Introduction
One of the key developments in 2009 has been the surge of interest in the UCITS III framework among alternative investment managers. Against the backdrop of the global recession and some major financial scandals, there have been increasingly vocal demands for greater transparency, risk management and regulations for hedge funds. In this situation, an increasing number of managers have started looking at the UCITS III platform as a way to not only meet the requirements of existing investors but also to market their funds to new clients who have traditionally been sceptical about, or unable to, invest in unregulated products while at the same time, utilise their unique alpha-generating strategies.
Since last year, Eurekahedge has been closely monitoring this new class of alternative vehicle and is currently tracking 400 UCITS hedge funds[1] in its database. The 2009 returns of the Eurekahedge UCITS III Hedge Funds Index (beta version) stand at a healthy 14.1%. Additionally, according to our estimates, there were 97 new UCITS III-compliant hedge funds launched during the year, bringing the total size of the sector to US$52 billion.
Overview of UCITS III Hedge Fund Industry
UCITS, an acronym for Undertakings for Collective Investments in Transferable Securities, is a set of directives passed by the European Union member states to allow cross-border investments as a step towards financial services uniformity. The original regulation was later upgraded to expand the range of activities that management companies are allowed to undertake and to include more asset classes and a broader range of derivative instruments. The expanded range of products and instruments that managers can use makes the UCITS III framework quite adaptable to various hedge fund strategies.
Although the UCITS III directive has been in effect since the early 2000s and has been amended to include various new financial instruments over the years, it was only recently (due to the financial crisis) that major players in the alternative investment community have started showing greater interest in this sector. In reality, UCITS III provides the middle ground between hedge fund managers, who are constantly looking to use non-traditional strategies, and investors, who are looking for greater risk management, transparency and liquidity.
The salient feature attracting hedge fund managers is the ability to use their preferred investment techniques in a regulated environment, which, in turn, helps them market their fund to new pools of capital and satisfy the demands of their current investors. The strategies available to managers include shorting using derivatives, investing in hedge fund index products, multi-strategy (ie, investing in fixed income, equities, and derivatives through the same fund), CTA/managed futures-investing while the fund of funds model can also be implemented under the UCITS III umbrella. Additionally, managers are also allowed to utilise leverage (100% of the net asset value) and charge performance fees. Another key aspect of UCITS III regulation is the ease of marketing the fund across the European Union: once the fund is approved in a European Union member state, it can be registered in other states and marketed across the region to traditional hedge fund clients and retail investors while European pension funds are also allowed to allocate UCITS III hedge funds to non-home jurisdictions.
In providing for the investor, UCITS III guidelines encompass a comprehensive regulatory framework which includes key guidelines on the amount of leverage used, diversification, liquidity, transparency and comprehensive risk management among others. Hedge fund and fund of funds investors who suffered heavy losses during the financial downturn and were further unable to withdraw their capital due to gated redemptions have been lobbying for greater regulations on the alternative investment industry; as such, funds under the UCITS III umbrella are uniquely placed to cater to their demands.
Some of the key features of UCITS III regulation are listed as follows:
a) Funds must be domiciled in Europe.
b) Funds must have a recognised administrator.
c) Managers must invest in liquid securities, which can be sold in less than two weeks without substantial loss of value (maximum redemption period is 14 days although generally, it is much less).
d) In terms of diversity, funds cannot have more than 10% exposure to one stock.
e) There are guidelines on systematic risk management (advanced methodology that meets defined qualitative and quantitative criteria).
f) Parameters are defined for employing leverage.
g) There are guidelines on daily reporting.
These measures serve to instil confidence among investors that they will be able to avoid a situation where their capital will be heavily exposed to declining stocks and fraudulent activities and that they will be able to withdraw their money more readily.
Industry Make-Up and Growth Trends
Over the last two years, the UCITS III hedge fund industry has grown at a rapid pace – currently, the total assets stand at US$52 billion, comprising more than 500 funds globally. The development in this new sector has occurred mostly between 2008 and 2009 as managers from across the alternative investment universe began to take a keen interest in it. Not only have there been funds launched under UCITS III framework by new managers, large management companies with existing hedge funds have also launched regulated versions of their funds to attract greater asset flows. Several funds of funds companies, which came under severe criticism during the financial crisis, have also opened their UCITS-compliant multi-funds while absolute return fund managers and mutual fund companies are increasingly taking advantage of the flexibility offered by the new regulations to launch their own hedge fund-like products.
Number of UCITS III Hedge Funds
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Total AuM
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545
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The following pages will provide a snapshot of the current landscape of the UCITS III hedge fund industry while exploring the trends over the last two years.
Strategies
Figure 1: UCITS III Hedge Funds by Investment Strategies
In terms of strategic mandates, the UCITS III hedge fund sector shows some interesting developments. As with European and global hedge funds, the largest share in the regulated hedge funds is also held by long/short equity managers. The provision in the UCITS III regulations allowing for shorting through derivatives is one of the key factors that attracted hedge fund managers to the framework. Additionally, a significant number of UCITS III hedge funds are targeted to the retail segment and it is easier to market the long/short equity strategy as most investors have an inherent understanding of it as opposed to more complex strategies.
However, other than the prominence of the long/short equity, there are very few similarities in the strategy-wise breakdowns of UCITS III and regular hedge funds. One of the most important differences is that there are very few event driven and no distressed debt hedge funds that subscribe to the regulation. These strategies tend to invest in low-grade debt and illiquid assets to generate very high returns; however, the UCITS III regulations currently disallow any investment into illiquid securities, which are defined as securities that cannot be realised within seven days at a reasonable price without a substantial loss in value.
Multi-strategy funds feature heavily in the UCITS III hedge fund landscape, making up more than a fifth of the sector. The increased number of asset classes, including complex financial instruments such as derivatives, which were added as eligible assets, led to greater interest in the UCITS platform by multi-strategy hedge fund managers. In comparison, multi-strategy funds only make up 10% of the European hedge fund space.
Manager Location/Domicile
Figure 2: UCITS III Hedge Funds by Manager Location
Since UCITS III is a directive of the European Union, it is hardly surprising to see the continent dominate the landscape in terms of head office location, accounting for more than 85% of the managers. Traditional onshore European hedge funds centres also account for most of UCITS III hedge fund managers, with the exception of Switzerland which holds only a 3% share as it is not part of the European Union.
The UK holds the major share as the location of choice in this sector, making up almost half of the total fund population. Being one of the most important financial service centres in the world, the country is already home to a large number of alternative investment management companies (43% of all European hedge funds are based in the UK) and as such, it is the natural location for UCITS III-compliant vehicles offered by existing companies. Furthermore, for new managers who are considering launching a UCITS III fund, the location offers access to large pool of hedge fund and fund of funds investors. UK investors are also familiar with the UCITS framework and are a ready source of start-up capital for the newly regulated hedge funds. Additionally, London also boasts a wide range of service providers and administrators, as well as top talents and infrastructures, making it a one-stop shop for managers looking to set up a fund.
Given that North America hosts the largest number of hedge funds globally, the region is also represented in the location-wise breakdown of UCITS III alternative investment managers. The high demand of regulated products, especially by institutional investors, has led a number of US-based management companies to launch their respective UCITS III class funds. Going forward, we expect an increasing number of UCITS III fund launches in North America as the investment class gets more attention and gains greater popularity among the region’s investors. Furthermore, based on media reports of hedge fund managers considering relocation to Switzerland due to new tax regulations in the UK, it is quite possible that Swiss-based managers will also increase their share of the pie.
Figure 3: UCITS III Hedge Funds by Domicile
An important decision facing management companies in setting up UCITS III hedge funds is the domicile of the fund. According to European Union directives, all UCITS funds are required to be domiciled onshore in a member state of the European Union. While traditional European hedge funds are primarily domiciled in offshore centres like the Cayman Islands, the largest onshore hedge fund domiciles are Luxembourg and Ireland. The UCITS III hedge fund sector is primarily based in these two countries as well, accounting for the domiciles of almost 80% of the funds.
There is a variety of reasons why Luxembourg and Ireland are preferred over other countries. The two centres possess the necessary infrastructure to service UCITS funds that intend to attract cross-border investments, hosting a large number of service providers (administrators, custodians, legal firms) for managers to choose from. Another important consideration for managers is the tax structure in the country of domicile and this is the factor wherein Ireland and Luxembourg come out as clear winners as they do not have any substantial taxes on capital gains by UCITS-compliant funds established in their respective jurisdictions.
Between the two countries, Luxembourg comes out on top for less obvious and more operational reasons. One of the greatest attractions for hedge fund management companies to launch UCITS-compliant products is the ability to target the retail investor market – Luxembourg service providers are better suited to administer high volumes on a daily basis as there are a number of retail funds that are already domiciled in Luxembourg. Additionally, Irish regulation requires custodians to take on the added role of independently monitoring a fund’s investments and reporting to shareholders, while Luxembourg does not apply similar regulations for funds that are structured as SICAV (acronym for Spanish sociedad de inversión de capital variable or French société d'investissement à capital variable), an open-ended collective investment scheme that derives its value by the number of participating investors and which is a common structure in Europe.
Regions
Figure 4: UCITS III Hedge Funds by Regional Investment Mandates
The largest chunk of UCITS III assets are obviously invested in Europe; however, there is an increasing diversity over time in terms of investment geographies. Since the regulation is a European Union phenomenon, Europe-based hedge fund managers were the first ones to launch UCITS III-compliant products and because most managers tend to invest in the regions they are based in, it is hardly surprising that Europe accounts for 41% of the assets under management.
As is the case with the traditional European hedge fund space, a very small number of UCITS III hedge funds are dedicated to investing in North America as most European managers who invest in the US do so as part of a global mandate, which forms the second largest share of investment mandates. A large percentage of funds invest solely in Eastern Europe & Russia (9%) as the latter’s markets have generated very high returns and also because they are in close geographical proximity and have strong links to European economies. These countries provide the managers with exposure to emerging markets, which have generated greater returns on investments – the Eurekahedge Eastern Europe & Russia Hedge Fund Index gained a massive 60.76% in 2009 on the back of a strong recovery in the underlying markets.
Similarly, there is a number of UCITS III hedge funds which are specifically focused on emerging markets in Asia and Latin America as many European investors are keen to gain exposure to these growth areas but would like to do so through a regulated vehicle that offers greater transparency and liquidity.
Performance Review
Figure 5: Eurekahedge UCITS III Hedge Funds Index vs MSCI World Index
Eurekahedge’s databases list a number of UCITS III-compliant funds that have a track record of up to three years, and as such, we have included 2007 returns in the performance analysis. When compared with the underlying equity markets as shown in Figure 5, the current trend indicates that this new asset class not only provides downside protection but also manages to capture most of the upside, hence providing greater returns over the longer term with less volatility than investing directly in the markets or through mutual funds/unit trusts. However, regular hedge funds have delivered better results in the short term and the medium term as they can operate without any restrictions.
Figure 6: UCITS III Hedge Funds vs Mutual Funds
Figure 6 shows the returns for the last three years between UCITS III hedge funds and regular mutual funds. The primary difference between a mutual fund and a UCITS-compliant hedge fund is that the latter is allowed to use alternative investment strategies, such as synthetic shorting and leverage, to boost returns. As a result, UCITS hedge funds were able to arrest the downside in the markets, delivering returns of -14.72% at a time when mutual funds were down, on average, 35% and the underlying markets lost up to 60% - the MSCI Europe Index was down 48.2% in 2008. Although the 2009 returns of UCITS III hedge funds do not match those of mutual funds because of their short exposures and greater risk protection measures, from a longer-term perspective, they have outperformed mutual funds by 15.2% over the last three years.
Figure 7: UCITS III Hedge Funds vs Global Hedge Funds and Global Funds of Hedge Funds
UCITS III hedge fund returns also show an interesting trend when compared with the performances of other alternative investment vehicles. As shown in Figure 7, these regulated products tend to fall at the midpoint of hedge fund and fund of funds performances. When compared to funds of hedge funds, there are two main factors which helped UCITS III managers in the last two years: firstly, in 2008, they had greater flexibility to close on positions that they were holding and were able to quickly liquidate them as the markets started to tumble while funds of funds were left exposed to various illiquid hedge funds with gated redemptions; and secondly, in 2009, funds of funds witnessed redemptions through most of the year, hence being forced to redeem their capital out of underlying hedge funds that were going through a record year. UCITS III managers, on the other hand, saw strong interest in their funds from investors (almost 100 UCITS III hedge funds were launched in 2009). It must be noted here that the investment mentality of UCITS III and funds of funds clients is different since the regulated vehicles are also targeted to the retail segment while fund of funds investors are generally large institutional clients and high net worth individuals.
Although UCITS III hedge funds delivered higher returns than funds of funds, they were outperformed by traditional hedge funds over the last three years. Reasons for this include high leverage employed by unregulated hedge funds to boost their profits as well as the strong returns generated by event driven and distressed debt strategies which have negligible representation in the UCITS III space.
In Closing
While hedge funds that were launched under the UCITS III framework have generated significant attention last year, it remains to be seen whether this new class of investment vehicle will gain widespread popularity. The key question for this new sector is whether investors are willing to settle for a lower performance, vis-à-vis hedge funds, in return for lower minimum investment, greater regulation and better liquidity.
Going forward, we anticipate an increase in the pace of UCITS III hedge fund launches as the regulation becomes more popular. Eurekahedge is in the process of launching its UCITS III hedge fund database along with the Eurekahedge UCITS III Hedge Fund Index – watch this space for more information on this new investment class.
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