Ucits regulations pose challenge for hedge fund strategies

Date: Friday, June 11, 2010
Author: Hedge Funds Review

Ucits-III compliant hedge funds challenge institutional investors and strategy methodology

Despite the move to more highly regulated and prescribed funds by some hedge funds, a some pension funds and similar institutional investors remain reluctant to invest in these products.

There is talk among some hedge funds that have started to offer a Ucits III compliant fund of restructuring their offerings to overcome this reluctance.

Some hedge funds have launched Ucits III funds only to find the realities of investment compliance and the consequent implications for the business have been imperfectly understood. As a result funds have taken an unnecessarily conservative approach to legal ratios and calculating limits often on the advice of auditors.

The example of guaranteed issuers illustrates this point. In these circumstances there is a 35/30/6 split ratio which can go up 35% into any guaranteed issuer. If both sides are at 35, it can then go up to 100% provided there is no more than 30% per issue and there is a minimum of six instruments in that issuer. If there are two issuers above 35, there needs to be 12 instruments.

The conservative approach says there has to be six within each issuer. For some hedge funds, it is possible to mix and match the guaranteed instrument in the portfolio: 10 and two or eight and four, for example.

The same applies to defining standard transferrable securities. Instead of netting two or more positions when measuring exposure or the mark-to-market value, the more conservative approach is to make a sum of the absolute values. While this may work for the commitment ratio, for standard transferrable securities it creates so many breaches that compliance officers become swamped.

Given the conservative nature of the target investor, it could be essential for funds to adopt a conservative approach. However, it can be easy to fall into the trap of being over-cautious. A more creative approach can be both a means of differentiation and provided it is communicated effectively a way of overcoming investor reluctance. It has the added benefit of not completely alienating the more typical hedge fund client.

Technology can help by providing the necessary tools to ensure compliance with Ucits guidelines and by providing transparency to prospective investors. Demonstrating that appropriate systems are in place to follow Ucits III compliance measures can help hedge funds demonstrate their ability to monitor transactions and keep within the rules.

These are still relatively few Ucits hedge funds.

In July the launch of the sixth section of Ucits IV which looks at the area broadly covered by the term ‘risk management', particularly for over the counter (OTC) instruments and will require a new level of detail in the commitment ratio and for OTC counterparty exposure.

The rules will provide a new set of hurdles for fund providers. There are one or two potential enhancements that could provide an interesting business problem to overcome.

With regards to OTC counterparty exposure, the current recommendation is that stock lending and repo positions should be included when calculating. This is interesting as some countries such as France have already included these positions as part of the commitment ratio. It may also explain the suggestion that counterparty exposure be calculated using the commitment approach.

Ucits IV continues the trend of distinct derivative flavours in regulation. The recommendations adopt a method already used in France. In most of Europe the commitment ratio works by grouping different derivatives together into discrete buckets, netting them and calculating the sum of the absolute value.

In France and now potentially across the European Union, instead of working out absolute values, different sub-calculations are conducted for each derivative type: options, futures and equities are grouped together, rate instrument derivatives sit in a distinct bucket and short sells and stock lending sit in a third. Each is calculated differently, pre-compensated and re-netted differently and then everything is added up and aggregated up to the limit of the fund's net asset value.

In terms of technology this is perhaps the most challenging part of the enhancements. Similar processes have already been built into compliance platforms in France.