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Anyone for 'hedge fund lite'?

Created:

22 February 2010

Updated:

25 February 2010

Written by:

Maike Currie

The last few months have been characterised by a deluge of so-called 'hedge fund lite' product launches as an increasing number of hedge funds, bruised and battered by the credit crunch and the subsequent run on liquidity, dip their toes into the retail space via Ucits III funds. Consequently, private investors are now being offered access to unique investment strategies and techniques previously the preserve of pension funds and the very wealthy. Are these funds a route to powerful diversification strategies, experienced managers and capital preservation all within the 'shelter' of recognised regulatory structure? Or are you in danger of getting into a fund without truly understanding the intricacies and risks involved?

Using Ucits

The advent of the Ucits III directive, a lengthy piece of regulation passed by the European parliament in 2002 has given investment managers greater freedom and scalability in terms of their fund offering, a Ucits III fund can, for example, be marketed across the European Economic Area to all retail investors.

The acronym for the rather lengthy: 'Undertakings in Collective Investments in Transferable Securities' - Ucits III allows fund managers to invest in derivatives for reasons other than just efficient portfolio management, it permits the use of net short positions and allows investment across diversified indices and their derivatives which includes hedge fund indices. These broad investment powers essentially enable hedge fund managers to 'mirror' existing offshore hedge funds or funds of hedge funds and offer these to retail investors within a regulated structure.

The potential for tapping into a whole new client base, combined with calls for the tighter regulation of hedge funds, has led to an increasing number of players launching funds under the Ucits III banner. According to recent figures from data provider, Hedge Fund Research, more than 200 Ucits III compliant hedge funds are now trading with assets under management (AUM) totalling over £3bn.

From an investor's point of view the development is largely positive. These funds provide access to investment strategies and managers previously unobtainable due to the high minimum investment requirements of hedge funds within a regulatory framework which demands strict liquidity requirements (Ucits III funds have to trade on at least a bi-weekly basis). And when used correctly, these funds promise to add diversification to portfolios, as well as protection in falling markets.

Tim Gascoigne, global head of portfolio management at HSBC Alternative Investments, adds that because Ucits III funds can be passported onshore to investors across Europe, these funds are more tax efficient for investors paying capital gains tax in the UK at 18 per cent rather than potentially 50 per cent income tax on gains made from investments in offshore funds. "Also investors have tired somewhat of the investment trust alternative because of discounts to NAVs in these vehicles which have remained stubbornly high," he says.

Not all the Ucits III or 'hedge fund lite' funds launched are however being targeted at the retail investor, but as Kate Hollis, global head of fixed income and alternatives at Standard and Poor's fund research, says, if you are approaching a pension fund or institutional investor to invest large amounts of money into a fund - "a regulated fund is certainly a more easy sell".

In addition, launching a 'Ucits III clone' of an existing fund opens up a new investment opportunity for existing clients to buy into, given that a few of the more popular hedge funds are closed for further investment. Ucits III funds are also not subject to the penal political oversight most hedge funds are currently being placed under following the credit crunch and the Bernard Madoff fallout - and ultimately, as Ms Hollis puts it, "Ucits III has become a global brand".

The long-only story

It's not just hedge funds using the Ucits wrapper. Long-only UK fund managers have utilised this piece of regulation to launch funds for private investors for some time now. These funds are more commonly termed as 'absolute return' funds.

Mr Sexton says the launch of these funds, together with 'lite' hedge funds is part of the convergence of the traditional long only industry and the hedge fund industry. "Ucits III facilitates this by giving the traditional long-only industry the additional tools to enable them to move towards the hedge fund space. This is appealing to the traditional long-only industry because of the higher fees that they are able to earn running these types of funds. It also appeals as a defensive measure - to protect their existing business from the encroachment of hedge funds offering more sophisticated solutions than simple long only investment management," he explains.

One of the first players to venture into this space was BlackRock with the launch of the BlackRock UK Absolute Fund, managed by Mark Lyttleton. Since its launch in the fund has enjoyed enormous success, with close to £2bn under management, and other managers, including Cazenove, Gartmore, Jupiter have followed suit.

While Mr Lyttleton himself did not have any experience of hedge fund management, having joined BlackRock as a graduate trainee almost 17 years ago, most of the recent fund launches come with managers experienced at running hedge funds. Philip Gibbs, manager of the recently launched Jupiter Absolute Return Fund, is for example, using a very similar strategy to the one used on his existing Bermuda-domiciled, Hyde Park Hedge Fund. Similarly, the Gartmore European Absolute Return Fund, managed by Roger Guy and Guillaume Rambourg, which recently marked its first anniversary by posting a double digit gain, is based on Mr Guy's successful AlphaGen Capella hedge fund. The Gartmore UK Absolute Return Fund managed by Ben Wallace, an experienced hedge fund manager, is based on his Alphagen Octanis hedge fund, while the recently launched Gartmore Japan Absolute Return Fund, is a Ucits III onshore version of the AlphaGen Hokuto Hedge Fund, managed by John Stewart.

"Some managers had to adapt their existing hedge fund strategies to the Ucits III limitations but overall I think the development is very positive. Investors have now got a new investment vehicle that can be used to diversify risk and which can provide genuine relative protection compared with the stock market," comments Tim Cockerill, head of investment research at Ashcourt Rowan, on the new launches.

A key issue to be aware of however is that these funds are not all the same. "With a fund such as BlackRock UK Absolute Alpha, one is essentially backing the stock picking prowess of Mark Lyttleton and the BlackRock UK research team. By contrast, Standard Life Global Absolute Return Strategies Fund gives the investor access to a highly diversified spread of positions across currencies, bond and equity markets aimed at taking advantage of market inefficiencies and the macro views of the Standard Life team. What is important for investors is to understand what a given fund is trying to achieve, which of the available investment powers will be employed and for what purpose," explains Mr Sexton.

It is also important to understand how a fund under consideration might perform in different market conditions. "Buying a fund that protects the investor from market downside is fine - as long as the the investor understands that the upside from a rising market is also likely to be much lower," says Mr Sexton.

Dean Cheeseman, head of fund of funds at F&C Investments, echoes these concerns, saying: "Investors have become increasingly capital and cost conscious and the Ucits III vehicles will have an increasing role to play not least given that these funds are well diversified and uncorrelated to main markets. My main concern however is whether individual investors understand the risks associated with these funds. Some funds have alarming downside, yet many of these funds are marketed as offering 'absolute returns'."

More reasons to tread carefully

Ultimately, as an investor into Ucits III, you need to do your homework and understand what you are buying into. Concerns have been raised that hedge funds are using the Ucits III wrapper to tap into new markets without fully understanding the requirements of a Ucits fund. At the same time, analysts have warned that investors could be lulled into a false sense of security by the Ucits III tag around what is often for all intents and purposes, essentially a hedge fund.

Collins Stewart Fund Management recently echoed warnings from the Financial Services Authority (FSA) over hedge fund managers' ability to manage funds within the Ucits framework, saying that managing a fund with certain regulatory restrictions as well as daily or weekly liquidity requires a very different skill-set to managing a fund which has a longer liquidity profile, lock-ins and the ability to impose a gate, if necessary.

Mr Richard Hodgetts, manager of the Collins Stewart Alternative Strategies Fund, says investors should not become complacent on the due diligence they undertake just because these funds are regulated. "The Value at Risk (VaR) method used to measure risk for 'sophisticated' funds allows a Ucits III hedge fund to gain significant exposure to markets similar to their unregulated neighbours. We believe some investors will not realise the extent of leverage being used by some Ucits III hedge funds or understand the limitations of VaR as a measure of risk. We recommend that investors use the same level of care that is required when choosing a Ucits III hedge fund to a traditional unregulated hedge fund," he says.

Then there is also the issue of fees. Many funds entering the Ucits III space typically charge similar fees to their unregulated versions. "Some managers are worth the 1 to 2 per cent annual management charge and 20 per cent performance fee and some are not. We select managers that we believe will consistently produce superior risk adjusted returns net of fees. Fees become a larger issue when a manager fails to meet their objectives but is still compensated for underperformance," comments Mr Hodgetts.

As mentioned, funds launched within the Ucits III framework will generally come from two sources; managers currently running offshore hedge funds and managers currently running traditional long-only funds. Mr Hodgetts warns that investors should be wary of traditional long-only managers entering this space and their ability to produce alpha on the short book. "We will only invest with managers that can show they have relevant experience and the necessary skills to short individual stocks," he says.

Mr Hodgetts further adds that not all strategies managed in offshore hedge fund structures can be replicated in the Ucits III framework. Therefore an understanding of both the unregulated strategy and an understanding of the Ucits III rules is required to make an assessment on whether the strategy can successfully be replicated. He adds: "It is likely that we will see many investors disappointed when a Ucits III hedge fund fails to live up to the expectations set by its unregulated offshore cousin."