Introduction

UCITS, an acronym  for Undertaking for Collective Investment in Transferable Securities, are  directives that aim to supervise funds,  allowing them to operate freely throughout the European Union on the basis of a single authorization from one member state.

In December 2001, the EU Commission adopted the third version of its directive,  known as UCITS III.  This allowed  some hedge funds strategies to be offered and distributed across Europe.  Before that time, uniquely LONG ONLY STRATEGIES were accessible in UCITS format. Thanks to the UCITS III revision, permitting managers the use of derivative instruments and leverage, alternative strategies were also now eligible for inclusion as UCITS products, in effect bridging the gap between Hedge Funds and Long Only approaches.

Since then, UCITS IV became effective in 2011, introducing new reporting and classification procedures,  but practically changing little with respect to the strategy implementation.

In general, the main restrictions put in place by the UCITS directives force diversification,  limit monthly VaR (hence leverage) and ensure that only liquid strategies can be offered under this legal structure.  A fund cannot provide redemption terms worse than twice a month.

In addition and very importantly because UCITS funds are regulated  they do not fall under the AIFMD scope and therefore can be marketed freely to European market participants.

The current state

Since 2006, the total Assets Under Management (AUM) in Absolute Return UCITS funds has grown  steadily as shown in Figure 1 below. As of the end of October 2013, according to Alix Capital, the total AUM in the absolute return UCITS space reached a peak of 180 bio EUR.

Figure 1

The market share of UCITS funds in Europe already represents one third of the total AUM of the Alternative space (Figure 2).

We will explain below why we think this market share is clearly destined to grow due to the new regulations Europe is imposing on its financial industry.

Figure 2

The largest strategy by number of funds is Equity L/S followed by Macro and Fixed Income. However, if we slice the Universe by AUM, then the largest strategy is by far Fixed Income followed by Multi Strategy and then Global Macro (figure 3).

Figure 3

 

Unlike the classical offshore Hedge Fund world, the Fixed Income Space dominates the UCITS universe. This is due to the fact that larger asset management firms have a substantial range of absolute return funds dedicated to Fixed Income.  Historically, these were mainly long only funds, whose constraints have been relaxed to gain an advantage (or to limit the losses) in the event of higher interest rates. Because these funds have a major role in many institutional portfolios, they are inherently very large. Hence, this explains the dominance of this Fixed Income strategy in the EU onshore market.

Many market participants do not perceive these types of funds as authentic Hedge Funds. The consequence is that other more “typical” Hedge Fund strategies like L/S Equity, Event Driven, Macro, CTA, Market Neutral have a much lower weight within the global UCITS universe than in the offshore world.

Opportunities

One should understand that the UCITS structure is very appealing to European investors for three main  reasons:

First,  the legal oversight guarantees the complete segregation of duties between administrator, custodian and portfolio manager. It also sets up an investment framework that ensures diversification and liquidity. These legal protections are most welcomed especially in the aftermath of 2008. For instance, it gives a possible avenue of recourse to investors in the event of a fund “blowing up”.  If a fund encounters serious problems and the investor can prove that the manager was in breach of covenants in the prospectus, then the MANCO (Management Company in Luxembourg) is deemed responsible. Consequently, the MANCO has to bear the financial costs associated with that breach. Note that the MANCO is supervised by the CSSF (the Luxembourg financial watchdog) so it is very likely that the investor can gain some redress.  In the case of a typical offshore fund, the fund closes down, the investors’ money is lost and that’s it…..!

Second, the potential tax treatment of UCITS funds is very attractive. The tax differential versus offshore funds can be quite significant for EU residents. For instance, tax deferral schemes exist when you are invested in UCITS funds.   Gains are only realized upon withdrawal, not when reallocated amongst other UCITS funds.  In addition, in many EU jurisdictions you pay tax only on Capital Gains in the case of withdrawals from UCITS funds,  whereas a higher rate Income Tax is perceived on capital generated by positive performance from offshore funds.  Furthermore, with the gradual abolition of banking secrecy across the world as well as FATCA, MIFID regulations, etc., there will be less reason to hold offshore investment vehicles since tax evasion will become problematic as full transparency is required.

Third, Solvency II and Basel III create regulatory constraints, which are advantageous for liquid and regulated investment vehicles, in essence favoring UCITS products. The insurance company or the bank, which will invest in less liquid offshore funds, will have to block some extra capital to comply with the general capital adequacy required by the regulator. This will not be the case for UCITS funds.

Therefore, the investment community needs to realize that this paves the way for continued growth in the UCITS sector. Whether we like it or not, we are going in the direction of more regulation. We have shown that UCITS funds have important advantages over offshore structures both for tax reasons (in the case of private clients or retail investors) and for efficient use of capital in the case of institutional investors.

Of course, the transition will not be immediate. Furthermore, the investors will always need offshore funds for less liquid strategies or private equity.  However, for liquid strategies, investors will realize quickly that there is an inherent higher cost to be invested in offshore funds versus UCITS. Indeed, rates of return after tax should be always considered.  Naturally, institutional investors need think about the opportunity cost of investing in typical offshore funds.

In conclusion, UCITS can be perceived as a negative for US or non-European managers. However, we  believe that this will gradually open up the market to a new kind of client base. Because the universe of funds is still not highly developed in the Alternative UCITS space (as illustrated above), there is still the possibility to benefit from a significant First Mover advantage.

We are therefore of the opinion that alternative UCITS funds are here to stay, are indispensable for the future distribution of hedge funds in Europe (and beyond)  and that they are clearly far more than short term hype.

 

Written by Jerome Berset, CIO of Palaedino Asset Management Geneva.  Contact at