It is very difficult to assess the percentage of strategies replicable within the UCITS structure. If we talk about the number of strategies it is 70%, but weight by assets, and 90% of strategies can be replicated under the UCITS format.
It is key to understand that apart from a few strategies, like investment in very illiquid securities or pure short selling where it is very difficult to respect the counterparty risk ratio, most hedge fund strategies under a legal offshore structure (Cayman, BVI…) can be replicated within a UCITS format.
We estimate the total of hedge funds under administration at $1.4 trillion as at end of Q1 2010. By applying a broad definition of the UCITS absolute return strategy, we can come up with a figure of $120 billion of UCITS funds under administration equally split between direct replication (Newcits) and synthetic replication (structured funds).
In both direct and synthetic replication, the key differentiator for UCITS funds versus Cayman funds is the use of OTC derivatives.
Direct replication consists of replicating an offshore hedge fund strategy in a UCITS fund by replacing short positions in stocks usually covered by securities borrowing by OTC derivatives, namely contracts for difference (CFD) or equity swaps: a long/short equity manager can make use of equity swaps or CFDs to take long and short positions on stocks and bonds.
Synthetic replication: After having defined an index, for instance on a managed account, a basket of commodities, the fund enters into a total return swap with an investment bank to receive the performance of the index and pay the cost of funding.
The choice between synthetic replication versus direct replication is driven by the features of the underlying strategy and the compliance with UCITS requirements. Some strategies are not replicable directly due to the constraints of leverage or the usage of non-compliant instruments. For example, a UCITS fund cannot invest directly into commodities but can instead employ a synthetic derivative using a total return swap (TRS) that replicates the performance of a managed account investing in commodities, the performance of the TRS being the value of the index representing the managed account performance.
Key requirements for UCITS absolute return funds
Understanding of the legal framework
It takes time to appreciate the UCITS legal framework, and hedge fund managers need to understand what is involved in moving a Cayman fund to an Irish or Luxembourg fund. Everything is linked to regulation, the UCITS directive and finding the best way to fit the Cayman model into a UCITS one.
We know that some asset managers attracted by the UCITS vehicle are bringing more illiquid, complicated strategies to the table, for example funds specialising in mortgage-backed securities or those using a high level of leverage.
Relying on a robust front-to-back OTC derivatives platform
OTC derivatives platforms for structuring and execution are proposed by investment banks and prime brokers. Custodians and fund administrators are connected to these platforms and offer settlement, repository, and valuation services. At the asset manager level, you need to have the organisational capability to handle the requirements of OTC derivatives and to interact with these platforms.
The fund administrator needs to understand all types of OTC contracts that enable the replication of hedge fund strategies within the UCITS framework, and additionally, being capable of providing a suite of middle office services geared towards the requirements of OTC derivatives: trade settlement, repository, independent valuation and collateral management.
Finally, understanding the collateral management mechanisms that exist between the prime broker, the fund and the custodian, helps all involved participate towards the overall safety of the UCITS structure.
Distribution capacities
To take advantage of the distribution opportunities that come with UCITS, a platform partner with good distribution capabilities is necessary to take care of everything around share class and shareholder services.
Operational risk in UCITS vs Cayman funds
Handling OTC derivatives
On the market for more than 10 years now and used for direct replication, equity swaps and CFDs allow the fund to receive or sell the performance of a specific equity or a portfolio of stocks forming the underlying without purchasing or selling them directly.
These are complicated and non-standard products as rules such as reset, cost of funding calculation, and corporate action handling differ from one prime broker to another. For instance, on corporate actions, custody systems have to handle the calculations and management of dividends and splits even though the custodians do not physically hold the stocks in their books. Another example is managing the volume of transactions for statistical arbitrage hedge funds, where the underlying assets must be created in advance in trading and back-office systems to maintain an automated flow.
Several years ago, anytime the volume of transactions was too difficult to handle on manual and ad hoc systems, administrators used to take the short cut in managing CFDs by only taking the prime broker’s P&L and having one accounting entry for the total of all the detailed P&L on each individual trade.
This technique is not authorised in UCITS funds, where you need to account for positions on a line-by-line basis independently of the prime broker. All fund administrators will now have to develop systems that can account for equity swaps or CFDs.
Collateral management
UCITS funds cannot have counterparty risk above 10%. The amount of cash or securities you transfer to your prime broker should not induce a credit exposure superior to 10%. In practice, this ratio is not easy to monitor as the cash or securities transfer may be explained by changes in the mark to market of the fund, margin call on the book of OTC derivatives positions, or to an additional cushion that the prime brokers ask on the initial deposit (deposit call). For instance, in a more volatile market, prime brokers will ask for an additional cushion/protection against adverse MTM variations by requiring more on deposit, even if the position of the hedge fund manager has not changed. In practice, all prime brokers don’t always separate their reports between margin call and deposit call, rendering the credit exposure monitoring and collateral management process more complicated. Because it is a relatively low ratio (10%), most of the time funds will face daily margin or deposit calls. A process will need to be established between the asset manager, the custodian and the prime broker (or multiple prime brokers if the fund manager is seeking to reduce counterparty risk significantly). Be under no illusions that this will be complicated. It has to be a step-by-step process. You have to reconcile all your positions with the prime brokers. Then you have to independently value all these positions and then, with a very quick turnaround of between four and six hours, you have to agree the collateral management valuation with the various investment banks involved before processing the margin call.
Reconciliation process
This is more of a reconciliation risk for hedge funds with strategies which have a high volume of transactions. Due to the fact that these are OTC derivative positions, you do not have a single universally-accepted nomenclature for the codes. Someone has to be in a position to make this reconciliation at the fund level, the prime broker level, and the administrator and custodian level. Compared to a Cayman offshore model, where you have a prime broker overseeing all the assets, a UCITS model is a little more complicated as more actors are involved in the process. Most of the time the custodian has the segregated assets, the counterparty, namely the prime broker or the investment bank, has some assets, leaving the fund manager to reconcile the portfolio against both the prime broker and the custodian.
Synthetic replication
Herewith a short description of the first generation of synthetic replication within UCITS. We have seen more efficient and flexible structures with the funded swap model but ultimately mechanisms and objectives stay the same.
At the beginning, with the cash of the fund unit holders, the fund manager will start purchasing a portfolio of bonds and/or stocks. Then, he will pay the performance and will receive the cost of funding, and with the cost of funding obtain the final return that might be a pay-off on an OTC option, the performance of a managed account or a specific index. Where it starts to get complicated is when you move away from this plain vanilla transaction to more imaginative choices. Banks and fund managers like to launch such products with a very quick turnaround. Consequently fund administrators have to get used to analysing and understanding term sheets in a very short period of time. This is why we have set up a Paris-based team tasked with analysing the complexities inherent in the replication of hedge fund strategies, with all the operational processes (valuations, OTC derivatives processing, collateral management) being centralised in Luxembourg for Irish, Luxembourg, OEIC funds, etc.
Difficulties still exist concerning the valuation of OTC derivatives, despite their widespread use over the past 10 years. Administrators have made significant progress in being able to value a vast majority of OTC derivatives like interest rate swaps and credit default swaps. But with volatility-based strategies such as variance swaps or more complex contracts used by credit arbitrage hedge funds and emerging markets strategies, there are still difficulties in the valuation process, particularly with illiquid positions.
Importantly for UCITS hedge funds, you need to have two sources of valuation for the OTC derivatives in your portfolio. This is a huge difference to the offshore model, where, if it is indicated in your prospectus, the asset manager can be the only provider of the valuation of OTC derivatives in their portfolio. In UCITS, the valuation either has to come from the asset manager and the investment bank, or in the more common case, the valuation comes from the investment bank and from the administrator. As an administrator servicing many UCITS funds, we have developed in-house OTC derivative valuation capabilities relying on robust vendor systems used by investment banks.
Will UCITS reduce operational risk?
All this raises the question: is this additional layer of complexity and risk worth it? Is it worth accepting this replication of Cayman hedge funds under UCITS structures? We can not provide definitive answers yet, but we know that some believe (and lobby) that at some point there will be a problem with one or several UCITS hedge funds due to the added complexity that is being introduced and that it will jeopardise the UCITS label for the entire fund industry. It is fair to highlight the risk that this added complexity brings to the UCITS universe. However, if we look at the overall hedge fund industry, are we improving the level of security and reducing the level of operational risk by progressively moving from the offshore Cayman or BVI structure to UCITS? If you look at the different risks in a UCITS fund compared to a Cayman hedge fund due to the level of regulation, as well as the fact that you have more actors involved, responsible and accountable for the overall process of controls, most of the time the balance is in favour of the UCITS funds, meaning that individually and collectively the operational risk is lower under a UCITS banner. Where we add some complexity and potentially some operational risk, compared with the Cayman model, is with the OTC derivatives replication process.
With Cayman hedge funds it is pretty simple – all the assets are at the level of the prime brokers who have well-defined systems for daily monitoring of the portfolio P&L. The usage of derivatives at the prime broker level for such funds is limited to a few strategies, specifically those using credit default swaps or other swaps. Here you have a fundamental switch with the UCITS universe where operational risk is heavily linked to OTC derivatives but at the price of needing to have all the actors in the chain being capable of handling these OTC instruments.
The good news is that UCITS should mark the end of ‘lite’ net asset value, where fund administrators dealing with complicated strategies or strategy replication directly take a P&L from the investment bank rather than recalculate, leading to a poor system of controls and reconciliation with the absence of the ‘four eyes’ principles.
The UCITS model represents a significant reduction in counterparty risk. This is limited to 10%, thereby representing a good way to limit investor risk and systemic risk. The same goes for liquidity: UCITS funds need to have bi-monthly liquidity, but if they want to convince investors they will need to provide it at least weekly. This is not something optional.
Ensuring that the hedge fund manager can apply his strategy under the UCITS banner by respecting all the regulatory ratios permanently is fundamental to the initial set-up, as not only the fund manager but also the board of directors of the funds and the custodian or the trustee, depending on jurisdiction, are jointly responsible for monitoring and ensuring that the fund is compliant with the regulation.
Olivier Laurent joined RBC Dexia in 2004 as Head of the Hedge and Structured Funds team, in charge of the development and implementation of solutions for hedge funds, FoHFs and OTC derivatives products. Prior to this he spent two years analysing structured credit operations for IXIS in New York.
