The decision supported concerns expressed for some time now by funds of funds managers and other UCITS hedge fund investors that some strategies would experience replication problems, including issues involving tracking error. Indeed, in a conference call with investors earlier this year, BlueCrest president and head of systematic trading Leda Braga said she expected a tracking error of 1-2%, but added that it was higher than expected, and pointed to three principal causes for this: the requirement for weekly liquidity, the portfolio constraints under which UCITS funds must operate, and the fact that the offshore fund has more flexibility in terms of which asset classes it can invest in.
One of the issues associated with BlueTrend’s replication is believed to be its heavy investment to energy and fixed income derivatives, while many other CTAs currently have less exposure to the energy complex. Braga argued earlier this year that the additional UCITS rules were constraining the fund from taking optimal positions, a situation that would potentially take away from the UCITS fund’s performance. The BlueCrest president expressed concerns to UCITS investors that interest rate increases would significantly raise volatility, and lead to a position decrease on the part of the BlueTrend strategy.
The offshore version of the Bluetrend strategy is currently hard-closed; it will be interesting to see whether investors in the UCITS are offered allocations to the core Bluetrend strategy, or to other investment options. One seasoned hedge fund investor told this magazine that he suspected the closure of the fund was also being used as an opportunity to return money to investors. “The liquidity of the market has changed over the summer,” he said. “My guess is this makes them more inclined to close the fund.”
Problems ahead for UCITS CTAs?
Although some commentators claim the Bluetrend problem will be an isolated incident, this may not be business as usual for the UCITS hedge funds universe. Of particular concern are those funds seeking to replicate an offshore strategy, for instance via a CFD swap. Although under the UCITS directive the monthly VaR constraint is very loose, it is the area of diversification and asset class limit where further problems are likely to emerge. The liquidity constraints imposed by UCITS could also impose problems for managed futures strategies.
One potential minefield is emerging markets currencies, which have offered some solid trending opportunities for macro hedge funds and CTAs over the last year or so.
“This is really not surprising; we expect further disappointments, especially if a fund is sold as a perfect replicator,” says Guido Bolliger, CIO at Olympia Capital Management.
But could this have been done differently? Why not simply approach investors and ask them if they would tolerate an increase in tracking error, particularly if it is a temporary one? What mitigates against such an approach is that while investors won’t complain if this results in positive performance, their reaction will be completely different if a higher tracking error led to a drop in performance.
Certainly, the removal of many investment bank prop trading desks from the market could have impacted short-term liquidity over the summer. In addition, long-term trend followers, amongst them the largest of the CTA and managed futures operations, have been focusing on more short term volatility management. Trading signals are becoming shorter term in nature, and this is creating capacity problems.
But a source at one prime broker told UCITS Hedge that there was no evidence that liquidity had changed noticeably. Indeed, the prime brokerage executive observed that new liquidity providers in different market segments are emerging. One example of this is former bank traders turned hedge fund managers like Pierre Henry Flamand who left the Principle Strategies Group at Goldman Sachs to launch Endoma Capital in early November.
Liquidity comes with price tag
The Bluetrend issue is creating major questions for the way CTAs, especially larger ones, are choosing to replicate their strategies onshore. Investors in particular are becoming more concerned about the swap arrangements put in place by some of the UCITS hedge fund platforms, not least of these being the additional layer of fees. In addition, there are worries that funds of funds are favouring directional strategies. In a difficult market, this will be felt.
“Liquidity has a price,” says Bolliger at Olympia. “If you manage money under a constraint, that also has a price. We may yet get some surprises in this sector. We will need to see a complete market cycle before we can draw conclusions about UCITS III.”
There are a number of CTAs in the UCITS wrapper, among them Man AHL Diversity and the Winton Diversified Fund. Man runs its own UCITS platform, while the Winton fund is on the Deutsche Bank UCITS platform. But prime brokerage sources at a major UCITS fund platform operator say that the suitability of a given CTA fund for a UCITS platform will vary with the investment approach and strategy of the fund.
Despite the difficulties BlueCrest experienced with the BlueTrend UCITS offering, the sector still offers obvious possibilities for managers to market to a new group of investors. There is, for example, some evidence that platform operators are approaching US hedge funds to use UCITS to go after assets that are traditionally allocated to the long-only bucket. Managers find the logic attractive since it provides a good opportunity for them to diversify their investor base.
It is also interesting to note that BlueCrest has not given up on UCITS. In fact, UCITS Hedge understands that BlueCrest will be converting its Alignment fund, which runs a discretionary fixed income strategy, into a UCITS fund in the near future. The Luxembourg fund, which stands out from the other BlueCrest funds as the only onshore strategy, has no offshore reference on which to base tracking error. The fund has been monitored against UCITS conditions since its inception, and is currently not near any limits. This makes it a much more credible fit from the perspective of UCITS investors.
UCITS assets surge
And such investors are growing. This is underlined by new data from Merrill Lynch that shows UCITS hedge fund assets are up 127% to $50 billion since the beginning of 2010. Merrill says newly launched UCITS hedge funds raised $3.1 billion the first half of this year compared with $3.75 billion raised by traditional hedge funds in Europe. The data also showed that the five biggest UCITS hedge fund launches in the first half raised $2.124 billion, a figure virtually tied with the $2.135 billion raised for the five biggest European offshore hedge fund launches. There is no doubting the increasing maturity of this market.
Ultimately, if lessons are to be learned from this debacle, it is that the UCITS opportunity may not suit all strategies and all approaches after all. There are those with a vested interest in making hedge funds believe that 95% of strategies can be replicated, but the investor community is more sceptical. It is early days yet, but we suspect BlueCrest’s will not be the only UCITS fund to be withdrawn due to tracking error issues.
