Ucits wrappers for hedge funds have become a popular way for managers to access new investor sources as well as market and distribute funds more easily within the European Union.

Ucits statistics (PDF)

In the aftermath of the financial crisis, investors were clamouring for transparency and liquidity. Partly as a way to satisfy this demand and to reach new sources of assets in markets where investors were restricted to regulated, onshore funds, many hedge fund managers began eyeing Ucits. No one is certain when the first Ucits wrapper was put around a hedge fund but the idea caught on quickly post-2008.

Ucits products had already garnered a reputation and were seen by many investors as a badge of respectability.

So, it was natural that managers began to turn to Ucits as a way to allay fears of existing investors as well as potentially attracting a completely ­different group.

The use of a Ucits wrapper by hedge funds is not new. Some were doing it as early as 2003. Once the Ucits III directive was adopted in 2000, its provisions made it possible for hedge fund strategies to be used.

The result of this interest in Ucits by hedge fund managers has been amazing. The market in the funds has quickly grown, although it is still only a small fraction of the offshore hedge fund segment. While many smaller managers saw a Ucits wrapper as a panacea for investor concerns and a way to tap new markets, others were disappointed at the lack of enthusiasm for their funds.

The growth of assets under management (AUM) has been steep since 2008. Investors expect over $185 billion to flow into Ucits III absolute return funds in the next 12 months, according to a survey by Deutsche Bank. The bank estimates that $140 billion is under management in Ucits III absolute return funds and forecasts the size of this segment of the industry will double in 2012.

The survey by the Deutsche Bank hedge fund capital group indicates the industry will grow significantly, with allocations to all Ucits strategies remaining high. The bank surveyed 184 investor entities representing over $2.1 trillion in assets. These wealth managers, insurance companies, fund of funds, family offices and high net worth individuals on average expect to have more than a fifth of their total investments in Ucits III-compliant funds by 2013.

A report researched in November 2010 placed the size of the industry at $128 billion and a subsequent study by Strategic Insight estimated the industry is $156 billion as of September 2011.

Changing the game
“Ucits III is changing the way investors may gain exposure to the alternatives industry,” according to Anita Nemes, global head of capital introduction at Deutsche Bank. “Investors not only want to be able to invest in hedge funds but some of them want to do it in a liquid and transparent way that has the added benefit of regulatory oversight.”

According to Daniel Caplan, European head of global prime finance sales and alternative Ucits distribution at the bank, the outlook for the Ucits III absolute return industry is bullish. “The survey results confirm our experience that these products are appealing to investors, especially the larger institutional players,” he notes.

Globally absolute return Ucits funds saw AUM treble in 2010. AUM in single-manager absolute return Ucits funds was $30.3 billion at the end of December 2009 and increased by 198% to $90.5 billion a year later, according to Absolute Ucits. Its data claims the growth of AUM comes both hedge fund groups launching onshore products and in funds form the traditional long only asset managers using absolute return strategies in the Ucits wrapper. Some predict Ucits hedge funds could follow a similar or accelerated growth path as the offshore hedge fund industry.

With the emergence of Ucits absolute return funds, the worlds of traditional asset management and hedge funds are converging, according to Moody’s Investors Service. It says the Ucits absolute return funds and hedge funds are now competing for the same assets, although some point to the fact that most Ucits hedge fund products are aimed at a different segment of the institutional investor market than offshore funds.

Not a clone
Ucits hedge funds are not hedge fund clones, points out Moody’s. The funds usually do not have exactly the same objectives and do have many constraints that hedge funds do not have. Nevertheless, hedge fund managers can package some of their strategies into regulated Ucits funds, although operating such funds present challenges in terms of compliance and operations.

While the Ucits wrapper could be adapted to fit some hedge fund strategies, not all fit neatly into the tight restrictions mandatory under the regulation. As in the offshore world, the larger Ucits hedge funds attract the lion’s share of assets, with the vast majority of funds attracting $50 million or less.

Although Ucits is now a popular ‘brand’, it has gone through quite a few stages to get where it is today. The first undertakings for collective investments in transferable securities (Ucits) directive was implemented by the European Union (EU) in 1985. The idea was to facilitate cross-border marketing of investment funds and maintain a high level of investor protection. The funds were aimed at the retail sector.

The idea of the directive was to regulate the organisation and oversight of Ucits funds and impose constraints on diversification, liquidity and leverage.

The directive proved to be too restrictive and asset managers wanted more flexibility. Ucits II was drafted in the early 1990s but never adopted since at the time it was considered too ambitious in scope.

In 2000, however, the EU commission adopted and applied several directives that came to be known as Ucits III. The most important change for hedge funds was the fact more sophisticated investment strategies were able to be launched using the Ucits framework.

In July 2010 the EU adopted Ucits IV, which came into effect in July 2011. This was aimed at addressing efficiency, competitiveness and integration of the Ucits market. It focuses on four groups of measures: the regulation of management companies and the provision of management services on a cross-border basis, a provision for pre-contractual disclosures, the ability of Ucits to pool assets through a master/feeder fund structures and cross-border mergers and the simplification of the notification procedures for cross-border marketing.

This directive includes the introduction of what has come to be known as a management company passport enabling funds authorised in one EU member state to be managed remotely in another. The simplified prospectus was also replaced with a key investor information document (KIID).

Ucits III boosted the popularity of Ucits funds with managers and investors. Hedge fund managers saw the opportunity to ‘wrap’ their offshore unregulated strategies in Ucits vehicles and market their funds to new types of investors. Meanwhile, the popularity of Ucits outside of Europe continues to grew.

Although some question whether Ucits will retain its cache once the alternative investment fund managers (AIFM) directive comes into effect in 2013, most believe Ucits will continue to be popular. Its brand recognition is strong not only in Europe but in parts of Latin America, the Middle East and Asia. Now that investors are getting used to the idea of Ucits hedge funds, most predict a continuing growth in numbers and AUM.

Ucits limits

Investment restrictions
A maximum of 5% of NAV may be invested with a general issuer, 25% with credit institutions and 100% for government bonds, so long as there is a minimum of six securities and none exceeds 30% of the NAV.

Counterparty risk with any credit institution is capped at 10%. Ucits can invest a 20% maximum in another supervised fund. Total investments in non-Ucits funds limited to 30%.

Naked short sales are not allowed. To gauge leverage, sophisticated Ucits can use either an absolute or a relative value at risk (VaR) approach. They must also engage in stress testing.

Compliance
Pre-trade compliance technology uses business rules to automate monitoring and adherence to client, regulatory and asset manager guidelines, such as concentration limits by security or asset class or limits by counterparty. Pre-trade compliance generally occurs in the portfolio modelling module prior to transactions queuing up in a trade blotter. However, any trades entered into the trade blotter must also be scanned for pre-trade compliance, a process done in seconds.

Compliance with investment rules can be achieved much more efficiently with pre-trade checks than post-trade analysis that may only identify breaches too late and result in expensive corrective action (though post-trade is also necessary to deal with passive breaches as valuations fluctuate).

Pre-trade compliance works most effectively within an integrated solution that gives direct access to the full portfolio, otherwise it risks being too slow while it waits for information from a separate system, or the checks may be run against outdated information.

Risk measurement and management
Under Article 21 of the Ucits directive “the management or investment company must employ a risk management process which enables it to monitor and measure at any time the risk of the positions and their contribution to the overall risk profile of the portfolio; it must employ a process for accurate and independent assessment of the value of over the counter (OTC) derivative instruments. It must communicate to the competent authorities regularly and in accordance with the detailed rules they shall define, the types of derivative instruments, the underlying risks, the quantitative limits and the methods which are chosen in order to estimate the risks associated with transactions in derivative instruments regarding each managed Ucits.”

A risk management process is key in protecting investors from risks to which Ucits are exposed in relation to the performance of the activity of collective portfolio management. Recent market turbulence has emphasised the need for a comprehensive approach to risk management and for high standards of risk management.

In addition there are specific technical and quantitative issues regarding Ucits portfolio parameters to measure global exposure, leverage and counterparty risk concerning financial derivative instruments.

Source: Tradar.