Absolute return – the regulatory drivers

Regulation introduced the promise of absolute return strategies for investors seeking a way to less volatile returns, but it could also take the industry in as yet unknown directions.

Regulation and the investment community are uneasy bedfellows, unwilling many fund managers and advisers would probably say if they did not want to attract the wrong sort of attention from their regulators.

When it comes to the relatively modest niche of absolute return, however, regulation has perhaps been a more positive influence, although most in the sector would whisper that quietly.

Roll back to the turn of the century and absolute return strategies were the exclusive province of hedge funds and therefore only of appeal to a relatively exclusive group of institutional investors. The arrival of Ucits III (Undertaking for Collective Investment in Transferable Securities) in 2002 changed that and the sector has continued to expand – 2006-08 being the exception – under this regulatory umbrella ever since.

The Ucits directives are European Union regulations aimed at harmonising the rules for the management of open-ended investment vehicles as part of a broader regime of investor protection that embraces other directives such as the Markets in Financial Instruments Directive (MiFID) and, since the financial crisis at the end of the last decade, the Alternative Investment Fund Managers Directive (AIFMD).

The latter has had – and will continue to have – a major impact on absolute return strategies. Ucits III opened up the absolute return sector because it allowed European regulated funds to use a range of hedge fund-like techniques for the first time.

These included using derivatives – such as futures, options, swaps and contracts for difference – to generate investment returns and not merely as very limited devices for efficient portfolio management.

It also permitted investment in diversified indices and their derivatives as well as the retention of unlimited cash positions, the more extensive use of money market instruments and greater flexibility to combine multiple asset classes in a single fund.

Ucits compliant absolute return funds are subject to strict requirements regarding risk management, liquidity and reporting and it is these elements that have made the funds attractive to institutional investors, especially in continental Europe.

“Hedge funds structured under the Ucits wrapper are attractive to institutional investors for a number of reasons, including the increased transparency and disclosure of investments, limited leverage and attractive liquidity terms”, said a report from hedge fund data specialists Preqin last year.

A study by Preqin found that liquidity was the most common reason for investing in Ucits-compliant funds, with 63% of investors stating this as a key factor. “Traditionally, most hedge funds were only available through offshore structures with assets locked up for a fixed period. Ucits funds are an attractive alternative to this as they provide at least fortnightly liquidity,” says Preqin. Most do better than that.

It is not just the liquidity that attracts a wide range of European-based institutional and high net worth investors to Ucits-compliant funds to deliver the absolute return element of their investment strategy, however:”The strength of the Ucits brand has also attracted strong inflows from hedge fund investors,”says a Threadneedle Investments report on the growth of the sector.

“Following high-profile hedge fund fraud such as the Madoff affair, more investors are now seeking out the more rigorous standards on liquidity, reporting, risk management and custody that the regulated market offers the Threadneedle report adds.

The growth of the sector – 2006-08 excepted when there were net outflows- has been relatively steady. “It has been building and I don’t think there has been a single decisive change of direction,” says Richard Frase, a regulatory partner at Dechert LLP.

“Ten years ago hedge funds were hedge funds and were based in the
Cayman Islands and so on. They had an established client base but realised some of them might be attracted to a regulated environment. Hedge funds started to add the odd Ucits fund to their product range, not so much because they wanted to but because they could see the appeal they would have to many continental European clients.”

This interest has steadily grown “but there are a lot of hedge fund managers who are happy with Cayman and really don’t have any interest in going down this route,” adds Frase. He suggests that US, Asian and many UK investors are still comfortable with the offshore option.

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