The decision by BlueCrest to wind up its onshore managed futures UCITS at the end of November, citing tracking error, also raised questions about the viability of UCITS hedge funds. And research from Bank of America Merrill Lynch (BoAML) indicated that in the first half of this year, new fund raising from Europe by offshore and UCITS hedge funds was neck and neck, with much of the latter coming from existing or previous investors, while UCITS funds seem to be tapping more new money.
BoAML noted that UCITS hedge fund assets were up by 127% to more than $50 billion in assets under management already this year. Newly launched UCITS hedge funds have raked in $3.1 billion in the first half of 2010 at a time when the fund of hedge funds industry was still seeing net redemptions. Compare this with the $3.75 billion raised by offshore hedge funds in Europe, and you can see UCITS are rapidly closing the gap.
Look at the money raised by the five largest UCITS hedge funds and that gap gets even narrower: they raised $2.124 billion in the first half of this year, against $2.135 billion from the five largest offshore hedge funds (based on assets raised in Europe).
Yet with the launches coming thick and fast, we understand there is a considerable regulatory backlog in Luxembourg already, with many funds, including launches by high profile managers like John Paulson, still waiting to bask in the UCITS glow.
Fundamental arguments or just a trend?
Is this a ‘me too’ phenomenon, or are there some fundamental aspects driving the shift by the hedge fund community towards UCITS?
At Iveagh, the family office of the Guinness family, Chris Wyllie, partner and head of portfolio management, sees the alternative investment world is big enough for both UCITS and offshore hedge funds. “It is good that we have offshore specialists involved in launcing UCITS,” he says. “I believe that hedge funds have a massive part to play in the wealth management portfolio. There are huge issues around the idea of risk free assets at the moment, for instance, will bonds really protect you if we go into another crisis? I don’t believe we’re seeing the end of the offshore hedge fund, clearly not everything is suitable for UCITS, and investors are still going to want that flexibility.”
Wyllie sees the offshore hedge fund returning to its roots, providing alternative beta products. “If a strategy relies on a high level of leverage, or a lack of liquidity, then it won’t be able to use UCITS.”
Stephane Diederich, managing director at Alpha UCITS, a specialist in fund distribution, points to the fact that 75% of non-US fund assets are already invested in UCITS. It is a powerful global brand, recognised and understood by institutional investors as far apart as Hong Kong and Chile. Increasingly, it has less to do with the EU and passporting, and more to do with transparency and an element of regulation.
“This is not a retail only product,” explains Diederich. “For the long only world, the UCITS is the main institutional vehicle. Hedge fund managers are launching UCITS because they want to target institutional investors.”
He also points out that investment by institutional investors in hedge funds, outside the UK, remains relatively small, and is paltry compared with allocations made by US investors. During the credit crisis, the high level of redemptions from European clients of hedge funds can be attributed to the high level of retail – i.e. high net worth – money invested. Pre-2007 the character of the European investor base was heavily slanted towards private banks, family offices, and funds of funds with a private investor base. Most continental European institutions were either not investing, or making relatively small allocations.
“European institutional investors are heavily regulated,” observes Diederich. “They may not buy offshore funds in many cases.”
Not a retail story
In addition, UCITS launches by hedge funds are not targeted at the retail market: the minimum investment ticket for many funds prices them well outside of even the high end intermediary tier.
The cost issue also creeps in from time to time, with a regular myth being perpetuated that UCITS funds are somehow more expensive. Indeed, in many cases they are cheaper, explains Diederich. Himself a former partner at Brevan Howard, he notes that the firm’s UCITS fund has substantially lower operating costs than its Cayman equivalent. Even managed accounts can be 80-100 basis points more expensive than UCITS equivalents. Liquidity, of course, still has a cost, and the question remains whether investors will pay that price. Investors opting for the liquidity of an onshore fund may have to tolerate a performance discrepancy against the offshore version. Investors will need to continue to do their homework, as many funds being launched now have not had their liquidity premises tested in the fires of a major financial crisis and loss of confidence, as occurred in 2008.
Diederich cautions against the assumption that the UCITS fund is ‘safer’: there is still plenty of scope for what he calls “an Amaranth-style blow-up” in a UCITS fund. “There is a lot of scope within the UCITS rule for going belly-up,” he says. “But if a UCITS blows up for the wrong reasons, you do have more recourse.”
It will be interesting to see how funds of funds can continue to add value in the UCITS space, as much of their rationale has been eroded with the presence of transparency and liquidity in the UCITS hedge fund universe. It is now harder to run an asset/liability mis-match and harder too to arbitrarily suspend redemptions. Having said that, it is also easier for the FoF vehicle to run an active portfolio – no more waiting for three months for shares to be redeemed.
One final argument in favour of offshore funds is that they are less correlated. UCITS hedge funds tend to gravitate towards a handful of well-trodden strategies. In the end, this could mean the loss of diversification benefits.
Conclusion
“There are very few purists sticking to offshore hedge funds exclusively,” says Stephane Diederich. “Plus, regulators want the industry to be onshore. In future, the core investment model is likely to be UCITS, with managed accounts and offshore funds forming the satellite investments. But it will take years.”
Yet with regulators and investors in Europe already forming up behind UCITS, the argument for the growth in this sector seems compelling. Diederich estimates investors in Europe are currently under allocated to hedge funds, to the tune of 1-2% on average, compared with 10-15% in the US. Even a small move towards hedge funds in the European institutional space, say to 3-4%, would represent trillions of new assets for the industry that has simply not previously been allocated.
