Flight to Mystery

Assets managed by European UCITS III funds have increased to $52.3 billion over the last two years. These special purpose vehicles are about to kill the traditional hedge fund industry, and are emerging as the new generation of sophisticated investment strategies.

“Using cautious estimates, projections for 2012 indicate that over €8,000 billion will be invested in UCITS products, an increase of 60% – from €5,000 billion at end 2007.”

Eurekahedge Pte.

Finally, some happy news for all the bankers who have been living in fear lately of how the new financial regulations – also known as the Dodd-Frank Legislation – will affect their business. I’m proud to announce: Problem solved!

It was Morgan Stanley who put me on the track to this brilliant solution a couple of weeks ago when they announced the launching of its first UCITS III Fund on the Firm’s FundLogic  trading  platform.

Since then, I’ve discovered that all the big US, and all global non-European, banks are doing the exact same thing.

They are in practice outsourcing their investment bank activity to Europe.

The new financial regulations in both US and EU are aimed at traditional hedge funds (who have been blamed for everything from causing the financial meltdown to climate change) and the well-known tax heavens – also known as offshore banking.

But the financial industry seems to have found an alternative in EU’s UCITS III Funds. (Undertakings for Collective Investments in Transferable Securities).

And the alternative is about to get even better with the introduction of UCITS IV in 2011.

In fact, it’s so good that several financial institutions are bringing their offshore accounts from places like Calman Island and Bermuda onshore – inside the EU area.

A collective investment fund may apply for UCITS status in order to allow EU-wide marketing.

UCITS’ are a set of European Union directives that aim to allow collective investment schemes to operate freely throughout the EU on the basis of a single authorization from one member state.

In practice many EU member nations have imposed additional regulatory requirements that have impeded free operation with the effect of protecting local asset managers.

In other words; the EU countries are now competing to offer the funds the best possible framework, with as few regulations as possible.

At the moment Ireland and Luxembourg is leading the race.

Morgan Stanley’s UCITS III Fund will be managed by by P.Schoenfeld Asset Management LP (PSAM) in Ireland.

Shahzad Sadique, Executive Director and Head of FundLogic at Morgan Stanley says in a statement: “We are seeing a huge level of interest from investors to access alternative asset manager expertise through UCITS Funds and are delighted that PSAM has partnered with Morgan Stanley. We are currently seeking regulatory approval for a number of funds managed by leading alternative asset managers and look forward to launching more UCITS funds on FundLogic in the next few months.”

(Morgan Stanley Press Release)

Mostly Illegal

UCITS III Funds are illegal to offer and sell in the US and most other countries around the world, except within the 30 countries connected to the European Economic Area (EEA).

The idea behind the UCITS is to create a single market in transferable securities across the EU. With a larger market the economies of scale will reduce costs for investment managers which can be passed on to consumers.

However, many asset managers are using UCITS as a main channel for globalizing their businesses with considerable interest outside the EU and as far out as Asia and South America.

UCITS III Funds   is the second version of the EU Commission’s directive outlining a framework for investment funds suitable for marketing to retail investors and has standardized rules for authorization, supervision, structure and activities of collective investment undertakings in the EEA and so to enable them to be distributed throughout the EEA.

This significantly enlarges the range of investment instruments that could be used, notably allowing use of derivatives.

It makes it possible for hedge fund managers to launch versions of their strategies in a UCITS version so many more investors can access them.

According to the EU directives, a UCITS fund must be open-ended, liquid, well-diversified, invest only in certain “eligible” assets (i.e. quoted securities, money market instruments, deposits, certain derivatives and units in other UCITS) and can only employ limited leverage.

Examples of Financial Derivative Instruments that can be used:

CFDs: Under UCITS III rules, the manager can be long up to 100% in directly held equity securities and short up to 100% using stock specific derivatives such as contracts for difference (CFDs) or stock specific futures. Therefore, the fund can be leveraged up to 100% of NAV.

• Total Return Swaps: This involves investing in a portfolio and swapping its return through a total return swap for a return that is related to a reference basket (or index). Examples of a suitable reference basket could be an equity long/short strategy or a commodity index. This structure is ideal for managers that find the restrictions of the previous option too onerous as the reference basket itself does not have to comply fully with the UCITS rules.

Credit Default Swaps: CDS can be used in a number of ways in fixed income strategies, for example hedging exposures and buy/write protection, or playing the basis between the CDS and underlying corporate spreads.

* Certificates (either individually or in a series) can also be used within the UCITS III framework to replicate the risk/return profile of FOHFs. Alternatively, a UCITS eligible index can be created to replicate all of the underlying hedge fund strategies; the index needs to meet the UCITS criteria of eligibility though.

With any of the techniques mentioned, distribution is paramount to global take-up of UCITS III, and has become the most dominant channels for cross-border sales of UCITS funds, owned by third-party distributors and open architecture platforms.

Hedge fund managers, sitting in a larger asset management company with existing mutual fund platforms, are ideally positioned to distribute UCITS III funds offerings, benefiting from access to a wider spectrum of clients.

Road to Freedom

Because the UCITS lies outside the scope of the European draft Alternative Investment Fund Managers Directive, which is likely to impact unregulated offshore hedge funds in yet undefined ways, this is potentially beneficial as the AIFM.

Directive is likely to impose constraints on European investors investing in third-country funds, and most likely include those domiciled in offshore jurisdictions such as Cayman Islands and Bermuda.

However, Morgan Stanley is not one of the pioneers in this area.

Last month it emerged the world’s third largest hedge fund, Paulson & Co, is coming to Europe.

Founder John Paulson, who made a 589% and 351% profit in his two Credit Opportunities hedge funds on the US subprime collapse, is making himself available via a UCITS fund later this year.

But neither Paulson is the first to make his skills available to retail investors via funds domiciled inside Europe.

Others are bringing Caribbean-based product onshore because of the EU’s plans to regulate hedge funds in such a way that non-EU managers, including Paulson, and offshore funds, would be barred from taking money from European investors.

One way for such managers to get around this is launching portfolios in Europe.

Marshall Wace is shifting all its Cayman Islands portfolios to Europe.

Rival Majedie Asset Management did so, too.

Gartmore and RWC Partners will make regulated variants of every offshore fund they launch now, too.

Investors seem increasingly to opt for onshore funds where one is available.

However, Dalton Strategic Partnership has drawn a line in the Caribbean sand, and is taking steps specifically focused on keeping offshore fund clients.

The European UCITS long/short fund of Dalton Strategic Partnership grew from €4m at launch in February to €50m now, during which assets in its Melchior European hedge fund stayed static, for example.

Similar stories are told at Man Group for AHL, RWC Partners for US equities funds and Gartmore for various portfolios.

The transparency, liquidity and regulatory oversight required in a UCITS addresses investor concerns in a post-Madoff, post-credit 2008 crunch environment.

However, the regulation allows an even greater risk taking, in fact, it encourages greater risks.

Dalton’s onshore funds will double the risk-taking appetite of Melchior.

Magnus Spence, partner, explains:

“We are differentiating the products one from another, and need to recognize and meet the different needs of investors in offshore hedge funds and UCITS III hedge funds. Investors in UCITS hedge funds tend to seek lower-risk strategies, which typically offer return targets of between 5% and 10% per year.”

“In contrast, many traditional investors in offshore hedge funds are prepared to accept a considerably higher level of investment risk in return for performance greater than 10%.”

What Dalton’s latest move shows is that not everyone is so keen on “on-shoring” after all.

Barclay’s are among the big banks who still offer offshore products to its clients, now within the UCITS framework:

“The Structured UCITS Funds for Offshore Bonds range allows investors access to a leading range of Funds, all approved under the EU UCITS III Directive. A UCITS III fund refers to any collective investment scheme set up under the UCITS Directive of 1985, as modified by the amending proposal of 2001. As the UCITS Directive is a pan-European directive, the main benefit of UCITS III is that it makes it easier to passport and market such funds throughout Europe. UCITS III allows funds to invest in a wide range of financial instruments, opening up the range of investment strategies available to fund managers,” Barclay’s write on their website.

Adding: “Our Fund range is developed by our asset class neutral structuring team. Our team creates innovative products across asset classes – developing solutions to help clients achieve optimal asset allocation as well as manage risk. Our team specializes in delivering quantitative asset allocation strategies within a UCITS III compliant fund format.”


Risk? What Risk?

The regulations impose a daily VaR calculation on the UCITS funds.

I guess most of you know what Nassim Taleb thinks about the VaR method.

In addition, the chart below, showing weekly changes in the S&P500 from 1950 to 2009, proves that this standardized risk valuation ALWAYS comes up with a wrong result:

According to Singapore-based Eurekahedge Pte, assets managed by UCITS III funds have increased to $52.3 billion over the last two years.

The largest chunk of UCITS III assets are invested in Europe, which account for about 41 percent, while globally mandated funds account for 32 percent.

An increasing number of UCITS III funds will start in North America as the investment class gets more attention and gains greater popularity, Eurekahedge says.

Currently, the head office locations of firms that have started the funds are predominantly in Europe, with the U.K. accounting for almost half.

Using cautious estimates, projections for 2012 indicate that over €8,000 billion will be invested in UCITS products, an increase of 60% (equating to double-digit growth each year) from €5,000 billion at end 2007.

And it’s about to get even better!

From Europe with Love

A recent survey showed that UCITS III hedge funds could have a negative impact on the hedge funds.

Almost 7 of 10 respondents say that the increase in UCITS versions of hedge fund strategies will result in “liquidity premium of hedge fund strategies to disappear” and their performance will fall. HFMWeek reports.

90% of respondents say that the UCITS trend will continue. And two thirds of them plan to take part, aiming to create UCITS versions of their own funds to avoid being shut out by strict new European Union hedge fund regulations, according to FINalternatives.com.

And in July 2011 the UCITS IV is due to be implemented across the EU Member States.

The principle features of this new legislation are:

  • New rules surrounding fund mergers (Management company passport allowing UCITS authorized in one Member State to be managed remotely by a management company established in another Member State. In practice, currently, a management company can only manage a UCITS where it is domiciled in the same Member State as the fund.)
  • Clarification on the Management Company Passport. (Simplification of the procedures for cross-border distribution to minimize  the ability of Member States to impose their own local registration requirements. Currently, different Member States impose their own local registration requirements which can vary on a country-by-country basis).
  • New freedom to use Master/Feeder funds within pooling techniques. ((mostly tax-driven  asset-pooling).
  • Revised rules on regulator to regulator cooperation. (Framework for the domestic and cross-border mergers of UCITS allowing consolidation of UCITS and potential reduction of the Total Expense Ratios of such funds currently passed on to investors.)
  • The new UCITS IV Key Investor Information requirements. (Replacement of the simplified prospectus with a key investor information document designed to present comprehensible information similar for the UCITS of each Member State).

This enable investment companies to lure customers with products that guarantee a positive return, and at the same time promise zero risk.

Here’s an example of a UCITS prospectus, marketed by KBC Asset Management:

Disclosure of risks in UCITS III Prospectusses

Here’s an overview of the key features of the UCITS III funds.

Already Abused

For the hedge fund manager, UCITS provides a delivery channel to a different investor base diversifying business risk.

It also addresses investor concerns about the operational and fraud risks that plagued parts of the offshore unregulated industry in 2008. In addition, it provides a potential means of dodging the AIFM directive.

There will be managers who see UCITS as a convenient dodge and an easier path to raising capital, and there will be those who see it for what it is; the evolution of European mutual fund legislation to ensure better investor protection while providing investors more choice.

It is important that managers comply with the spirit of the law as well as the letter.

The risk to UCITS as a brand is that it is abused by some managers which abuse the market uncovers in the usual discontinuous fashion and the fallout tars all UCITS with the same brush.

UCITS is designed for liquid strategies.

Shoe-horning illiquid strategies into UCITS are a very bad idea. Not many people are aware that UCITS has a gating facility. This is an emergency feature for when normally liquid markets seize up. To run an illiquid portfolio in a UCITS in the hope that the gate provision is never needed is irresponsible on the part of the manager and the service providers who help to bring that UCITS to market.

UCITS is designed for low to moderate leverage strategies. The Sophisticated Fund classification which measures leverage in terms of VaR allows liquid strategies where delta notional exposure is not an appropriate measure of leverage admission as a UCITS.

It is not there so that a highly levered and risky strategy can easily be slipped into a UCITS.

UCITS is designed for portfolios of eligible assets which are eligible by virtue of their liquidity, price discovery and transparency.

It is designed so that the UCITS can feasibly supply the represented liquidity, provide an accurate and representative valuation of assets and not carry surprisingly large liabilities on the balance sheet which unexpectedly erode the value of the Net Asset Value.

How this $12 trillion market will develop over time is still a mystery.

So, use with care, my friends!

Additional reading:

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8 responses to “Flight to Mystery

  1. Your thought of article is very much creative and interesting to read.

  2. Just read it and went gosh, I know why I was poor in the debate class. – There is a statue of limitation. – Samuel Goldwyn 1882 – 1974

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