For hedge funds that wish to set up under the UCITS banner there are plenty of advantages to counter the restrictions on investment flexibility. For one, the additional layer of security strongly appeals to investors’ reduced risk appetites in the post-crisis era. Liquidity, transparency and governance are the order of the day as investors seeking absolute returns become less willing to turn to traditional higher risk, higher leveraged, and, often, more opaque strategies.
It is not surprising then that more managers are keen to acquire a share in the market especially given that alternative UCITS funds launched in 2010 secured €6bn of net new flows. As well as appealing to those well-acquainted with the hedge fund approach, UCITS broadens the potential audience of investors to target.
Moreover, with regulation governing traditional hedge funds likely to become more stringent under the AIFM Directive, and rules around capital requirements and short selling still to be determined, UCITS offers a more certain way to access European investors.
However, for those considering adding a UCITS fund to their offerings, there are a number of practical and legal considerations to be borne in mind. Many of these – selection of strategy, jurisdiction, audience and responsibility for day-to-day operation – while undoubtedly critical to successful operation of the fund – are in fact an extension of the due diligence process required for any new start up.
That said, there are unique challenges involved in moving to a more tightly regulated space. The fact that only 50 funds secured 90% of 2010’s net new flows into alternative UCITS reveals the complexities of setting up and maintaining an alternative fund under the UCITS banner.
With greater restrictions on strategy selection and asset allocation, increased requirements around liquidity management and valuations and more prescribed controls on the information that must be supplied to investors, compliance monitoring, risk management and transparent reporting rise to the very top of hedge funds’ previously performance-focused agenda. The need for accurate, validated data and clear audit trails, proving adherence to requirements such as concentration limits by security or asset class, or limits by counterparty, is also critical. The thought of achieving such complex requirements without some form of automation would rest heavily on the shoulders of any fund manager.
Indeed, any fund operating under tighter regulatory scrutiny and increased investor pressure demands significant levels of control to ensure that funds do not fall foul of any restrictions and remain within the bounds of the selected strategy. Importantly under UCITS the guiding principle is pre-trade checks. Compliance with investment rules can be achieved much more efficiently with pre-trade checks than post-trade analysis. The latter may only identify breaches too late, and result in expensive corrective action which proves to be a lot more costly than managing compliance in a preventative fashion.
Pre-trade checking works most effectively within an integrated solution that provides direct access to the complete portfolio – its positions and its exposures – otherwise it risks being too slow, waiting for data from separate systems or running checks against outdated information.
Indeed, integrated systems and straight-through processing are some of the most important factors when it comes to demonstrating appropriate control. This is one of the clearest themes emerging from UCITS fund management: the need for timely sharing of accurate data, whether that be for risk management, auditing, portfolio management or compliance checking. For firms considering a UCITS fund, ensuring that systems can communicate with each other is key. Even a world-leading compliance system will deliver sub-optimal benefits if it is not interoperable with risk and portfolio management systems, for example.
Interoperability and integration take on a particular resonance in the UCITS landscape because of the different role of a depositary/custodian in the alternative fund space. Trade instructions notifications, and completion of trade files with the necessary security settlement details, which are typically responsibilities of a prime brokerage service package, are not covered by the UCITS depositary/custodian, and fall under the remit of the firm operating the UCITS fund.
The different relationship with prime brokers when compared with depositaries/custodians also has an impact on the way that risk management is conducted. A single prime broker would traditionally have been able to produce a series of risk numbers because they had complete visibility of the entire portfolio. Depositaries/custodians are not compelled to offer such analysis but even where external partners do offer some form of risk management it is likely to be at the end of the day, by which point the fund can be sailing fairly close to its risk parameters – or maybe even exceeding them. If that happens, firms may be required to unwind an otherwise profitable trade. There is therefore a strong argument for intra-day risk checking capabilities, even though it is not prescribed specifically in the UCITS III directive.
Perhaps unsurprisingly, rules governing risk management feature more heavily in the regulation of UCITS funds directives. These provide a more stringent set of controls around liquidity and emphasise the need for greater risk management and documentation capabilities than is currently typical. Specifically funds should be able to back-test the portfolio and compare actual losses with estimated losses over any given period. They will also be required to have effective counterparty risk management: this in turn requires the ability to generate a total view of the portfolio and to demonstrate where the fund is exposed to different business units or divisions within the same parent issuer.
Funds are also required to permit redemptions on a twice-monthly basis, which highlights one of the biggest differences between a UCITS fund and a more typical alternative investment fund. Whereas a traditional alternative fund may accept redemptions at only very limited intervals, investors in a UCITS fund are able to withdraw their money within a much shorter timescale. This is critical for the successful management of a UCITS fund and presents a key challenge to hedge fund managers.
Setting up an alternative UCITS fund undoubtedly has its challenges. However, it has been an important revenue stream for hedge fund managers who have been able to capture in-flows when the market witnessed significant out-flows. It has also allowed firms to win back clients in showing a commitment to the more risk-averse trading environment. The right technology can play a critical role in the management of a UCITS fund, and in certain instances can make the difference between success and failure.
But the benefits of appropriate technology can extend beyond the UCITS fund itself. Not only does it assist greatly in satisfying the regulators who scrutinise the UCITS fund, it also improves operations on the traditional unregulated side of the business. That enables investment managers to demonstrate best practice on both sides of their business: and in a competitive but nervous marketplace, that could be a useful tool.
