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.

James Bowers, head of product at Henderson Global Investors, also highlighted this regional split in preferences for sourcing the absolute
return element of a portfolio. “Regulatory drivers have meant that the regulated onshore funds have become much more attractive to European institutional investors.

We expect that trend to accelerate and for Cayman funds to be only for
active American and Asian investors,” he says. Bowers says that many large
investment managers are looking to “put a hedge fund strategy into a Ucits clone.” 

“It is going to drive some of the traditional strategies out of Europe as Ucits funds now have several years of running hedge funds-like strategies but with all the benefits of investor protection. Ucits has become a sort of kitemark [safety mark] that investors feel they can trust.

“The buyers are largely the same – institutional funds, family offices,
large and small pension schemes. They have all previously looked at traditional hedge fund products to deliver their absolute return strategy,”
says Bowers.

He acknowledges that hedge funds remain an attractive option for the delivery of some investment strategies using assets now permitted within Ucits regulated funds, such as commodities.

Retail investors have also been drawn to absolute return, especially as a strategy for managing the growing volatility of equity markets without putting their money in very low return fixed income funds. It has been especially attractive over the last two years to ISA (Individual Savings Accounts) investors in the UK.

“The enhanced investor protection provided by the Ucits framework gives funds managers the flexibility to provide retail investors with access to absolute return funds which historically were only available to institutional investors,” says Alex Hoctor-Duncan, head of Blackrock’s EMEA retail business.

“We have seen increased appetite for EU domiciled funds in the absolute
return space driven primarily by investor appetite and the regulatory
landscape,” says Hoctor-Duncan, although he adds that some retail investors still look at other offshore vehicles. “There is some initial evidence which suggests that more sophisticated customers who want an offshore element to their absolute return strategy will invest through Qualified Investor Funds and Collective Investment Funds”. 

Gregor Macintosh, head of sovereign and foreign exchange at Lombard Odier, says that the appetite for absolute return strategies is developingall the time.”Everybody realises they have allocated too much to fixed income over the last 15 years and they need to find ways of making that work more efficiently.”

He says that this extends beyond European investors and now includes
the likes of Japanese pension funds. “What they are worried about is the
long allocation to fixed income. They are not attracted to riskier options so
they look at absolute return funds as replacing like with like but without
the correlation to the interest rate cycle or the corporate credit cycle.”

How this appetite for regulated funds will survive the next wave of regulatory changes seems to be an open question. There is convergence
between Ucits (in Ucits V) and its 2010 cousin AIFMD, especially on issues
such as remuneration, depositories and liabilities, and discussions have
already started with the drafting of Ucits VI.

Preqin warns that the provisional shopping list of topics for inclusion in
Ucits VI is already alarmingly long. “Our assumption is that these changes will impact provisions around the list of eligible assets, how efficient portfolio management techniques are employed, OTC derivatives, liquidity management and the use of long term investments.”

For those operating funds regulated under the AIFMD regime – which created a new type of regulated investment outside the Ucits regime
embracing hedge funds, private equity funds, property funds and infrastructure funds – there are still several key dates looming.

Under the Directive, EU fund managers can market alternative investment
funds to professional investors in the EU through the pan-European marketing passport. This is not currently available to non-EU managers of AIFs. 

This is set to change in 2015 when the passport will be extended to
non-EU managers in some circumstances and then, possibly, extended
further in 2018 with the introduction of a full two-way passport.

Alongside this there is a potentially complex interaction with the regulations
for private placement for private equity and venture capital managers which could also alter the balance of advantage between onshore and offshore
managed funds, at least for the larger institutional investors.

All of this is taking place against a background of growing demand for
absolute return strategies as an essential tool for coping with the seemingly relentless rise in volatility.

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