Funds of funds finding UCITS to their liking

Date: Wednesday, June 23, 2010
Author: UCITS Hedge

Just over a year ago, Italian hedge fund specialist Kairos Partners became the first investment manager to launch a fund of funds entirely dedicated to UCITS hedge funds. It was a brave move for the Milan-based business, considering the available universe was still fairly limited. But at the same time, the team at Kairos recognised the potential UCITS III-compliant hedge funds offered to them.

At the time the industry was recovering from the attrition caused by the liquidity crisis post-Lehman, but Kairos recognised that the benefits inherent in the UCITS directive, particularly transparency and liquidity, would suit them very well. They were also traits that Kairos’ fairly cautious investor base, primarily Italy-based, would buy into.

Kairos CEO Paolo Basilico said last autumn that the arrival on the UCITS stage of major names in the business, like AHL and Cheyne, were good indicators that the UCITS structure would be embraced by the larger industry. In addition, the strategies that would be able to cope with the directive were those Kairos felt most comfortable committing to; those that would find it difficult were not necessarily funds they would invest with, UCITS or no UCITS.

It makes sense in many ways. The fund, Kairos Long Short, has increased in size to over €350 million as money has flowed in from institutional investors in not only Italy, but other European markets like Switzerland, Germany and France. Kairos has also been tapping retail distribution networks successfully. The success of the fund has clearly demonstrated the potential UCITS represents for funds of hedge funds.

For some fund managers, the ‘retailisation’ of the market was a thing of dread even two years ago: investors would not understand the products, they argued. There were also the logistics to consider: small asset management firms could not afford to operate like a retail shop. But the deployment of UCITS products lets firms like Kairos link into third party distribution networks that are already licensing funds for cross-border sales and have been doing so in the traditional long-only funds space for over a decade. Why do more work when it is unnecessary?

“From the operations perspective we have not found it too difficult,” admits Michele Gesualdi, a portfolio manager with Kairos. In terms of portfolio management as well, Gesualdi has not found the current universe of UCITS hedge funds too constricting. The Kairos fund has a 20% concentration limit, with a target of between 20 and 25 underlying managers. Gesualdi has been finding that the quality of the firms entering the UCITS space is higher, on average, than in the hedge fund universe globally. The managers tend to hail from the serious shops, and the strategies are those that are most easy to analyse. “In the end, we don’t have to see as many funds to find the ones we like,” he says.

A more recent launch has been that of HDF, which announced it was raising money for a multi-strategy fund of funds called HDF Marlin. In this case, the decision to launch came at the request of its customers, who wanted the firm to apply its expertise within a structure that enjoyed the benefits of flexibility and liquidity which the UCITS directive affords.

HDF has an emphasis on diversification of investment style. This has meant it has needed the universe of available hedge funds to reach a point where such diversification becomes possible. According to Christophe Jaubert, a fund manager at HDF, substantial diversification between funds and strategies is an essential part of the firm’s risk management procedure.

In addition, from the underlying managers themselves, HDF is looking for a proper awareness of how to generate performance while fully respecting the UCITS operating rules. Jaubert says they would also need to demonstrate that they “can stick to the UCITS liquidity requirement in any market environments,” not just when the sun is shining.

“We’re not worried about capacity,” he adds. “There are still enough funds to choose from out there.” And he is seeing some interesting opportunities from new funds HDF has not invested with before. The directive is bringing management talent to the notice of European investors that might not have attracted the same attention previously. This has got to be a major attraction for non-European funds considering the UCITS approach.

Challenges and opportunities
Many funds of funds managers are turning to UCITS as an opportunity to re-established the model of the fund picker in the alternative investment universe. With its liquidity requirements, the directive is an opportunity to prove to investors that a fund of funds can provide solid returns without recourse of a lock-up. Sometimes this requires using a larger universe of funds.

The Iveagh Private Investment House has also recently launched a UCITS funds of funds, this time with Switzerland’s 47 Degrees North as the fund’s sub-advisor. In this case, according to Iveagh’s head of portfolio management Christopher Wyllie, a much broader universe of funds is being researched, including absolute return funds and 130/30 funds. Indeed, Wyllie does not feel a fund manager needs to have a short component to his strategy at all in order to qualify for his portfolio. The key for investors, he says, is liquidity. And this is reflected in the daily dealing offered by his Iveagh Newcits Fund.

“Some investors are still locked up in funds of funds,” says Wyllie. “They still want absolute returns, but many people have been hurt by gating or even in some cases by outright fraud.”

At HDF Jaubert and his colleagues are fully cognizant of the fact that liquidity has a cost, and that some performance may have to be given up for this. “We’re seeing two kinds of investors,” Jaubert says. “Some are coming to UCITS for regulation and some for the liquidity. After the 2008 crisis we have seen many insurance companies shying away from funds of funds due to liquidity issues.”

Ultimately, savvy funds of funds managers are aware that, in Jaubert’s words, “UCITS is not a guarantee of performance and success.” Funds of funds will still need to do their due diligence and keep a sharp eye on the funds they invest with. Now is not the time to get lazy. All of the fund managers we spoke to for this article demonstrated a degree of concern that investors are already seeing the UCITS designation as some form of safety standard, a low risk benchmark which it simply is not.

“There will always be fund managers who will stretch a point,” says Chris Wyllie at Iveagh. “Fund of funds managers will have to be very careful that a fund is compliant, make sure that the leverage and liquidity rules are being applied. There may be occasions when managers of UCITS funds suddenly find they can’t provide the underlying liquidity, they may have to gate investors. That would be unacceptable behaviour, but investors have to be aware that funds may not always do what it says on the tin.”

In HDF’s case, the firm has an almost obsessive determination to ensure that managers will be able to meet the UCITS liquidity requirements under a variety of tough market scenarios. This is because there is no alternative to homework. Nobody else is carrying out the level of detailed and ongoing oversight in the UCITS space that funds of funds are providing; there is no large bureaucracy in a cellar in Brussels carrying out detailed spot checks on funds. For Iveagh’s Chris Wyllie, this is a major vindication of the ongoing funds of funds model. The UCITS wrapper is not a short cut, he argues.

Alternative approaches
The UCITS opportunity is also being utilised in other ways by the fund of funds community, perhaps best illustrated by the recent launch of the Active Trading Fund by Strategic Investments Group (SIG) and Permal. This product is being sold as a UCITS III absolute return multi-manager fund. With $250 million already under management after a month of trading , it is rapidly gathering speed. But what makes it different is that while the master fund is UCITS-compliant, the underlying portfolio is composed of managed accounts.

To meet the UCITS requirements, investment manager Permal is focusing on those managers like TT International, QFS Asset Management and Apex Capital that can generate absolute returns in liquid global markets. With no commingling of investors, and with the accounts all being handled by ATF’s custodian State Street, the fund can offer weekly liquidity and full transparency. Not only that, but Deutsche Bank has been brought on board to carry out independent risk monitoring.

Each underlying managed account is still UCITS compliant, but the fund owns the positions, not the manager. “ATF has weekly liquidity with no mismatch across the platform,” explains SIG’s Thanos Ballos. “This is the result of listening to our institutional and family office investors who wanted a regulated, liquid, multi-advisor fund, offered within a UCITS framework, and with the added safety of independent risk controls.”

It is plain to see that this fund, which offers weekly liquidity with 48 hours notice and has a target volatility of between 5-7%, is a legacy of the experience many investors had of the liquidity crunch in 2008-09. It has been designed to address exactly those concerns that have driven many former hedge fund investors away from the fund of funds sector.

To our knowledge the ATF fund is the first UCITS fund of funds to go exclusively down the managed account route rather than focus on a portfolio of underlying UCITS funds. According to a poll of 30 funds of funds groups in December carried out by KdK Asset Management, almost twice as many fund of funds firms favour UCITS over managed accounts (see Fig.1).



So what’s the catch?
Funds of funds launching dedicated UCITS products will need to think hard about their fee structures. At Kairos, Michele Gesualdi has noticed some managers trying to levy what he calls “traditional” hedge fund fees, but believes they are being short-sighted. Thus far, there has not been much in the way of downward fee pressure in the UCITS space, but that may have to change, particularly for those funds that wish to build a retail brand. One option might be to issue a retail share class with palatable fees for retail investors and financial advisers.

Even at the end of last year, according to the results of the KdK survey, funds of funds were assuming that the cost of managing a UCITS fund would be higher than the offshore equivalent (see Fig.2). This means that investors will be disappointed if they believe UCITS and the greater atmosphere of transparency that it could promote in hedge fund investing will lead to lower fees.



At Iveagh, Chris Wyllie sees higher fees for UCITS funds being a means for offshore groups to protect their core strategies. Yes, the UCITS fund will be available for those who want it, yes the liquidity may be superior, but investors will have to give up some performance and pay higher fees into the bargain. “It is a moveable feast,” he says. “We’ll see where it settles. If people see the right risk/return profile, they may be prepared to pay for it.”

Wyllie predicts that the issue of fees will introduce a degree of competition which was not there before. Many so-called absolute return funds are not charging the 2 and 20 structure of the offshore funds universe, but still meeting the requirements of the UCITS directive. In addition, investors like Iveagh are avoiding the big UCITS hedge fund platforms where they can because of the additional levels of fees they represent. Where this is the only point of access to a fund in the UCITS zone, they will still invest. The onus is therefore on the platforms to make sure they have exclusive UCITS-compliant access to the big names.

Those funds that have already launched products into this space are just the tip of the iceberg, if the KdK research is to be trusted. We expect more to appear over the next few months as the underlying universe of funds continues to expand and capital raising efforts bear fruit. The fund of funds is not dead yet: it is alive and well in UCITS-land.