By Simon Kerr, Publisher of Hedge Fund Insight
It was noted in Hedge Fund Insight in May this year that most of the capital raised by European hedge funds in 2013 had gone into UCITS versions of the funds rather than the offshore versions of those hedge funds. At the time the comment was “this bias to UCITS versions of hedge funds is despite investors saying that they are struggling to achieve diversity in their (hedge fund) UCITS portfolios because of the limited range of hedge fund strategies available in the fully regulated funds. The slightly fearful inference is that investors would sooner jam capital into a lesser performing but regulated versions of successful funds than take the extremely minor risk of investing in the offshore version of brand name funds.” This article will look at the size of the performance shortfall of UCITS versus offshore hedge funds.
UCITS versions of hedge funds have underperformed the equivalent offshore funds from the launch of UCITS III as a fund format in Europe in 2009. There are several reasons for this including limitations on leverage, the necessity of a manager of a UCITS product to hold some cash, and UCITS versions may have to avoid some of the illiquid holdings of the offshore hedge funds. There is also a unit size for dealing factor, whereby an OTC swap may have a dealing size of $3-5m dollars, which would be fine for an $1bn-plus hedge fund, but not feasible for a $120m UCITS III version which has 80 positions, even if the UCITS mandate allowed such a holding at all.
A recent study showed that over the three and a half years from January 2010 the UCITS Alternatives Index underperformed the HFRI Fund Weighted Index by 3.79% on an annualised basis. However, the HFRI Fund Weighted Index is not investable. Looking at the difference between the HFRX Global Investable Index and the returns from the UCITS Alternatives Index may be a fairer comparison, and the UCITS index delivered only 47 basis points less on an annualised basis. There is an argument to be made that investing institutions could probably gain access to most of the managers who are in the HFRI Fund Weighted Index but not in the HFRX Global Investable Index. To the extent that is true the difference in returns between UCITS hedge funds and onshore US hedge funds and offshore hedge funds is closer to the 3.79% level. That is the multi-year performance gap.
A shorter and more recent analysis period for differential returns is shown in the Table below.
Source: Preqin Hedge Fund Analyst
The universes for “All Strategies & Regions” and “Euro Denominated” in the Table are very different for Hedge Funds and UCITS Hedge Funds. So, for example, the successes of Japanese Long/Short managers over the last year will be reflected to a much greater degree in the non-UCITS figures, as will the returns from distressed and event driven managers. There may be 552 UCITS hedge funds but only the the three strategies shown in the last three rows of the Table are represented by a good variety of individual funds.
The three strategy level rows of the Table give the best like-for-like comparison. It seems that over the last year UCITS III hedge funds have continued to underperform hedge funds in more lightly regulated forms. The hedge funds in the fully regulated European format have produced returns at least 2 1/2 percent lower than hedge funds in other formats. The performance gap of the last 12-months is smaller than that produced over the 3 1/2 year period of the longer term analysis referred to above (3.79%). However with 10 Year Euro swap rates at only 2.2% such a performance drag cannot be lightly dismissed.
Acting on Perceived Risks
At present it would cost an investing institution investing in a hedge fund just less than 50 basis points additional fee to have a managed account set up in their name to replicate exactly the same strategy as any offshore hedge fund. It would cost around 25 basis points and maybe less to have a depository hold the assets of a hedge fund rather than a prime broker. If the concern of investing institutions is insufficient transparency they should set up a managed account version of an offshore hedge fund. If the concern of an investor in hedge funds is fraudulently losing control of the assets then they should pay for a depository to be involved with the offshore hedge fund. In these two cases it could potentially allow 2 1/4 % extra return to be available versus the use of a UCITS III version of a hedge fund.
There are ways to bridge the perceived gap in operational/fraud/regulatory risk between offshore hedge funds and UCITS III hedge funds at costs which are a lot less than the persistent performance shortfall of UCITS hedge funds versus their offshore cousins. 40 Act funds and funds-of-one are also growing in popularity for the same reasons. UCITS III hedge funds are useful to enable retail investors or the mass wealthy to get access to hedge fund strategies, but should investing institutions with hundreds of millions of Euros committed to hedge funds be in them at all, except for regulatory reasons?
Challenging and well-researched as this article is, it omits several key considerations:
– Better liquidity in UCITS – at worst, fortnightly redemptions, but more generally available daily. Liquidity is, currently, the single biggest consideration in hedge-fund investing by institutional and professional investors.
– Greater ease of access in UCITS
– Greater ‘comfort’ for investors of a regulated vehicle – standardised documentation, reporting, risk controls etc
– Post-FATCA, the tax transparency in UCITS is a major benefit for managers
– UCITS is the structure most favoured in some of the world’s fastest-growing fund markets, especially Asia.
In short, the numbers tell only part of the story – and quite a small part at that.