Funds of Ucits hedge fund are increasing as the numbers grow although choice is small compared to offshore funds. There is concern abot concentration and lack of diversification of strategies.

At present there are only a handful of established funds of Ucits hedge funds (FoUHF), although the first months of 2010 have seen the launch of several more. Whether this is a sign there is real appetite for FoUHFs or an attempt to jump on the regulated fund bandwagon remains to be seen.

There are now estimated to be around 600 single-manager Ucits-compliant hedge funds with over $200 billion in assets under management (AUM). This is a tiny universe for FoUHFs to draw from compared to the over 10,000 offshore hedge funds with $1.7 trillion AUM.

Questions have been raised about whether the Ucits hedge fund universe is big enough for FoUHFs to start considering their options. There are also concerns that the small numbers means FoUHFs are concentrating investment in much fewer funds than normal and lack true diversification.

Another issue is that in a time when capital raising for hedge funds is proving tough, FoUHFs have yet to prove they are truly attractive for investors. FoUHF managers report slow progress in asset raising and many investors remain unconvinced of the benefits of the model.

Collins Stewart launched the first daily-dealing FoUHF in October 2009. Nine months on the fund still has just £14 million AUM.

Blue Activos Financeiros, which runs a FoUHF for Portuguese bank Grupo Banco Espírito Santo, is still sitting with its Ä10 million of seed capital after launch in April 2010.

HSBC Alternative Investments head of portfolio manage- ment Tim Gascoigne says HSBC’s Ucits AdvantEdge fund, launched at the end of 2009, now has AUM of $160 million. He hopes this will grow as the company gains passports in order to distribute it in more EU countries.

Marketing and distribution is key to the success of the asset-gathering effort. Like single-manager Ucits funds, FoUHFs are often launched to try and reach a new group of investors that might not otherwise look at hedge or absolute return funds.

Collins Stewart is planning to begin marketing its FoUHF to independent financial advisors (IFAs) in the UK later this year now that the fund has established a track record. Fund manager Richard Hodgetts is looking for money from investment platforms run by IFAs and similar retail investment houses rather than concentrating on the institutional sector.

Gascoigne says HSBC has been working on ensuring its FoUHF receives a passport for a variety of EU countries. He expects assets to flow in once the fund is saleable in places such as France, Germany and Italy.

In the meantime he says HSBC has seen investment from the Middle East and Asia for the AdvantEdge fund. The company is able to distribute globally thanks to its international footprint as well as the brand recognition that Ucits has.

To market a FoUHF successfully, like a standard FoHF, a manager needs to be able to prove that the fund provides the diversification and protection for investors to make it worth the extra layer of fees.

Despite the relatively small size of the Ucits universe, the selection process for a FoUHF is broadly the same as the selection process for a FoHF. Networking and existing manager relationships are cited as the main way of finding Ucits hedge funds for inclusion in the fund of fund vehicle.

Building on the past
Hodgetts says Collins Stewart is relying on a long history of relationships with the traditional hedge fund market to build its portfolio of underlying funds. He believes the quality of managers coming to the Ucits market has been “excellent”, adding, “So far, so good” – although many within the industry would disagree.

Jean Keller, chief executive at 3A Alternative Investments, says the company’s Dynamic Ucits Fund has a portfolio of around 20 managers. Half of these are managers 3A already knew, while the others were new to the company and were discovered after launching a Ucits-compliant hedge fund.

Picking the funds that form a Ucits FoHF portfolio is just as time-consuming as selecting funds for an offshore FoHF. Keller says it can be harder work. This is partly due to the need to ensure that all the underlying funds are true Ucits funds.

“We have seen some pretty jazzy stuff out there,” says Keller. “It’s a lot of work and you have to analyse this. We try not to invest when we feel that it’s not in the spirit of the Ucits regulation.”

That means finding strategies that fit comfortably within the Ucits rules and regulation. João Brito e Cunha, managing director of Blue Activos Financeiros, says it remains to be seen whether all the managers coming into Ucits will be able to comply with the directive’s stringent rules that they are often unused to.

Keller and others also express concern that some hedge fund managers are trying to force hedge fund strategies into a Ucits vehicle.

The Commission for European Securities Regulators (CESR) is currently undertaking a consultation to establish guidelines for the calculation of risk measurement within a Ucits fund acknowledging the fact that sophisticated and complex derivatives are now more common, particularly in Ucits hedge funds.

“You’re looking for funds and strategies that will perform almost as well as the offshore hedge fund strategy. That has turned us away from some certain funds,” adds Gascoigne.

FoUHF managers are wary in particular of Ucits hedge funds that use a total return swap to replicate an existing offshore fund. For a multi-manager Ucits product the total return swap structure gives too much exposure to the underlying offshore fund. Although the offshore product may be a good investment for a hedge fund investor, the swap gives Ucits investors too much exposure to the risks of the underlying fund.

“We want to make sure that our assets are onshore and are controlled and regulated,” Brito e Cunha says, explaining why he prefers a true Ucits hedge fund to swaps or similar replication structures such as index funds.

However, FoUHF managers are also looking for funds they believe are true absolute return funds in a Ucits structure. Hodgetts says Collins Stewart is watching around 70 managers he believes are genuinely shorting for alpha in the way an offshore hedge fund would.

Hodgetts is also monitoring underlying liquidity closely. As a FoUHF with daily liquidity,  Collins Stewart can only invest in single-manager funds that also have daily liquidity.

Hodgetts notes that more single funds with weekly liquidity are now being launched and this is a situation the company is watching. “We need to be cognisant of our opportunity set and if too much of it moves against us we’re going to have to re-evaluate,” he says.

Concentration is also appearing in the universe of strategies being launched. The constraints of the Ucits rules mean around half of all hedge funds launched within the vehicle so far are equity long/short. That is mirrored in the portfolios of FoUHFs. Commodity trading advisors (CTAs) and managed futures are also well represented, along with global macro funds.

There is a strong risk FoUHFs are currently unable to diversify themselves sufficiently between strategies and also between each other. As well as being loaded towards equity long/short, the majority of Ucits hedge funds are run by European managers and invest in European financial instruments.

American dream
Both Gascoigne and Keller say this is why they are increasingly looking at US managers who have or are planning to launch Ucits funds. At present there are only a few of these, including big names like York Capital on the Bank of America Merrill Lynch platform. More US-based managers are expected to launch Ucits hedge funds this year.

Another issue FoUHF managers have to deal with is transparency. An often-trumpeted benefit of Ucits is that investors are supposed to be able to access far greater transparency than in a traditional offshore hedge fund.

FoUHF managers think this is not always the case. They report information is often provided for all investors in a Ucits fund at a level suitable for the retail sector and it can be difficult to get full disclosure about an underlying fund’s investments.

Keller is comfortable with the amount of information 3A receives from its underlying managers. “To know at all times what’s in the portfolio is unrealistic. If this is what you want you’re much better off with a managed account. Transparency’s a lure because in the end you have to be able to make the correct use of the information,” he says.

Liquid refreshment
Liquidity is another factor encouraging FoUHFs to establish. Badly burnt in the financial crisis in 2008, many FoHFs discovered the underlying hedge funds in their portfolios were not able to meet redemption requests. The FoUHFs see Ucits hedge funds as a safer bet. However, even here there are some problems.

While Ucits hedge funds can offer daily liquidity, many find this too onerous and cumbersome and are opting for weekly or twice-weekly liquidity. This in turn could force FoUHFs to review what kind of redemption terms they can offer their investors.

It remains to be seen whether a FoUHF provides investors with any extra protection over a single-manager Ucits allocation. As in offshore FoHF vehicles, investors are paying for additional due diligence and manager selection. As the Ucits universe grows, that fee will be worth even more.

Some would argue investors would be better off investing directly into a single-manager fund hosted on a platform. As in a FoUHF the due diligence would have been carried out and the manager selected by a large institution while the investor has the opportunity to diversify a portfolio more easily. Even here, however, choice is limited.

Managers say for clients who do not want to go down the platform route or set up a managed account structure, FoUHFs offer another way of accessing the Ucits universe. However, in the long run FoUHFs are more likely to appeal to smaller institutions and private client investors who might like the idea of an absolute return Ucits but find the prospect of investing directly into a Ucits hedge fund too daunting to face alone.