Giles Turner, news editor, talks to Olivier Laurent, director of Alternative Investment Product Management at RBC Dexia, on whether the trend of hedge funds launching UCITS strategies is more hype than reality, and the benefits of the structure for custodians.
Olivier Laurent has often found himself at the germination of some major financial trends. In 1995, he worked with Natixis Asset Management, one of the first French asset management firms to concentrate on pricing and risk control for OTC derivatives, an unknown unknown in the mid-90s.
Laurent was also present at the beginnings of the now dread collateralized debt obligations, working for a firm that provided financing to hedge funds specialized in the instrument. I had never encountered such complex instruments, or any that yielded such high margins, which I suppose should have been a warning sign for the troubles to come, he says.
While Laurent worked through a period of remarkable growth after moving to RBC Dexia in 2004, seeing assets under custody in our alternative clients jumping from $5 billion in 2004 to more than $130 billion today, he has seen a fair number of crises come and go. One of the most challenging was being asked to calculate the value of a portfolio with significant positions in Indonesian asset swaps with a daily liquidity because investors wanted their money back at a fair price, at the height of the emerging market crisis in 1998, he recalls. I became convinced then that, despite the resilience of derivative instruments, their pricing methodologies and the integration of their liquidity components need to be made as transparent as possible to avoid herd behaviour and further financial shocks.
The next possible trend Laurent may look back on is NEWCITS, or hedge funds that comply with the accessible UCITS structure, an instrument that is stirring up excitement within the fund industry and the media. However, Laurent is keen to stress that these instruments need to be examined carefully. NEWCITS is a misnomer. Essentially, there is nothing new about the product it is simply the application of hedge-fund strategies within exactly the same UCITS regulatory framework as all other UCITS funds, he says. Some big traditional asset managers have been using alternative strategies within UCITS for many years without any complications. What is new is the burgeoning interest of hedge fund managers in developing UCITS products. We have certainly seen a lot of interest from our clients, but this does not always mean that a UCITS fund is the right solution for them. It is worth bearing in mind the requirements for liquidity, risk management and reporting that come with the UCITS brand. This can be a bit of a culture shock for our hedge fund clients who do not always realise at first the extra burden this represents. We tend to work with them to guide them through the requirements to ensure they adapt their strategies if they have to.
The fear that many strategies are simply not compatible with UCITS has been voiced by industry. According to a recent EDHEC-Risk Institute survey, the liquidity demands of UCITIS funds led to 69% of respondents stating that the liquidity premium of hedge fund strategies will disappear and that performance will fall.
Laurent is optimistic on the number of hedge fund stratagies that are compatible with the UCITS structure. We believe that 90% of all hedge fund strategies can be replicated in the UCITS format. During the first semester of 2010, we analysed what is required within the UCITS structure and compared the types of instruments authorised under UCITS where you have to manage the counterparty risk, with Cayman hedge fund strategies. The fact is that while some hedge fund strategies are very esoteric and cannot be replicated under UCITS, they are actually applied to a very low amount of assets under administration. Our analysis showed that Hedge Funds strategies representing 90% of all Cayman invested assets can be replicated within the UCITS format.
Although 90% of strategies may be replicated, many are unsure they will have the same returns? There is a lot of academic research into the subject, Laurent explains. There was a study by Lyxor saying that so far there is a drag of 50bp, regarding the performance of hedge funds under a Cayman structure versus performance under a UCITS structure. We looked at the performance of the portfolios which we administrate at RBC Dexia, and we didnt see a significant lag regarding the performance of these funds.
Regarding the instruments used, and what is authorised under the UCITS format, it is not obvious to see why there would be worse performance using a UCITS, rather than a Cayman format. Some might say that it could be due to the need to have daily liquidity, but 50% of hedge fund strategies are long/short equity portfolios and most of these portfolios dont have liquidity problems. I would say it is too soon to assess whether UCITS means less performance or better security. To me it is not proven.
As a custodian, liquidity is key, and as the AIFM Directive continues to be postponed, the extent of a custodians liability towards the assets of a hedge fund remains unanswered. It is here that UCITS structures are their most agile. On paper, in a UCITS structure, you can have up to bi-monthly liquidity, but we know that the expectation of investors is to have daily liquidity he says. My point here is we, as a custodian, want to be sure that there are no issues regarding the liquidity of these funds. I think all UCITS actors, from investors to custodians through hedge fund managers, and ultimately fund promoters themselves have to carry out assessments to ensure that funds respect their liquidity ratios.
We have recently seen some hedge funds investing in illiquid mortgage backed securities, and trying to have their funds regulated by the Irish regulator. I do not know whether this has been successful or not, but here at RBXC Dexia, we do not currently agree to being custodians to such funds as we dont feel very confident about that kind of structure. Maybe we are wrong, but it raises too many questions around liquidity. I think it would be very difficult to ask the regulator for additional laws or rules regarding liquidity, it has to be based on overall assessments.
If anything, UCITS structures are boon to custodians at a time where traditional revenues streams such as securities lending and FX fees are declining. Hedge funds remain a powerful if unpredictable asset class. Hedge fund UCITS, with easily defined liabilities for a custodian, will be a pleasing trend for custodians after the lawsuits resulting from the collapse of Lehman Brothers and the Madoff fraud. I think the thing we like with UCITS is that the responsibility of the custodian is very well defined, and so we know what we have to do, says Laurent. For instance we have to know where the assets are at any given moment. I think this is clearer than for other structures offered to hedge funds such as QIF or SIF, where the role and duties of the custodian are almost always contractually defined, and have to be agreed with each individual manager and inscribed in that funds prospectus.
One area of worry is the speed hedge fund UCITS are growing, with an estimated 35 billion invested in the strategies. After the rapid rise and fall of CDOs and mortgage backed securities, any asset class that grows too rapidly may be met with suspicion by a now intrinsically conservative marketplace, especially when UCITS, a supposedly liquid and relatively low risk asset class, are seeing new funds invest in MBS and distressed strategies.
Another area of concern is the eagerness domiciles have in attracting hedge funds to launch UCITS strategies. Ireland and Luxembourg, the two major UCITS centres, have seen their fair share of economic difficulties over the past few years, and they are eager to advertise their respective domiciles as the premier location for hedge funds looking to launch UCITS strategies. However, this eagerness to see UCITS structures as a financial panacea, rather than another asset class, may contain a hint of desperation. For Laurent, this is a concern, but he remains confident that the feet of regulators remain firmly on the ground. I was surprised when I came back from vacation to see a lot of announcements from the Irish regulator that seemed to ease the rules for hedge fund managers, he explains. For example, they will now be capable of to set sub-funds bearing their names directly, even if they are not the promoter or member of the promoters group. Besides this technical point, and despite the competition between Ireland and Luxembourg to attract as many funds as they can, I think it is all being done in a very secure environment. The regulators are very knowledgeable, and are very well connected to the asset management and custodian associations. I was in North America in July, and fund managers are always impressed by the level of knowledge of the Irish and Luxembourg regulators, specifically on technical matters regarding hedge fund strategies.
Until the AIFM Directive is finalised, the flow of hedge funds launching UCITS structures will remain a steady stream rather than a raging torrent, and as regulators continue to shuffle their feet, Laurent recalls another podiatric anecdote: I’ve had the opportunity to travel all around the world during my career and of all the cultural quirks I have been lucky enough to experience, my favourite remains that of a Japanese compliance officer who, when I was in Tokyo auditing a client derivative portfolio, came to greet us at his office wearing slippers.