Onshore hedge funds: an attractive alternative?

Hedge funds have traditionally been perceived as unregulated, opaque “black box” products. The industry is coming under far greater scrutiny since the financial crisis and Madoff scandal, not just from investors, but also from regulators keen to create an efficient and more transparent onshore hedge fund industry.

“UCITS was not made for alternative investments whereas AIFMD is; this makes a huge difference.”

Lionel Paquin

Recent years have seen a plethora of hedge fund products launched under the UCITS banner. However, their success has been muted as the regulators have become increasingly sceptical of complex strategies squeezing into the UCITS framework, and institutions have been put off by performance drag and lack of illiquidity premium. The implementation of the AIFM Directive earlier this year could offer a much better balance between what regulators and institutions want, and a framework that is conducive to hedge fund performance.

Following the financial crisis, the idea of an onshore, regulated and liquid hedge fund industry appealed to many investors who had found themselves locked into poor performing funds. Institutions were subsequently being encouraged by their constituents to reallocate assets to products that offered the greater safety of regulatory oversight and disclosure requirements as well as daily, weekly or monthly liquidity.

In fact, onshore hedge fund offerings in the form of alternative UCITS, that sprung up in response to this perceived demand have failed to really gain traction, particularly among UK institutional investors.

According to figures from independent research firm, Preqin, the proportion of European- based public and private sector pension funds allocating to UCITS-compliant hedge funds is just 12% and 5% respectively. In the UK, only 20% of all hedge fund investors allocated to UCITS products compared to 63% in France, 56% in Luxembourg and 50% in Spain.

Glory days over?

UCITS hedge funds also still only represent 7% of total hedge fund AUM ($2.7trn) and, looking at product launches, it could be argued that the glory-days of UCITS hedge funds could already be numbered. Preqin’s research shows the number of UCITS compliant hedge fund launches is well off its peak of 108 funds in 2010. Launches less than halved to 46 by 2012 and stood at just 17 by May 2013.

Citi’s Rise of Liquid Alternatives survey (May 2013) observes institutional investors have already rebalanced the more liquid parts of their alternative allocations. Given that strategies requiring more illiquid assets have been difficult to replicate within the UCITS framework, optimism about continuedinstitutional interest appears to be muted at best. Despite the perception institutional investors would find the liquidity of UCITS funds an attractive feature, the liquidity provided by UCITS is actually much greater than institutions require. They prefer, instead, to profit from the illiquidity premium.

According to Jennifer O’Leary, head of fixed income hedge fund research at Towers Watson: “In general our clients do not require the liquidity provided by UCITS funds and recognise the issues in this structure.”

For all but the simplest, most liquid hedge fund strategies, the high degree of liquidity required by UCITS coupled with the restrictions on leverage and instruments that can be traded has an inevitable dampening effect on returns – a strong deterrent for institutional investors.

Nick Buckmaster, chairman of the London Borough of Waltham Forest Council pension fund, says: “The hedge fund space has not performed that well in recent years and UCITS restrains managers’ ability to generate returns. We prefer offshore hedge funds because of the lack of constraints and their ability to do something a bit left of centre, but it is tough to find returns in this environment.”

Slowing interest in UCITS hedge funds reflects increased institutional awareness about their limitations in terms of replicating private fund structures. This is particularly acute for institutions, who can easily compare the relative performance of UCITS hedge funds versus an equivalent offshore fund run by the same manager.

UCITS down

Preqin’s research shows UCITS hedge funds have consistently underperformed over different time periods, even when performance is negative despite the lower volatility UCITS funds are designed to offer. During Q2 2012 non-UCITS hedge funds returned -2.41% while UCITS hedge funds returned -2.58%. Over one, three and five years non-UCITS funds have also outperformed by 3.13%, 4.71% and 5.07% respectively.

The scale of drawdowns posted by UCITS hedge funds in recent years has been similar in magnitude to non-UCITS hedge funds with both structures seeing maximum declines of approximately 3.3% in 2010. In 2011 UCITS fell 7.49% compared to 7.4% for traditional funds, but in 2012, UCITS hedge funds fared far worse in the uncertain markets declining 3.3% versus 2.7% for traditional funds.

Volatility of UCITS hedge funds has been lower too, although more recently the difference has been smaller. The difference in the monthly three-year rolling volatility between UCITS and non-UCITS hedge funds was 2.6% in 2010 and has since decreased to 1.17% in 2012 and 0.82% in Q1 2013, Preqin’s research shows. The problem for UCITS funds facing the duo of greater drawdowns and lower volatility is a longer and slower climb back to profitability.

Many UCITS hedge fund managers argue UCITS hedge funds are lower risk and tend to outperform on a risk-adjusted basis. Not everyone agrees, however. O’Leary argues: “They are likely to be lower return, but I don’t think they will necessarily have commensurate lower risk though as the restrictions on certain instruments can lead to less efficient implementation, which can increase risk.”

Few investment strategies are well suited to the constraints imposed under UCITS, both in terms of liquidity and tradable instruments. Long/short equity, managed futures and macro are generally regarded as a good fit and evidence suggests those funds do relatively well. Credit Suisse research, for example, found less divergence in the average performance of long/short equity UCITS hedge funds versus their offshore counterparts than was the case for an eventdriven strategy (in both cases, the UCITS and offshore funds were run by the same manager).

The desire to offer UCITS compliant funds has, however, led to managers ‘squeezing’ their strategies into the space, a trend that creates significant risk and undermines the value of the whole sector.

Sebastian Schaefer, managing partner and founder of Green Shoots Capital, argues: “Some strategies are just not suitable for UCITS. Some have made the decision not to launch products under that banner, but others have tried to squeeze their strategies in. This isn’t really doing them, their clients, or the industry, any favours and they should resist the lobbying pressure to do so.”