned into believing they are accessing some hot investment talent.” There is also ongoing debate about whether the risks of these funds are properly understood by retail investors. If they go bad, and losses end up being significant even in funds investors thought were ‘safe’, the industry’s reputation could suffer. But whatever their flaws, UCITS alternative funds can be a useful addition to portfolios, and they are certainly here to stay, with many more set to come to market in future. Half of UK respondents to PwC’s survey said they were planning to launch one in 2015-16, compared to nearly a third of the US firms surveyed. PwC predicts the demand for liquid alternative mutual funds will surge from $260bn at the end of 2013 to around $664bn by 2020. Firms will need to make sure they have skilled portfolio managers, plus the operational and marketing expertise to meet retail demand for UCITS hedge funds, while keeping a close eye on performance and profitability.

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