Introduction
The interest among investors for UCITS III hedge funds surged in 2010 and has continued into the start of 2011. In this report, we monitor the developments in UCITS III hedge funds and touch upon some of the key aspects of the industry such as location of managers, strategies being employed as well as looking at some of the main performance trends.
The size of the UCITS III hedge fund[1] industry has grown rapidly both in terms of assets under management and number of funds. As at end-February 2011, we estimate there to be 719 unique managers[2] with assets of nearly US$200 billion.
Figure 1 shows the growth in UCITS III hedge funds since December 2007.
Figure 1: UCITS III hedge fund industry growth over the years
The popularity of alternative investments under the UCITS III framework started to increase from 2007 onwards. Against the backdrop of the global credit crunch, the financial crisis and some major financial scandals, investors and regulators demanded greater transparency from hedge funds, better risk management and more regulations. In this situation, funds that follow a proper regulatory framework have witnessed greater interest from investors.
For hedge fund managers, the UCITS III platforms presents an opportunity, not only to meet the new requirements of existing investors but also to market their abilities to new clients who have traditionally not invested in their funds, either due to scepticism about unregulated products or because of internal rules preventing them from investing in such funds. At the same time, the regulations also allow enough flexibility for managers to implement their unique alpha-generating strategies after catering to some specific requirements. As such, we have witnessed a number of hedge fund managers developing and actively marketing UCITS III versions of their funds, while a few fund management houses have made wholesale changes to bring all of their funds within the regulations. Additionally, we have also seen some traditional mutual fund operators venture into the alternative space by utilising the unique features of the UCITS III regulatory framework. 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) Guidelines for 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. For a more detailed introduction on the unique features of UCITS III regulations and fund structure, please refer to our previous report[3].
Figures 2a–2b display the relative growth among UCITS III hedge funds and global hedge funds[4], showing that the UCITS fund industry has generated greater growth vis-à-vis regular hedge funds in terms of both fund population and assets under management. While the assets under management have increased due to the preference of investors for regulated alternative investments, the fund population has seen dramatic increase coming from the following three sectors:
a) Existing managers launching UCITS III replicas of their funds to attract greater assets
b) Hedge fund-like products launched by mutual fund companies
c) Hedge fund management companies making wholesale shifts into UCITS as a long term strategic move
Figures 2a-2b: Growth of UCITS III hedge funds relative to global hedge funds
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Geographical Mandates
Figures 3a-3b: Geographic investment mandates of UCITS III hedge funds by assets under management
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Since UCITS III is a European regulation, it comes as no surprise that the largest share of investments on a regional basis goes to Europe. Also, UCITS III managers continue to be located primarily in Europe and most managers tend to invest in the regions that they are based in. Since the regulation is a European Union framework, Europe-based hedge fund managers were the first ones to launch UCITS III compliant products and as such, have had a longer time to establish themselves and build a strong client base, leading to larger sized funds. Table 1 shows the average size of hedge funds focused on various geographies. It should be noted that while funds investing in the United States have a larger asset base, there are very few such funds versus Europe and global-focused funds. 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 by total AuM as well as by fund population.
Table 1: Average AuM of UCITS III hedge funds by geographical mandate
Investment geography
|
Average AuM (US$ billion)
|
North America
|
498.6
|
Europe
|
333.3
|
Global
|
270.6
|
Asia ex Japan
|
162.4
|
Latin America
|
141.5
|
Japan
|
26.8
|
Source: Eurekahedge
Figures 3a–3b also show a trend of increasing diversity in geographic focus of investments. While most funds that wanted to invest in Asia and North America still do so through a global mandate, the increase in the share of North America- and Asia-dedicated funds implies that the UCITS III regulation is gaining traction among non-European managers. Additionally, it also shows that European investors are keen to exposure to regions other than Europe, and we expect this share to grow over time. One point to note here is that Asian hedge funds get a significant amount of their capital from Europe and indeed, many of the managers themselves are European, hence, more likely to have historical ties to European asset allocations. As such, an increasing number of Asian hedge funds have started to offer UCITS III compliant products to cater to the changed requirements of their investors.
Head Office Location and Domiciles
Figures 4a-4c: Head office location by number of funds
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Europe continues to account for more than 90% of UCITS III hedge funds. This is primarily because a) UCITS is an EU regulation, hence, it is easier for European funds to subscribe, and b) most UCITS investors are European and it is easier to market the fund if the manager is based in Europe. The United Kingdom retains the leading position and has further increased its share of the pie. Compared with 2011, the population of UCITS III hedge funds in 2007 enjoyed a wider distribution due to its pan-European base. The share of UK-based UCITS funds has increased since 2007, primarily because of the strong launch activity witnessed in the last two years. For new managers who are considering launching a UCITS III hedge fund, the location offers access to a large pool of hedge fund and fund of hedge funds investors. UK investors are also familiar with the UCITS III framework and are a ready source of start-up. Additionally, London also boasts a wide range of service providers, administrators and infrastructure, making it an excellent venue for managers looking to set up a UCITS III hedge fund.
Figure 5: Fund domiciles by number of funds
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, together accounting for more than 80% of the industry. These two locations are preferred over other EU nations because they possess the necessary infrastructure to service UCITS III hedge funds (large number of service providers) as well as having beneficial tax regulations. Currently, the two centres hold distinct advantages over each other: while it is much cheaper to set up in Ireland (Irish regulators require fund promoters to have a minimum capital of €0.635 million whereas the requirement in Luxembourg is in the region of €7.5 million), the service provider industry in Luxembourg is better suited to administer high volumes of transactions on a daily basis which is a key benefit since a number of managers are launching UCITS III products to target retail investors.
Strategic Mandates
The structure of the UCITS III hedge fund industry has also witnessed some interesting changes in terms of strategic mandates. As with geographical investment mandates, there is now greater diversity in the sector in terms of asset classes and strategies employed. At the start of 2007, the industry was dominated by equity investing funds and the top 2 investment mandates accounted for 65% of funds. Since 2007, there has been a major shift away from long-only absolute return strategies, although long/short equities mandates remain highly popular.
Nearly 50% of the funds launched in 2009 and 2010 employ the long/short equity mandate. They do so for the following reasons:
a) Long/short equity forms the largest share of global hedge fund strategies (31%), hence, the proportion of existing hedge fund management company launching UCITS III hedge funds would naturally be more in favour of this strategy.
b) It is relatively easier for long/short equity managers (and of course, long only absolute return funds) to operate under the UCITS III umbrella.
c) As opposed to complex strategies, long/short equity is more intuitive and easily marketed to retail investors who may not understand sophisticated financial products unlike traditional hedge fund investors.
Additionally, there are also a handful of long-only absolute return funds that have modified their strategy to take advantage of the shorting ability available under the UCITS III framework, hence, effectively becoming long/short equity funds.
Figures 6a-6c: Changes in the strategic mix of UCITS III hedge funds by assets under management
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Performance Review
This section compares the performance of UCITS III hedge funds against other comparative investment vehicles as well as the underlying markets between 2005 and 2010. We will also look at the relative performance of different strategic mandates and investment geographies within the UCITS III hedge fund sector.
Figure 7 shows how UCITS III hedge funds have performed versus hedge funds, funds of hedge funds and the MSCI World Index.
Figure 7: Performance of UCITS III hedge funds vs other alternative investments since 2005
When compared with the underlying equity markets, UCITS III hedge funds have not only provided better downside protection but also have managed to capture most of the upside, hence, providing greater returns over the longer term with less volatility than investing directly in the markets.
On the other hand, hedge funds have outperformed their UCITS III counterparts over the long, medium and short terms as shown in Table 2.
Table 2: Performance of UCITS III hedge funds vs other alternative investments
Eurekahedge Hedge Fund Index
|
Eurekahedge UCITS Hedge Fund Index
|
Eurekahedge Fund of Funds Index
|
MSCI World Index
| |
5-Year annualised returns
|
8.41%
|
3.98%
|
1.85%
|
-1.28%
|
3-Year annualised returns
|
6.15%
|
1.63%
|
-2.02%
|
-2.59%
|
2010 Returns
|
10.84%
|
6.92%
|
4.44%
|
7.83%
|
Sources: Eurekahedge and MSCI
While UCITS III hedge funds have gained more than 20% over the last five years, hedge funds have delivered nearly 50% over the same time period. Additionally, hedge funds have also outperformed UCITS III hedge funds in all time frames. 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 very little representation in the UCITS III space. However, with an increasing number of hedge fund managers launching their own UCITS III hedge funds, we expect the performance numbers to compare more favourably in the future.
In terms of performance, UCITS III hedge funds fared better against funds of hedge funds and the underlying markets in most measures. In the 5-year and 3-years annualised return measures, UCITS III hedge funds have delivered significantly better returns than funds of hedge funds and the underlying markets. Additionally, in 2010, although they underperformed the MSCI World Index, managers were able to capture most of the upside available.
Figure 8 shows the annual performance of UCITS III hedge funds versus other investment vehicles over the last five years. Although hedge funds have delivered the best overall performance almost every year, the returns of UCITS III hedge funds have been quite similar.
Figure 8: Performance of UCITS III hedge funds vs other investment vehicles
Strategies
When comparing the performance across different strategic mandates, we see that funds investing with a long-term macro mandate have delivered the best returns. Macro-investing funds delivered excellent downturn protection during the global financial crisis at a time when most other strategies witnessed significant losses and as such, managers take the lead in the 3-year annualised return measure.
Figure 9 shows the performance of UCITS III hedge funds across the different strategies.
Figure 9: Performance across strategies
Over the last 12 months, UCITS III long-only absolute return funds have outperformed the other strategies primarily through taking leveraged positions in trending underlying markets. CTA/Managed futures funds have also delivered healthy returns amid sharp upward movements in commodity prices. Increased corporate activity during the last 12 months worked in the favour of event driven managers who also witnessed healthy returns.
Table 3: Performance of UCITS III hedge funds across strategies
Arbitrage
|
CTA / Managed Futures
|
Event Driven
|
Fixed Income
|
Long / Short Equities
|
Long-Only Absolute Return
|
Macro
|
Multi-Strategy
|
Others
| |
12-Month returns
|
2.83%
|
9.48%
|
6.38%
|
3.74%
|
6.09%
|
12.81%
|
4.72%
|
2.12%
|
3.95%
|
3-Year annualised returns
|
2.99%
|
-1.26%
|
2.77%
|
3.19%
|
2.66%
|
0.36%
|
5.46%
|
2.67%
|
-4.00%
|
2011 YTD returns
|
0.86%
|
0.76%
|
0.52%
|
0.52%
|
0.07%
|
-1.31%
|
-0.27%
|
0.11%
|
-1.48%
|
Source: Eurekahedge
Geographies
Figure 10 shows the performance of UCITS III hedge funds across the different geographies.
Figure 10: Performance of UCITS III hedge funds by geographic mandates
Although Latin American managers have posted the strongest performance, it should be mentioned that there are very few UCITS III hedge funds investing in Latin America and the average performance is slightly skewed by exceptional gains posted by two managers. That said, Latin America has been attracting greater attention from managers and investors alike due to excellent growth prospects and developed financial regulatory system in the largest markets.
Among the rest of the regions, North America-investing UCITS III hedge funds have delivered the most consistent returns while Asian funds witnessed the best returns over the last 12 months.
Table 4: Performance of UCITS III hedge funds by geographic mandates
Asia ex-Japan
|
Europe
|
Global
|
Japan
|
Latin America
|
North America
| |
12-Month returns
|
8.94%
|
7.49%
|
6.14%
|
9.36%
|
17.77%
|
7.72%
|
3-Year annualised returns
|
1.83%
|
2.08%
|
1.51%
|
-5.45%
|
5.19%
|
2.69%
|
2011 YTD returns
|
-3.94%
|
0.54%
|
0.28%
|
4.33%
|
-4.27%
|
2.24%
|
Source: Eurekahedge
[1] In this report, we include funds employing absolute return strategies with a hedge fund like structure.
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