The global investment fund industry managed around $38 trillion at the end of 2014. Of this, $14 trillion, or about €11 trillion, is managed in Europe, which nearly €8 trillion is in UCITS funds (Chart). These “undertakings for the collective investment in transferable securities” are EU regulated investment funds which have also been very popular outside Europe, especially in Asia. Importantly, UCITS also opens up hedge fund strategies to a much wider audience.
The hedge fund universe contains an estimated 10,000 funds and UCITS hedge funds number at least 600. Sweeping generalisations regularly made about UCITS hedge funds include that they have higher costs, lower risk targets, are diluted siblings of offshore hedge funds and also suffer from liquidity mismatch problems. All of these claims can be true for some funds but completely untrue of others. There is no substitute for doing the due diligence on each UCITS fund, and here we examine three popular blanket statements.
A UCITS structure may entail cost line items that are not essential for an offshore structure, including a depositary and sometimes fees associated with Total Return Swaps. But what counts is the Total Expense Ratio (TER) and UCITS are at least required to publish this in their Key Investor Information Document (KIID).
In contrast some hedge fund managers are not able to quantify their TER so we have to try and estimate it from financial statements, or request it from administrators (who sometimes claim that the service level agreement does not include calculating a TER!). The good news is that some UCITS are capping their TERs at very competitive levels, as low as 1.5% and sometimes even lower for early bird share classes available for the first 25, 50 or 100 million invested in a new structure, meaning that the new UCITS can even be cheaper than the offshore.
Bear in mind that a TER is meant to include service provider costs and brokerage commissions as well as manager fees (but not frictional turnover costs, which we touch on later). By way of comparison, some offshore funds have headline management fees of 2% and every year the EY hedge fund survey documents the number of extra costs that are being lathered on top of the management fee, ranging from research to regulatory compliance. So, some UCITS have apparently competitive TERs but is this merely commensurate with lower risk levels?
Non-European investors should be aware of how a UCITS fund is taxed in their particular jurisdiction. For example, our Canadian friends are generally free to invest in UCITS funds though, as these are European rather than Canadian domiciled, and therefore treated as offshore investments, the Canadian tax authorities may apply an “imputed” amount of tax regardless of whether a fund earns a return.
If some UCITS have lower targeted or realised volatility than offshore fund siblings run by the same manager, this will often be because the manager has chosen to specify a lower risk level for the UCITS. It is true that some UCITS have a leverage limit of 200% that would be lower than many offshore hedge funds, but many UCITS instead have a VAR (Value at Risk) based limit which can be surprisingly high. The absolute VaR limit is 20% at the 99%, 20 day level, which is generally a multiple of most hedge fund volatility. A relative VaR limit can be even higher as it is double the level of a reference benchmark, which could be a highly volatile index such as technology – or even biotech!
We know plenty of UCITS that are run pari passu with offshore funds, or have virtually no tracking error. There are even some UCITS funds feeding into offshore master funds, and vice versa while others have total return swaps with portfolios of offshore funds.
But some UCITS do have lower risk than offshore funds pursuing similar strategies, and this is usually a consequence of UCITS investment restrictions rather than big picture risk limits per se. UCITS cannot hold more than 10% in one security so strategies that rely on running a very concentrated book will find UCITS somewhat dilutive. The inability to borrow cash securities means UCITS cannot use repos (repurchase agreements), which may restrict the size of their short book investment universe.
The UCITS requirement to provide liquidity at least twice a month may also rule out less liquid instruments, so strategies that rely on picking up illiquidity premia or on maturity transformation will not be suited to UCITS. We have noticed some managers of equity related UCITS have lower small cap weightings than in their offshore funds.
There is a growing debate over whether it is appropriate to invest in credit assets, using liquid vehicles such as Exchange Traded Funds (ETFs), UCITS, ’40 Act funds and other liquid structures. The concern is that even if liquidity provision carries no explicit cost, its implicit costs (including bid-offer spreads and market impact, which do not appear in TERs) will be borne by longer term investors who end up cross-subsidising shorter term traders who enjoy a free ride to dip in and out of funds. With the exception of permanent capital vehicles such as closed end funds, this issue can arise for any type of investment vehicle that does not charge entry or exit costs. This debate has intensified as liquidity in credit markets is reportedly deteriorating as banks and brokers, hampered by regulation, are holding far less inventory than they once did.
How serious the issue is will vary enormously by the type of asset traded. The most liquid credit index products can have bid-offer spreads lower than a basis point whereas some distressed debt assets have a five point bid offer spread that could equate to 15% of the price of assets trading at 35 cents on the dollar. We have not noticed any UCITS trading distressed debt and indeed some of them even avoid lower rated credits.
But it is not impossible for a UCITS to trade assets with material bid-offer spreads. The UCITS rules require liquidity provision and many vehicles do not charge for this – but the rules do not stipulate that liquidity must be free of charge. UCITS can impose fixed or variable bid-offer spreads, which are sometimes described as “anti-dilution levies” or “swing pricing”. UCITS can also invoke gate provisions to slow down outflows and both of these policies may be appropriate for UCITS investing in some types of assets.
The most serious potential liquidity mismatch in a UCITS could arise from the little-known potential for UCITS to invest up to 10% in pre-IPO private equity. The 10% at a point in time could end up being a far larger percentage if the other 90% falls in value – or if the fund experiences outflows and uses liquid assets to meet redemptions rather than side-pocketing the pre-IPO private equity. How can investors avoid this problem?
The answer is very simple. Plenty of prospectuses of both offshore funds and UCITS rules have a prohibition on pre-IPO equity. Investors can seek out funds that offer this assurance or ask for it to be appended to offering documents. Although the UCITS rules may offer a framework of risk rules, as always the devil is in the detail of the documents. There is no substitute for reading the prospectus. Portfolio transparency in the form of administrator NAV transparency reports is also de rigueur for many allocators, with the Hedge Fund Standards Board (HFSB) having devised a template for these reports.
Allocators and investors who are interested in learning about UCITS that meet our criteria should get in touch.
Hamlin Lovell, CFA & Keith Tomlinson, CFA
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