Perhaps the most surprising foray into UCITS territory has been the adoption of the European regulations by some hedge funds. This has, naturally, raised a few eyebrows among industry watchers, since working within the UCITS III framework appears to be the diametric opposite of the traditional way of doing business behind the brass-plated doors of Mayfair. Nonetheless, a number of firms regard the UCITS III fund as an ideal vehicle for attracting more conservative institutional investors, or rather re-attracting those made jittery by the credit crunch.
However, there remains a marked reluctance among pension funds and the like to invest in these new funds despite relatively strong performance. Hedge funds are therefore looking to restructure their offerings and take a new approach.
Hedge funds take conservative approach
Historically some hedge funds have taken an unnecessarily conservative approach to UCITS in terms of investment compliance around legal ratios and limit calculations often on the advice of auditors. The example of guaranteed issuers illustrates the point. In these circumstances, there is a 35/30/6 split ratio which can go up to 35% into any guaranteed issuer. If both sides are at 35, it can go then go up to 100%, provided that there is no more than 30% per issue and a minimum of six instruments per issuer. But if there are two issuers above 35, there needs to be 12 instruments. The conservative approach says there has to be six within each issuer, whereas for some hedge funds, it is possible to mix and match the guaranteed instrument in the portfolio: ten and two or eight and four, for example.
The same applies to defining standard transferrable securities. Instead of netting two or more positions when measuring exposure or the mark-to-market value, the more conservative approach is to sum the absolute values. While this may work for the commitment ratio, for standard transferrable securities it creates too many breaches for compliance officers.
Given the conservative nature of the target investor, taking a cautious approach could well be essential. But as the regulations move on, it is important to take a more creative approach, which can act as a means of differentiation and a way of overcoming investor reluctance. It also has the added benefit of not completely alienating the more typical hedge fund client. Technology can help here. Not only by providing the necessary tools to ensure compliance with UCITS guidelines, but by providing transparency to prospective investors.
Early days for UCITS engagement
These are still relatively early days for hedge funds’ engagement with the UCITS III regulations. But it is an indication of how far UCITS is being adopted in areas that have traditionally shied away from such client offerings and measurement techniques. The areas covered by UCITS III sit well with the current investment climate. Nonetheless, the CESR committee is not resting on its laurels. July sees the launch of the sixth section of UCITS IV, which will look at the area broadly covered by the term ‘risk management’, particularly in the field of OTC instruments, and will require a new level of detail in the commitment ratio and for OTC counterparty exposure. This new chapter will provide its own new set of hurdles for fund providers. Although not necessarily challenging for the more sophisticated compliance and portfolio analysis platforms, there are one or two potential enhancements that could provide an interesting business problem to overcome.
With regards to OTC counterparty exposure, CESR recommends that stock lending and repo positions should be included when calculating exposures. This is a notable feature since some countries, (such as France), have already included these positions as part of the commitment ratio. It may also explain why CESR suggests that counterparty exposure should be calculated using the commitment approach.
Distinct derivative flavours
UCITS IV also seems set to continue the trend of distinct derivative flavours in regulation. The recommendations for the new commitment approach adopts a method already seen in France, but represents a significant change in this calculation elsewhere. At present, in most of Europe, the commitment ratio works by grouping different derivatives together into discrete buckets, netting them and calculating the sum of the absolute value. In France, and now potentially across the board, instead of working out absolute values, different sub-calculations are conducted by derivative type: options, futures and equities are grouped together; rate instrument derivatives sit in a distinct bucket; and short-sells and stock lending sit in a third. Each is calculated, pre-compensated and re-netted differently. Everything is then added up and aggregated up to the limit of the fund’s net asset value. Out of these three buckets, the new formula for calculating rate instrument derivatives will prove the most complex.
CESR is putting forward two measurement options which will enable netting and hedging of positions to occur. Moreover, the new approach for calculating rate instrument derivatives recognises the fact that interest rates with different maturities are linked and so applies modified duration as a factor.
Although the second option represents a significant change to calculation methods it is in the first where the true challenges lie. It will require contracts to be segregated by modified duration (less than 1, between 1 and 3.6 and above 3.6). Each segment is then assigned an assumed interest change factor expressed in percentage terms. Exposures relating to the positions in each of the segments, whether they are short or long, will then be multiplied by the assumed interest percentage.
Positions, depending on certain characteristics, are then matched within each segment. The residual positions can then be matched across the remaining segments until any unmatched positions remain. A factor defined by the bucket and the match type (within or across buckets) is applied to each matched position per segment and across segments to increase the exposure. The same process is applied to the unmatched positions. The sum of these figures is then multiplied by 12.5.
The second option follows a similar approach but buckets are divided by time scale (up to two years, two to seven years, seven to 15 years and over 15 years.) The process of matching positions across and between buckets still takes place but the factors applied throughout the process are different, and the process is less complex.
Although similar processes with different calculation formulae have already been built into compliance platforms in France – namely around compliance monitoring of breaches – in terms of technology, the commitment ratio is perhaps the most challenging part of the enhancements. The lack of standard market practice for such a revolutionary calculation will require buy side investors to group together to discuss and define an appropriate common approach for implementing this new measure. To add to the pressure, the new approach needs to be implemented and operational by July 2011.
The key to the new commitment ratio approach, as with all aspects of the UCITS family of regulations, is to facilitate an open dialogue across the industry and for firms to remain in communication with technology partners to ensure that regulations are adhered to in the most appropriate way, and that the trading technology is adequately prepared for any relevant changes set to occur in the future. Interesting and challenging times await.
