The claims are not attributed to anyone in particular as they have been so widely reported. The aim here is to enlighten and understand some of the controversies surrounding the UCITS regime rather than sensationalise the concerns that investors or managers may have.
It is important to remember that UCITS, whatever the concerns and constraints, remains a growing conduit for investors to access hedge funds. Data from the 11th Annual Global Hedge Fund Investor Survey by Goldman Sachs Prime Brokerage shows that investors are increasing their allocations to UCITS structures and managed accounts in 2011, while decreasing their allocations to a manager’s main fund by almost 4% (See Fig.1). The survey noted that investors ranked enhanced liquidity and transparency as the most important factors in their decision to allocate through a UCITS vehicle. Given this favourable business backdrop for UCITS products, it is vitally important to look closer at some of the concerns that have developed.
Performance differences
It is true that the main UCITS obligation regarding fees is to disclose them; the rules do not cap overall fees or expense ratios. Investors should not infer pre and post fee performance differences by comparing hedge and UCITS indices, because the two benchmarks have different strategy and manager compositions.
Investors should also remember that reported headline performance of a UCITS fund only applies to day one investors; those entering at different dates and levels will of course have a higher or lower high water mark setting their performance fee. Therefore to compare like with like on performance data one needs to synchronise the start date of the analysis; even then, differences in periodicity of fee accrual and payment can also cause divergent performance.
Time zone issues can also be important. Offshore administrators located in the Caribbean typically price at the close of the US trading day around 9pm European time, whilst UCITS administrators in Luxembourg, Dublin or Malta are more likely to define month end as 5pm European time. Over time that four hour gap should not lead to any systematic out- or under-performance, but it could create big differences in some months. Related to this issue, time lags between receiving subscription inflows, and investing them, can also cause discrepancies.
Investors ideally need to drill down not only into particular managers and strategies, but also look at the costs structure of individual UCITS vehicles where costs can differ, even for the same manager and strategy. Concerns about costs can be divided into easily visible fees, and any costs associated with any increase in portfolio turnover.
1. “UCITS have higher fees”
Where UCITS pursue the same strategy as a sibling fund with a higher volatility target, there is scope for risk-adjusted fees on the UCITS to be substantially higher so investors should follow the approach taken by allocators to currency overlays and global tactical asset allocation overlays – and insist that fees are calibrated to the risk target.
Leaving aside variations in volatility, clearly UCITS funds do involve extra layers and levels of service provision (e.g. more frequent pricing and associated reconciliation routines, regulatory reporting including risk management calculations, index providers, depositaries, collateralisation of swaps) and therefore extra costs, all else equal. But is the comparison always an exercise in comparative statics? The managers we speak to are fully cognisant of potential for higher total expense ratios on UCITS hedge funds. Consequently they have in several cases sacrificed some of their own management fees to align UCITS costs more closely with offshore costs, or placed a ceiling on costs over and above management fees. AIM Hedge and FX Concepts have followed the first approach and Cheyne Convertibles the second.
Some investors might find the notion of foregone fees inconceivable, but if UCITS attracts investors who cannot go offshore or prefer the structure, then giving up 30 or 40 basis points a year of management fees could be worthwhile for investor base diversification. If it helps raise assets, the fee concession could be far cheaper than paying 20% of fees in perpetuity to a third party marketer, or possibly even more to other distribution platforms – without mentioning rapacious private bankers. Traditional asset managers already price-discriminate to a huge degree, sometimes charging two or three times as much to retail (e.g. 1.5%) as institutional (e.g. 0.5% or 0.75%) investors, for the same underlying product. By comparison, for a hedge fund manager to receive 1.7% instead of 2% is a marginal decision – especially when no concessions are made on the all important performance fee!
Separately, UCITS IV from July this year paves the way for multiple funds right across Europe to feed into one master fund, either afresh or through mergers amongst currently discrete fund structures. Both developments are expected to reduce the costs associated with operating many distinct vehicles.
2. “UCITS have higher non-fee costs”
If a UCITS and an offshore fund use different brokers, which may in turn have different exchange memberships, there may be differences in execution efficiency, commissions and clearing fees paid per trade. There is no a priori reason to expect these to be higher for a UCITS; it will vary from one bank to another.
Assuming equal costs per trade, the frictional costs of transacting more often to meet shorter dated liquidity worry some investors, and these costs include commissions, bid offer spreads and market impact. The fret is that loyal and long-term investors could be subsidising the trading costs of shorter term investors. This debate on how fee structures can reflect transaction costs is a far wider one that applies to all types of funds, not just UCITS.
Starting from first principles, the fairest fee structure would allow bid offer spreads on a fund to vary according to the corresponding dealing costs on the underlying assets, to prevent the fund from offering artificially costless trading. Moreover, the ratio between inflows and outflows would determine at what point inside the spread trades were “crossed” – so buys and sells would only take place at the same central price if subscriptions matched redemptions.
Why are these types of fee structures – and those that charge redeemers actual costs – so rare? Most investors in practice seem to prefer the simplicity and reduced administrative costs of facing one price for buying and selling, even if it does entail some inter-temporal inequities between cohorts of investors, and this is just as true of traditional hedge funds as of UCITS. Cynics may also point out that performance fees charged from offer to bid would be less than those charged from mid to mid prices!
Yet whether UCITS hedge funds turn out to have higher turnover is an empirical matter. Anecdotal evidence suggests that some retail investors are a lot stickier than some more fickle fund of funds allocators. After all, mutual fund timing was the preserve of professional traders rather than small private investors. And scope for trading funds more often is only one of many reasons for investing in a UCITS, which are only at most daily funds; those who need to trade most frequently can do so intra-day through exchange-traded funds. Clearly, investors not classified as sophisticated by regulators often cannot select a longer liquidity product even if they expect to remain invested for years. And financial institutions, such as insurance companies, face a regulatory incentive to own UCITS funds because they eat up less regulatory capital.
Time will tell if UCITS do have higher turnover, but as with other aspects of UCITS the structure is flexible enough to let managers take steps to reduce churning. Firstly, while the default liquidity is at least twice monthly, UCITS funds do have the discretion to put up gates, although this is rare (and widening dealing spreads to reflect the actual costs of liquidity provision seems far fairer). Second, UCITS can turn away specific investors, restricting the amount of cash associated with types of structured products that can foreseeably lead to higher turnover: examples include CPPI (Constant Proportion Portfolio Insurance) that need to be rebalanced after predictable intervals of price moves. Insight, for instance, has stated that they are capping allocations from structured products.
What is a daily dealing option worth?
A holistic view of costs can only be formed in the context of the investor structure. The daily liquidity option should have a non-zero value even for the most far-sighted investors: endowment funds with theoretically infinite time horizons did experience liquidity bottlenecks in 2008 and 2009 that may in some cases have forced them to postpone or miss out on investment opportunities including taking up private equity entitlements.
For investors who are using either leverage or currency hedges, the daily liquidity option could have huge value if it allows them to maintain lines of credit or keep intact currency hedges. Why does daily dealing help? Firstly a daily fund should be ascribed greater collateral value by lenders (especially if the event of foreclosure has no regulatory capital repercussions), and even if banks have wholeheartedly pulled the plug a daily fund can be monetised to meet margin calls on leverage or hedges. So, a probabilistic calculation could easily place a far higher value on the daily liquidity option than any tangible extra costs – even ignoring “headline” and reputational risks of informing investors that currency hedges have been abandoned.
Therefore, the appropriate benchmark for UCITS fees may not be offshore funds with monthly or longer liquidity, but rather non-UCITS managed account platforms that offer daily or weekly dealing. The platforms have often involved extra costs of between 0.25% and 0.75% at the headline level, and somewhat less if this includes services like audit, administration and custody.
3. “UCITS tracking error dilutes returns”
Those who insist that UCITS hedge funds are the poor relations of traditional funds have been emboldened by the very high-profile closure of Bluetrend, which during its short life as a UCITS lagged the offshore fund’s performance. The particular feeder in question was, unusually for a systematic strategy, executing trades independently of the offshore fund, as opposed to simply entering into a swap with an index run parallel to its offshore fund strategy. We say parallel to, rather than pari passu with, as index swaps are not completely immune from tracking error risks; such indices might sometimes need to under-weight certain positions to stay in line with UCITS diversification rules, (even though this is not widely advertised).
Pre-fees risk targets of a UCITS may diverge from that of an offshore fund, but generally need not for “sophisticated” UCITS. For instance Edhec claim that 85% of hedge funds historically would have been inside one of the risk limits for a sophisticated UCITS: the volatility target of 20% VAR at the 99% confidence level over 20 days (this also works out at over 20% annualised volatility). That clearly implies that there is often scope to structure a UCITS with a higher volatility target than the comparable hedge fund, albeit in some cases with somewhat more diversification. A UCITS that specifies as its benchmark a long only equity index then has headroom to realise double the volatility of that index: this could easily be 40-50% a year.
The simple UCITS framework capping commitment at double fund value may of course dial down the volatility of some funds. The 200% gross exposure ceiling clearly will sometimes cramp the style of some strategies, and in particular restricting netting of exposures to contracts with the same counterparty could make it difficult to execute some more leveraged arbitrage strategies inside a simple UCITS.
The time taken to digest rapid inflows can cause any growing investment vehicle, including a UCITS fund, to suffer from “cash drag” when the strategy is profitable (or soften the blow of losing periods) but if managers and their investors feel this is important, they should discuss it and agree to stagger inflows over a longer period or across more interim dealing dates.
From a structuring perspective, the requirement to use swaps for shorting, instead of borrowing cash bonds or equities, could have caused substantial tracking error in 2008 when cash credit instruments did fall much harder than their derivatives. However, in normal (and under current) market conditions, this has not been identified as a source of performance discrepancy by anyone we have spoken with.
In summary, investors who do the research should be able to find plenty of UCITS that come close to the overall risk and return targets of traditional hedge funds – and for those that don’t, daily dealing regulated UCITS may also be easier and cheaper to borrow against for more aggressive investors who want to ramp up risk.
4. “UCITS too risky: blow ups imminent”
Exactly contrary to the previous concern, some commentators seem to think UCITS hedge funds are “too risky”. However, it is not clear how they are any more risky than traditional UCITS funds, which can be exposed entirely to equities from one volatile industrial sector such as mining or technology: securities and instruments, not sectors or factors, define diversification under the rules.
The reality is that most investment funds are exposed to market risk, and therefore prone to occasional blow ups. The UCITS framework addresses risks including liquidity, governance, transparency, leverage, counterparty, custody and various operational risks , and categorises funds according to historical volatility (which is also sometimes capped in absolute or relative terms), but as per the ubiquitous disclaimer “past performance is no guide to future performance” UCITS clearly has no special insight when it comes to placing any upper bound on future realised volatility. Market risk is by definition the one that remains beyond regulators’ control. Although stress testing and back testing are designed to gauge potential and realised volatility against the historical figures, it is naive to think that rules and tests can prevent large losses: the surprise is not that some UCITS may experience them, but rather why anybody ever thought the contrary and therefore now seeks to sensationalise the possibility of big losses.
It seems odd that some UCITS critics have homed in on collateralised total return swaps with indices as a special source of risk. Since these swaps are often over-collateralised and always have been with a custodian separate from the swap counterparty, they greatly reduce the usual counterparty risk of OTC derivatives. An approximation of residual risk is any adverse market movement since the last collateral rebalance, something that typically takes place daily. How is that more risky than long only equities?
5. “UCITS use swaps to avoid restrictions“
It is clearly true that using derivatives to swap into an index can avoid some restrictions that would apply to a UCITS making direct investments, but this does not mean that rules are being broken, since different guidelines govern direct and indirect index investments. It seems hard to argue that index swaps are some surreptitious form of regulatory arbitrage, when the UCITS rules explicitly allow for indices, which can include metals, commodities, real estate and even private equity – so long as the index itself meets requirements such as daily dealing, diversification, and the swap with the index is collateralised.
For instance, some people seem puzzled that a UCITS can own commodities indirectly via an index swap, but not directly own physical commodities. However, the risk profile of a commodity index is qualitatively different from that of physical commodities, where there are costs and risks associated with storage, damage, insurance, transportation and delivery. Whereas these features of physical commodity trading could be difficult to reconcile with daily dealing, an index that not only has daily liquidity but is also collateralised with cash seems easily consistent with daily liquidity. The interpretation could be that UCITS has no inherent bone with commodities per se, but rather seeks to avoid operational risks of physical commodities.
In conclusion, for all its safeguards the UCITS framework is more diverse and malleable than many investors may imagine. Deeper investigation, discussion and negotiation with managers are all part of a healthy learning process that is driving the evolution of this growing funds sector.
