The Ucits hedge fund brand is being slowly expanded to index products and exchange traded funds (ETFs). Innovations by Deutsche Bank, Marshall Wace and BlackRock are leading the way

Creativity and innovation have always been hallmarks of the hedge fund industry. The development of Ucits-compliant products is a natural progression but one that has required considerable work.

To date only a handful of companies have launched a Ucits hedge fund index and even fewer have delved into the trickier area of Ucits-compliant exchange traded funds (ETFs) based on hedge funds, although traditional Ucits ETFs such as those offered by BlackRock’s iShares platform are flourishing.

Those that have delved into hedge fund ETFs believe the products offer investors a chance to gain true exposure to hedge fund performance while providing the protection and daily dealing advantages of Ucits.

One reason Ucits products based on hedge fund indexes have been slow to take off is that until 2007 the Committee of European Securities Regulators (CESR) had not made a decision as to the eligibility of these within Ucits.

In July 2007 the CESR decided hedge fund indexes were eligible assets for Ucits investment, provided they applied the criteria for financial indexes set out by the European Commission. The CESR also said Ucits funds should perform extra due diligence before investing in hedge fund indexes.

As soon as the guidelines were issued, companies began working on product development. Deutsche Bank’s ETF platform DB X-Trackers set about trying to find a way of producing an ETF that invested in hedge fund indexes.

“We wanted to provide investors with transparency in terms of daily NAV [net asset value] and the ability to trade the product on a daily basis,” explains Manooj Mistry, head of DB X-Trackers in the UK.

The ETF is based on Deutsche Bank’s hedge fund index, which in turn tracks the performance of 40 managers on the bank’s managed account platform.

“Because the managed account platform is managed by Deutsche Bank we have full visibility in terms of what the fund managers are doing,” Mistry says.

The index is weighted according to the global Hedge Fund Research index weightings and consists of five Ucits-compliant strategies.

Mistry says the hedge fund index ETF took 18 months to develop and the company worked closely with the Luxembourg regulator, the Commission de Surveillance du Secteur Financier (CSSF), to do this. Difficulties encountered along the way included having to create disclosures and a more detailed index description than would normally be required.

“The difference is that this is based on actual hedge fund performance rather than just replicating the hedge fund strategy,” says Mistry. “What we have found is that the product has gained a lot of traction with a wide variety of investors. Because it ticks all the right boxes, it appealed to a lot of investors who might not be considered hedge fund investors.”

Since its launch in early 2009 the ETF has gathered $1.3 billion in assets under management (AUM), a better flow of money than most Ucits-compliant hedge funds.

Mistry believes the Deutsche Bank ETF was the first to be based on a hedge fund index.

At Marshall Wace, investor relations head Anthony Marber says the market neutral MW TOPS Global Alpha is the only ETF based on a single strategy.

Marber explains that the TOPS strategy delivers an “extremely diversified and liquid long/short equity portfolio.”

“When you look at the portfolio you might assume it was an index because it’s so diversified,” he adds. Marber says this is what enabled Marshall Wace to work alongside Dow Jones to create the MW TOPS Global Alpha index. The ETF tracks that index.

Marber says Marshall Wace believes the TOPS strategy delivers persistent alpha. Both before and after the financial crisis the company was looking at ways of diversifying its client base and giving more investors access to the
returns generated.

Broad appeal
He says the ETF is an “extremely liquid, conservatively managed, risk-managed product” which appeals to a wide range of investors. Through partnerships with distributors and banks, Marshall Wace is able to sell the ETF to investors who would not normally be able to invest in the company’s products.

“There’s never been a pure alpha ETF before,” Marber says. “This is exciting because most ETFs are used to provide passive exposure to a sub-sector, commodity or market.”

Marber adds: “There are institutional investors who use ETFs as a bread-and-butter instrument within their portfolios. They use them all the time as a way of getting generic exposure to a market sector, for example. For these people, therefore, we’re offering something they never had before in a form of instrument that they know extremely well.”

According to Marber, educating investors and building relationships has paid off, with $450 million inflows into Marshall Wace’s new daily-dealing fund, the bulk of this into the ETF, since launch in March 2010. He says while Marshall Wace currently has no plans to launch another ETF, it would be possible to do so using other TOPS strategies if there was sufficient demand.

At Lyxor, which has a series of popular investable hedge fund indexes, global head of sales and marketing for alternative investments Christophe Baurand says a Ucits fund exposed to a hedge fund index has fewer constraints and unlike many Ucits hedge funds is not a replication product.

Baurand explains funds tracking indexes can avoid the perform- ance drag associated with Ucits hedge funds.

Meanwhile, an increasing number of providers are launching indexes and databases of Ucits-compliant hedge funds as the universe grows in an effort to shed more light on what is still a developing industry.

Some within the hedge fund industry are yet to be persuaded that ETFs and index products are a suitable use of the Ucits brand. Even those producing these products acknowledge that investors must still carry out the necessary research before allocating.

Marber notes: “I certainly don’t believe that the Ucits stamp obviates the need for full due diligence on a product or the manager.”

Nevertheless, there is clear demand for Ucits ETFs and indexes based on hedge funds and this will surely encourage more managers to launch products in the future.