As Ucits hedge funds and funds of hedge funds (FoHFs) proliferate, questions are being asked about the ability of strategies to fit in the Ucits framework as well about the diversit of funds on offer.

Hedge funds first started using Ucits wrappers around their funds so institutional investors otherwise blocked from investing in offshore funds could find a legitimate route to access returns. Although Ucits are mainly used for retail funds that hold transferable securities such as equity and bonds where the potential loss is limited to the amount paid for them, Ucits hedge funds are a different beast.

The speed of the hedge fund – and funds of hedge funds – take-up of the wrapper caught most by surprise. Certainly, Ucits III opened the way for hedge funds to tweak the rules in order to fit the more liquid strategies into the framework. However, it is clear the phenomenon took Brussels bureaucrats by surprise. The idea of Ucits hedge funds was an unintended consequence of the Ucits III rules and Ucits IV is set to make the format even more popular among hedge funds.

The attraction to the product is a combination of a couple factors. In a world of continued uncertainty, Ucits is seen as a sure thing. It is already considered a global brand. Investors like it because it guarantees (up to a point) liquidity and transparency.

Hedge fund managers, particularly in Europe, nervous about just what form the alternative investment fund managers (AIFM) directive may eventually take, see Ucits as a safe haven. Since AIFM encompasses all alterative funds except Ucits, the structure offers some stability in an otherwise uncertain regulatory landscape.

Institutional investors in Europe as well as outside, specifically the Far East, like the product. Many see the Ucits stamp as a guarantee of quality. This, however, could be a double-edged sword. A Ucits hedge fund could be as complicated and just as risky as a traditional hedge fund structure. Due diligence is needed as well as an understanding of what the strategy is doing and how it is doing it.

Many in the industry worry about the tendency to shoehorn hedge fund strategies into the Ucits straitjacket. The idea of a total return swap vehicle introduces complexity and risk at a level not -probably intended for a Ucits vehicle, say some.  

The big question is whether or not Ucits is really the right vehicle for hedge funds. While there is no doubt that some hedge funds can transfer into a Ucits structure, not all strategies fit. Concerns over additional costs as well as limiting performance because of portfolio constraints have also been raised.

Brian Kelliher, a partner at Dillon Eustace, says there is no difference in rules between Ucits hedge funds and an ordinary Ucits, although managers need to be aware of strategies and other constraints. “The typical [strategies] that you’ll find are long/short because they fit nicely into the Ucits world. It’s the strategies that determine whether you’ll be compliant with the Ucits rules. What the hedge fund manager then has to do is become familiar with the Ucits rules themselves.”

There are differences in the way service providers are dealt with under Ucits. For example, there is no prime broker. “All assets have to be held by the custodian or controlled by the custodian. It does require a little more time in explaining the rules to them [hedge fund managers] from their perspective because they do see it differently. The whole -leverage rules are new for them,” notes Kelliher.

“It remains to be seen how well these Ucits do. The success of this will depend very much on their performance,” he adds.

That performance issue lies at the heart of the debate. Stripping away the concerns about whether a hedge fund strategy fits or not into the Ucits framework becomes irrelevant if the fund does not perform. Take a badly performing Cayman-domiciled hedge fund and put a Ucits wrapper around it and it is still a badly performing hedge fund.

What many investors question is whether the constraints of the Ucits directive affect the performance of the actual fund. The logic goes that there is little reason to buy a Ucits product that does not perform as well as a Cayman one, for example. The jury on this seems to be split, too. Many managers argue that the performance of a Ucits fund can match an offshore unconstrained fund.

Chris Wyllie, head of portfolio management partner at Iveagh, says his company has managed its own Ucits funds for 3-5 years. Although it can be a “pain”, the Ucits funds mesh together to “provide decent safeguards for investors”. He, like others, believes investors should not be lulled into a false sense of security just because a hedge fund is classed as Ucits compliant. “You can still get caught out and have a shock. Ucits can gate, too. Investors need to do their homework to make sure the fund is really structured appropriately for Ucits III,” he says.

Thomas Weber, a partner at LGT Capital Partners, believes Ucits funds are “complicated”. While they give investors an “added stage of approval and it is easier to put them on a balance sheet”, he is cautious about their usefulness.

“We are always careful if an additional structure element is attached to an investment. We try to avoid structures that make investments weaker. If the process of making a fund Ucits compliant does not inhibit the investment manager but adds on an additional layer of cost, as long as the client is happy to accept it, we’ll do it,” notes Weber of his fund of hedge fund selections.

Christophe Baurand, global head of sales and marketing for alternative investments at Lyxor, does not think Ucits hedge funds will compete with direct investment in traditional hedge funds. However, he does think some of the features of Ucits hedge funds, in particular the promise of liquidity, will make these structures attractive for many investors burnt by gating, suspensions and the general mis-matching of liquidity terms to underlying assets exposed in 2008. He thinks investors will continue to be attracted to such structures.

Others, however, are not so sure. Weber would like to see a performance comparison between Ucits hedge funds and their unconstrained counterparts. That, he believes, would be an interesting exercise.

Another reason hedge funds have been keen to move into Ucits is access to a different and wider investor base. Many pension funds, insurance companies and others in Europe are limited in their ability to allocate funds to non-regulated products. Ucits opens the door for many of these investors.

The passporting ability of Ucits is another attraction. Being able to market and distribute funds in multiple EU jurisdictions is attractive. However, a marketing and distribution network takes time and money.

The success of some of Ucits hedge fund platforms has encouraged more managers to consider Ucits. The platform  run by Merrill Lynch Investment Solutions (MLIS), part of Bank of America Merrill Lynch, has seen some success. The MLIS BlueTrend Ucits Fund, for example, closed at $642 million after only 18 months on the platform. Many believe its success was partly due to the ability of investors to access a BlueCrest fund, usually closed to investment.

The proliferation of funds of Ucits hedge funds is something that has also taken many by surprise. Again there are questions over whether the relatively small universe of single manager funds is sufficient large and diverse to accommodate a FoUHF structure. Investors, too, may question the added fees and complexity the FoUHF structure adds.

Despite the myriad views, Ucits hedge funds continue to launch. Whether these structures will be made redundant once the AIFM passes or just simply fade away like the 130/30 funds remains to be seen. What is clear is that investors around the globe recognise the brand and take comfort in the regulated and proscriptive approach of the regulations. This alone could ensure Ucits hedge funds continue to thrive even after the regulatory smoke has cleared.

Improvements for Ucits

EU legislation is constantly changing. The Ucits directive is no exception and in 2011 the fourth iteration of the legislation will be implemented by all member states.

Ucits IV streamlines or improves a number of aspects of the directive and will mainly make it easier for managers to market their funds across the EU. The precise details of how the legislation will be implemented will vary in each jurisdiction. However, the advantages of Ucits IV will be broadly similar.

For the first time Ucits IV introduces a management company passport. This means a management company established in, for example, the UK, will not have to establish a full operation in another EU member state to market its funds there. The management company passport will make life easier particularly for smaller managers who could find the current requirement to set up companies across Europe costly.

The Ucits IV legislation will speed up the approval process for marketing a fund cross-border. Instead of having to seek approval in each member state separately, regulators will exchange documents electronically and approval will be granted within weeks. For the first time it will also become possible to merge similar investment strategies marketed to different countries and sell them as a single fund across the EU.

Fund managers will have to produce key information documents (KIDs) for investors. These are limited in size to two sides of A4 paper. A KID is needed for each share class and in each country where the fund will be distributed, potentially leading to a large number of documents.

Ucits IV also allows master-feeder structures for the first time and requires funds to have a separate depositary established in the fund’s home member state. The definition of the role of a depositary has not changed from Ucits III although in practice the exact duties vary across EU member states.

This is one area where future legislation is likely to change the scene substantially, particularly with regards to depositary liability. T

he regime being proposed in the alternative investment fund managers (AIFM) directive would make the liability regime for depositaries significantly tougher than it currently is.  Joanne Harris