As the UCITS hedge funds market continues to mature, we are now seeing the first publications to emerge which address this market. Amongst the first is Newcits - Investing In UCITS Compliant Hedge Funds, written by a team of Italian authors, including Filippo Stefanini, Head of Research at Eurizon AI SGP SpA, Tommaso DeRossi, a management engineer at the Italian Stock Exchange, and Drs Michele Meoli and Silvio Vismara of the Department of Economics and Technology Management at the University of Bergamo.Italy has quickly developed into one of the leading markets for UCITS hedge funds in the last couple of years, with some funds being launched with solely Italian language prospectuses. This speaks of a growing familiarity in Italy with domestic onshore alternative investment vehicles, and it is not surprising that an Italian team has been one of the first to publish a dedicated UCITS textbook.
Newcits is a valuable work in that it serves as a good primer or manual for the manager or distributor who has heard much of the UCITS-related hype out there, and wants to see whether this structure would work for them. It is also of use to the institutional investor doing some more detailed due diligence on UCITS hedge fund products.
The book manages to cover off all the most important points that managers and investors need to address, and drills down into considerable detail – as it should. For example, besides dealing with the product directive and the management company directive, it also looks at the UCITS IV directive, the Key Investor Document, and the new AIFM directive.
Of particular use to the fund manager is the chapter addressing the operational models used for UCITS III funds. The authors note the primacy of the Luxembourg SICAV, the result of the “heterogenous” adoption of the directive by various European member states, particularly Luxembourg, France, Ireland and the UK. Others, such as Italy, were penalised because a fiscal regime providing taxation on accrued profits rather than on cash value is still in force, even if under revision.
As part of their operational examination, the authors tackle the issue of swing pricing – i.e. the effort to avoid penalising investors who remain in the fund, who might have to shoulder the additional costs of unwinding a portfolio to meet sudden redemption demands. They note in particular that there was plenty of this occurring towards the end of 2009, and proffer “a new industry standard introduced in order to protect existing investors and let the subscribing or redeeming investors be the only ones bearing the portfolio unwinding costs.”
Ultimately, they argue, the assignment of transaction costs can be unfair as they are not created by continuing investors, but by active shareholders, either entering or leaving a fund. They suggest changing the NAV to take account of capital movement costs so that they can be correctly allocated to active shareholders. For example, under a full swing pricing regime, the NAV is adjusted on a daily basis, according to subscriptions or redemptions, related to the net capital flow size.
Other possible solutions include partial swing pricing, based on positive net incoming or outgoing flow. This will, of course, lead to an upswing in NAV volatility, and the authors do take time to apprise the reader of both the pros and cons of swing pricing (e.g. protecting long-term investors from dilution, versus a possible increase in tracking errors).
One of the key strengths of the book is its clarity. For US managers who may perhaps still be unfamiliar with the role of the third party fund administrator, it clearly sets out the obligations of the administrators, including the valuation policy established under the Financial Accounting Standards principles. It also looks at the depositary bank requirements, a critical plank for the UCITS regime.
The authors accept that there are going to be times when it will be hard to apply fair value accounting to a UCITS portfolio, and that the hedge fund industry has seen this in the not-too-distant past. It is entirely conceivable that even the more transparent and liquid UCITS universe will leave some guesswork having to be employed. “In the absence of market information, it is permissible to use one’s personal assumptions, even if the basic concept must be the same: what would the asset’s trading value be if there was a potential buyer?”
There is a large and ongoing debate surrounding what can and cannot be housed in a UCITS hedge fund, amongst managers, investors and regulators, and it can provide for some heated debate. The authors of Newcits take an admirably clinical approach to the topic, looking in particular at long/short equity, relative value, directional trading and special situations/event driven strategies.
While the strategies themselves and their various risk factors are analysed, in particular where these can impact liquidity, the authors do shy away from advising on whether these strategies are suitable for UCITS, and this is really the crux of the argument. For instance, they acknowledge that distressed securities funds will have a long bias, and that they are exposed to the risk of credit spread widening, but there is little said about whether distressed funds should, or should not, be housed in a UCITS. Instead, there is a discourse on what the limits imposed by the UCITS III directive are, without actually returning to the strategies for a final analysis. Many investors doubt, for example, that distressed funds should be going anywhere near UCITS, and this book really ought to have taken more of a stand, because investors would appreciate a degree of guidance on this.
There is a short discussion on synthetic UCITS, and how a fund can be based on a total return swap, using an index as the underlying, a fairly common approach now amongst the major sponsoring platforms. Here, the authors finally break cover: “In our opinion, synthetic Newcits might frustrate the spirit of the UCITS III directive, even if regulators authorise them. Sometimes, their structures are so complex that institutional investors need to conduct an in-depth due diligence in order to be sufficiently aware of the risks and drawbacks of these products.” They rightly point out that the eventual impact of tracking error is not fully quantifiable to the investor in the moment of subscription.
The book is a valuable early addition to what will no doubt be an increasing corpus of literature on the UCITS/Newcits phenomenon, and for the professional who is seeking some more in-depth factual analysis of what is required to launch a successful UCITS fund, this is certainly a great first step.
Newcits: Investing in UCITS Compliant Hedge Funds, by Filippo Steffanini, Tommaso DeRossi, Michele Meoli and Silvio Vismara, is available from John Wiley & Sons Limited or good bookshops.
