Against that backdrop UCITS Hedge Contributing Editor, Nathan Peters, sought the perspective of one of the leading and most active UCITS alternative fund platforms, Bank of America Merrill Lynch (“BAML”). What follows is an interview with Paul Holmes, BAML’s Head of UK and Ireland Sales, on the subject of the development, use and prospects for UCITS hedge funds.
Q: Having launched six funds across the strategy spectrum, including one of the few event-driven managers in the space, how have you overcome some of the implementation challenges, such as liquidity? Also, what is BAML’s approach to the structuring aspect of the UCITS wrapper?
A: Fundamentally we believe in building portfolios that are UCITS-compliant from the bottom-up. That is to say we work closely with hedge fund managers so they understand what can, and cannot, be replicated in a UCITS fund. This is a detailed and time consuming process, but one we feel is critical. Alternative approaches such as managed accounts, index creation and total return swaps appear to be within the letter of the UCITS rules, but are approaches that we have avoided for a variety of reasons.
An initial reaction from many potential investors new to the UCITS-regulated hedge fund space is that investment performance must necessarily be inferior to that of the offshore equivalent – a trade-off for enhanced liquidity, if you will. While that may be the case for some strategies, it often surprises clients how many strategies and funds can be replicated in a UCITS format with little deviation from the offshore fund’s investment approach. Equity Long-Short, Equity Market-Neutral, CTA, FX, (some) Discretionary Macro can almost always be structured in a UCITS-compliant way, with the enhanced liquidity levels associated with UCITS funds and with little impact on the characteristics of the investment style.
For other strategies, the liquidity constraints do make it more complex, but the question we need to ask before launching any fund is: can the manager deliver the fundamental character of their investment DNA within the UCITS constraints? With York Capital, the answer was very firmly yes. The way that they manage money in their offshore funds is actually very consistent with the UCITS guidelines. For example, they historically operate highly diversified portfolios, place a premium on liquidity, and operate little leverage. The credit exposure was necessarily more constrained in the UCITS fund, but the Event-Equity and Risk Arbitrage components of the fund are very closely matched.
Q: What has been the take up and feedback on the investor side? What have investors expressed as their primary reason for investing in a UCITS vehicle and what are the characteristics of the typical BAML UCITS investor?
A: There is no one single reason why our clients are investing in UCITS-regulated hedge funds, just as there is no one dominant type of investor across our client base. Clearly post-Madoff the regulated structure is important, but my sense is that enhanced liquidity is perhaps the biggest draw, alongside the often favourable tax and regulatory treatment of passported UCITS funds versus their offshore equivalents.
In terms of investor type – we have a very diverse group. Some of the traditional funds of hedge funds are looking at UCITS as a means to improve the liquidity profile of their offshore product; the traditional long-biased multi-managers can finally access less directional strategies in a format that their typically onshore fund vehicles can access. Funds of UCITS funds are being established, and while it is early days from an asset gathering point of view they are an obvious market for us. The private banks – having suffered from the volatility in listed hedge funds – see the tax and regulatory advantages inherent in a UCITS structure versus the offshore equivalent as hugely attractive, and in many cases prefer the open-ended nature of UCITS to the closed-ended structures they may previously have used. In some countries, there are significant benefits for insurance companies holding their capital in regulated structures such as UCITS rather than offshore vehicles – and we have seen large inflows from this market. And finally, the retail platforms offer a highly diversifying outlet for us.
Q: You have offered investors access to periodic manager conference calls covering strategy and performance reviews, including time for investor Q&A. Are there any constraints to the information you are able to provide in these calls, whether at the request of the manager or for regulatory reasons?
A: UCITS-regulated hedge funds certainly deliver enhanced transparency to investors, but some sensitivity remains when managers are discussing specific trades (especially on the short side) with a wider audience. We certainly don’t want to find ourselves in the position where disseminating certain position-level information ends up hurting the performance of the fund for our existing investors. Having said that, we are always looking to maximise transparency, including regular investor calls with the portfolio managers.
Q: What are your ambitions in the space? You have announced that you plan an additional four UCITS fund launches in the coming months – will you continue to expand your strategy offering? How would you characterize the interest from US hedge funds?
A: Our UCITS platform is a key EMEA initiative for Bank of America Merrill Lynch. We believe that we are at the forefront of this new chapter in the history of the hedge fund industry, and it is our intention to remain a prominent player. In the short-term, we are looking to launch several more funds in the next few months, bringing certain strategies to the UCITS arena for the first time. We perform due diligence on a wide range of managers and are always looking to select what we believe to be genuinely world-class managers in their given strategy space. That approach will be a constant as we grow the number of funds on our platform.
In terms of US managers’ interest in UCITS, I would say it has changed significantly in the last 12 months. To be frank, up to that point it just hadn’t registered on the radar of most managers. Since then a few things have changed. The assets raised in this space in a very short space of time has clearly caught their attention; they have seen one of their major US peers – York Capital – raise assets and buy-in to the whole UCITS approach; and finally I think there is a realisation that this not only offers access to a new pool of assets within onshore Europe, but has the potential to redefine the broader hedge fund landscape. The European based managers were first to the table of course, but I suspect that through platforms like ours, the very best US managers will soon catch up. The draft EU AI Directive has also given a context and immediacy to some of these discussions.
As a personal investor in UCITS-regulated hedge funds I welcome the greater attention being paid to UCITS by the hedge fund community. I want to be able to offer clients the best investment strategies I can, regardless of where those ideas come from. Ultimately UCITS is a hugely democratising influence for European investors.
Q: How large do you believe the market for UCITS-regulated hedge funds is?
A: UCITS-regulated hedge funds will of course never fully replace their offshore cousins. There are many strategies that just don’t work within the constraints imposed by the UCITS format; and others where the manager is not willing to address the investment or operational constraints that UCITS may require of them. Having said that, I consider the emergence of UCITS hedge funds to be analogous to that of ETFs in the long-only space a decade before. Both then, as now, a significant sub-set of an established asset class was created from nothing in direct response to investor demands. UCITS hedge funds are reaching out directly to investors who, post-2008, are looking for actively managed flexible trading strategies, in a liquid, regulated and transparent format.
Q: How big could this become?
A: Frankly, who knows? What I do know is that the current long-only UCITS universe has around $7 trillion in assets under management. If we assume a relatively modest 5% move in the next couple of years toward hedge fund strategies this could become a $350 billion market in the not too distant future. If you add to that the likely increased demand from clients for genuinely un-correlated returns you could find in 10 years that the UCITS-regulated hedge fund space is as important, if not more so, than the offshore space.
Q: What is BAML’s policy on registration of UCITS hedge funds within various countries in terms of what is required for true cross-border UCITS hedge funds to become available?
A: Despite the attempts of various UCITS-related EU legislation over the years, I think it is fair to say that we are still some way from achieving a single-unified investment market place in Europe. It is perhaps one of the bigger surprises for hedge fund managers when we first start talking to them – but is an issue that traditional asset managers have had to deal with for many years. UCITS IV should go some way to helping level the playing field and make the lives of all cross-boarder investment managers that little bit easier. In terms of our policy it is fairly straightforward; we operate a number of Luxembourg/Dublin SICAVs and passport our funds widely across Europe and elsewhere. We are not particularly focused toward the retail side of the market but any hedge fund manager believing that UCITS offers an open-access panacea to the European market place should probably reign in their excitement a little.
Q: What is BAML’s approach to marketing UCITS hedge funds? Can we expect the type of advertising usually associated with traditional fund management groups?
A: Our focus is very firmly toward the professional investor end of the market. Having said that, as the UCITS hedge fund space is likely to grow exponentially in the coming years, it is going to become a very crowded, noisy and fragmented market very, very quickly. Our approach of appointing only the very highest quality third party managers is clearly a help in being visible and retaining client interest, and coupled with our excellent global distribution capabilities, I think we are coming at this from a position of strength.
It is a challenge oft faced by the long-only asset management industry, but I would much rather our managers were focused on running their portfolios to maximise risk-adjusted returns for our clients, than spending all their time on marketing roadshows. Getting the balance right will be important as hedge fund managers encounter the retail space for the first time. Indeed, one of the biggest challenges that we face as an industry is ensuring that just because we have the tools – in UCITS – available to access the retail client market in Europe, that we do this in a thoughtful and open way. The mass-marketing of certain potentially highly complex, volatile strategies in a UCITS format, especially under any label with the words “absolute return” in it, should make us all stop and think of the potential consequences.
Q: What do you believe are the determining factors that would lead a hedge fund to choose BAML as a distribution partner for their UCITS products?
A: We launched our first UCITS-regulated hedge fund back in 2007 and now have more than $1.3 billion in assets under management. As a result, hedge funds come to us because we have the experience, the detailed technical understanding of how to structure funds in a UCITS format, and an unrivalled global distribution capability that has only been enhanced since the Bank of America purchase of Merrill Lynch. The feedback from our managers and our clients has been very positive – long may that continue.
