Rise of Sophisticated UCITS Funds
Financial derivative instruments, (including OTC derivatives) have been eligible for use in Undertakings for Collective Investments in Transferable Securities (UCITS) funds for investment purposes since the introduction of the UCITS III product directive in 2001. This expanded investment power has given rise to a growing interest in a new breed of funds. Called by many names, "Sophisticated funds", "New-cits", or "Hedge fund-lites", UCITS III paved the way for the convergence between hedge fund strategies and UCITS.
If these funds have been around for nearly a decade – why the interest now? The widespread loss of investor confidence arising from the liquidity crisis, credit crisis, and revelations of Ponzi schemes has created a renewed demand for investor assurances from investment vehicles. UCITS is a branding of assurance via compliance measures.
For hedge funds, the post-crisis anticipation of higher regulation combined with newly understood advantages for acquiring new investors are driving the popularity of the UCITS vehicle. Sophisticated UCITS can use both regulated and over-the-counter (OTC) derivatives, including exposures to commodities, financial indices, credit default swaps (CDS), total return swaps and even hedge fund indices. Add to this the wide regulatory acceptance in many jurisdictions (EU, Asia and Latin America) UCITS provide an attractive vehicle indeed for accumulating funds under management to earn Alpha and management fees.
What does all this mean for traditional asset managers – the original players in this domain? Competition is set to increase and innovation will be critical to remain competitive.
For traditional asset managers and hedge funds, meeting the strictures of a UCITS structure will be key to reaching a broader investor base, both institutional and retail.
There is a learning curve involved in taking these products forward to take full advantage of allowable derivatives under UCITS III. Hedge funds must adhere to new transparency practices while traditional asset managers will need to step out of their comfort zones and learn to innovate with derivatives. Critical to this learning curve is the application of the independent valuation and risk management compliance guidelines in UCITS III as well as the ability to quickly adapt to changes in the investment climate.
Making the Cut
On an operational basis, the most prominent requirement of achieving and maintaining compliance as a UCITS fund is the frequent valuation of assets. In sophisticated funds, where there is more frequent and complex use of derivatives in portfolios, this adds an extra layer of complexity.
UCITS are compelled to be more transparent than hedge funds. They must observe strictly reliable valuations of all their derivatives not only for investment management reasons, but also for disclosure to maintain UCITS status. This means their valuation tools must not only cover the derivatives landscape broadly but also be transparent enough to withstand scrutiny by regulatory bodies and auditors.
The introduction of third-party valuation tools or services can contribute to the independence and therefore credibility of valuations. While accuracy is important, independence and transparency are more germane to UCITS compliance. Independent valuations are less biased than self-generated valuation. Transparently produced valuations are more easily verified than valuations produced by opaque or proprietary means.
Valuations and risk management requirements
The valuations produced by the UCITS risk management practice must remain as independent as possible from the investment manager's valuations. This is especially relevant with over-the-counter (OTC) derivatives which require the use of models combined with observable data.
Sophisticated UCITS measure their global exposure using approved methodologies such as Value at Risk (VaR), combined with stress-testing and back-testing. Both of these exercises require a reliable valuation process and supporting tools. Conditions such as keeping derivatives counterparty concentrations to less than 10% require active monitoring of derivative positions. Again, the tools that support these risk calculations must be widely accepted and transparent.
Indeed, expanding the investor base for a UCITS to those who seek explicit assurances of protection means proactively making risk measures available for examination. Transparency is a core part of the product being offered, not an optional feature. Risk management must abide by this philosophy.
Where counterparty credit risks must be taken into account, there can be disagreement between an independent valuation by a risk manager and the valuation preferred by an investment manager. The valuations produced by risk management must prevail through independence and superior transparency, supported by tools and methods that will withstand regulatory and audit scrutiny. As valuations and published risk measures converge to certain best practices, these tools may eventually become recognizable to investors, perhaps even by brand name.
The risk management framework for a sophisticated UCITS must remain strongly independent, consistent, and documented. Furthermore the fund must be able to provide fund risk measures to the board of directors, investors and regulatory agencies on demand. Investor protection and the continuing benefits of UCITS status depend on it. Proven valuation tools from a known provider are required to do this. In addition, risk management must be able to explain risk mitigations, which may include sensitivity and scenario analysis.
Positioning for the future
There is already a wide variety of financial derivatives in use within UCITS. As investment climates change, investment managers must adapt. Adaptation may require using derivatives not used before. Therefore, the selected valuation and risk measurement tools must be subject to a criterion of extensibility, meaning they must already cover or expand to cover the derivative classes the fund could potentially use in the future. A limited toolset can put both the strategic investment and the operational valuation capabilities of a UCITS fund at risk, and therefore the overall transparency of the fund at risk.
Speculatively, UCITS IV (targeted for July 2011) will introduce cross-border distribution advantages and centralized product delivery conditions that will encourage larger investment pools. This will in turn, up to the ante for ready and robust daily derivative valuations risk management solutions for sophisticated UCITS. Those ahead of the learning curve will be poised for success and will surely gain the first mover's advantage.