Knowledge key for investors seeking an edge with alternative Ucits

We currently observe an increase in new alternative strategies being launched in Ucits fund-wrappers.  The Alternative European Ucits industry currently consists of approximately 900 funds with combined assets of $200bn (€150bn), an increase of 265 per cent since December 2007.

The potential of alternative Ucits funds is clear: with AIFMD (the Alternative Investment Fund Managers Directive  – the regulation that was aimed at alternative investment managers, including hedge funds) not yet fully implemented, life for managers wanting to raise new assets is difficult. However, if their strategy is relatively liquid they can also pursue a different route and launch a Ucits fund. Given the current investment environment of low interest rates, the potential of losing capital due to rising yields and stockmarkets getting jittery every time the US Federal  Reserve threatens to reduce QE, there is clearly a need for investment solutions that are not purely long-only.

Potential pitfalls

Ucits-compliant alternative funds have recently become more favoured by retail investors as they address their needs for liquidity, transparency, and risk management as well as portfolio diversification

The Ucits framework defines eligible assets and non-eligible assets. The eligible alternative asset list shows Ucits is less restrictive than often perceived – it allows investments into closed-end funds (up to 10 per cent), structured products and embedded derivatives including credit, financial and hedge fund indices. However, assets may become illiquid during challenging market circumstances and Ucits funds may gate.

Although independent service providers are a requirement under Ucits, it should be borne in mind that the term ‘independent’ can be applied in many ways, for example the use of ‘Chinese walls’ or sister companies. In addition, although there are restrictions on instruments, leverage, diversification, liquidity – and regular reporting processed to both regulator as well as the investor are defined – measuring risk and VaR can be done in different ways.

Clear guidelines for reporting and risk/performance representation are designed to boost the transparency of these funds. For instance, the Key Investor Information Document (KIID) is an example of clear communication towards clients. However not everything may be understood by investors and there are no frequent insights into portfolios.

Although the 5/10/40 rule for investment allocation (which says a maximum of 10 per cent of a fund’s net assets may be invested in securities from a single issuer, and that investments of more than 5 per cent with a single issuer may not make up more than 40 per cent of the whole portfolio) or 20/35 rule for financial indices are intended to boost diversification, these rules may be by-passed, for example through the use of swaps.

In addition, a lack of understanding may also lead to some surprises for investors. For example, ‘government bond’ funds could be interpreted as very low risk investments while ‘absolute return’ could be interpreted as an always positive return investment, neither of which may be the case. Absolute return performance is benchmark unconstrained and can surprise clients both on the upside as well on downside.

Some strategies are not easy to understand for retail investors. They might have tremendous diversifying capabilities although the name of the fund is not a driving risk/return factor.

Classification

Due to these possible pitfalls, investors should treat alternative Ucits like a
traditional offshore hedge fund and should not rely on long-only due diligence methods. The following guidelines should help identify when to implement a higher level of due diligence:

• The fund is traditional long-only benchmark unaware, but is using either an alternative benchmark or a cash benchmark (but not being a money market fund)

• Applies an unconstrained investment style targeting an absolute return over a set period of time, or (variably) directional with
a strong focus on downside risk control (hedging)

• Has the ability to use significant leverage or shorts

• Uses a wide range of alternative instruments, including derivatives for investment purposes both long and short

• Is included or could be included in a hedge fund database or index, for example Eurekahedge for Ucits

Perhaps alternative Ucits funds should not be called ‘hedge funds’ but ‘edge funds’ as they use a wide investment mandate that almost exclusively relies on manager skill and edge to navigate through market circumstances. Before investing, investors need to be fully aware not only of the potentials but also the pitfalls and be aware of when a higher level of due diligence is required.   

Marc de Kloe, head of alternatives and funds at ABN AMRO Private Banking