Alternative UCITS: A Solution Or A Challenge For Investors?

RESEARCH PERSPECTIVE VOL.15 FEBRUARY 2016 Alexandros Kyparissis Hedge Fund Analyst Tel.: +447843144007 Email:alexandros.kyparissis@stonemountain-capital.com     Alternative UCITS: A Solution Or A Challenge For Investors?   With the deadline of UCITS V implementation coming next month, investors and asset managers should be aware of the characteristics of the increasingly demanded product of UCITS. The idea of the so-called “Newcits” was introduced for better investor protection after the financial crisis. UCITS III in 2001 introduced the use of derivative instruments such as options and futures and focuses more on the product side, while UCITS IV focuses more on the fund management. Regulators continuously seek for better protection of investors’ capital by imposing regulations regarding liquidity, short-selling, leverage, reporting, concentration risks and investable asset classes. UCITS V will not revolutionize the UCITS directive but focuses on improving the existing UCITS IV by harmonizing the depositary functions, putting limits on remuneration packages and governance. There is a demand for UCITS funds, with their assets continuously growing throughout the years, which is explained by investors’ need for transparency, better risk management and liquidity, the lack of which provokes suffocation to markets. The low or negative interest rates alongside with the turbulent markets, which are affected by financial and geopolitical factors, constitute the beneficial for alternative UCITS scenery. Numerous hedge fund managers eye opportunities on the UCITS spectrum due to the easier passporting of their product, but still some of them are tightened to their offshore structure. The transformation is facilitated either by UCITS platforms provided by investment banks or by UCITS management companies under their fund umbrella. In that way, the platform is subject to all the compliance issues and provides the fund with depositary services, provision of instruments, risk management and an extensive network for product distribution. Figure 1. Alternative UCITS funds and assets under management (Source: Absolute Research GmbH) The UCITS market growth is accompanied with the rising regulation in Europe (AIFMD, Solvency II, MiFID II) and the need from the investors for daily liquidity and lower fee structures. With their assets under management growing and the tendency of transforming offshore structures into UCITS increasing, the question is how well hedge fund strategies can adjust to the UCITS requirements can. The most perceptible concern is the liquidity offered in UCITS, which prohibits relatively illiquid strategies such as distressed debt or several REITs from being classified as liquid alternatives. Apart from liquidity, leverage is applied by many managers to enhance their performance, and the use of it under UCITS is limited and usually achieved through derivatives positions. More complex strategies may be classified as sophisticated UCITS, which are not limited by levels of leverage but by the level of Value-at-Risk requirements. The regulators seek for better risk-return trade-off and not only for mitigating risks, but are their actions pointing towards their goal? And do they or the investors actually understand the risks within investments? For example, some institutions consider alternative investments as risky investments and they urge the managers to stick to traditional investments, which according to this perspective is riskier than investing in other vehicles. The need for diversification especially in low yielding and noisy financial environment is something that investors should consider before their allocations. Similarly, in the asset management industry and especially in the hedge fund sector, limiting managers’ tools could demise their performance to generate alpha (α) for their investors. ​Liquid alternatives seem to be a robust diversification option for managers and by robust this perspective suggests the non-increasing correlation of UCITS funds with traditional investment vehicles and indices. In the years of financial crisis, investments which had until then uncorrelated profile such as real estate, started to behave like traditional investments which led to the vanishing of liquidity from the markets and eventually the crash. Although alternative UCITS have not been tested in crisis environment, their whole design is based on avoiding similar situations. This perspective attempts to analyse their performance and risk attributes compared to similar investing strategies for the period of 2012-2015. Table 1. Correlation Table Between Strategies, Stone Mountain Capital Research, 2016. The results of the correlation table hide very interesting features for the relationship of different strategies. The first relationship observed is expected and concerns its generally uncorrelated nature, with equities and bond markets, macro funds. Macro investing is intrinsically diversified due to the variety of asset classes it invests in, including commodities and currencies. Some macro strategies resemble fixed income strategies, because some macro strategies instead of gaining coupons, gain premiums from the derivative transactions they are getting involved with. Alternative UCITS Macro appears to have a stronger relationship with US equities, while the rest indices apart from Credit Suisse Global Macro are more correlated to fixed income than equities. The inverse relationship seems to be predominant for the rest of strategies, which is intriguing given the fact that fixed income strategies should be more correlated to each other than equities.  US equities appear to have strong effect on alternative investments after 2012, fact which may indicate that the equities market of the largest worldwide economy may affect the sentiment of investors globally. All fixed income indices but Credit Suisse’s index have higher correlation to S&P rather than the Merrill Lynch index a pattern which is followed by fund of funds market as well. Alternative UCITS Macro/CTA have higher correlation than their respective hedge fund strategies both with equities and fixed income. Alternative UCITS L/S Equity has lower correlation to S&P 500 than HFRX Equity Hedge and Credit Suisse L/S Equity, while the respective UCITS Fixed Income’s correlation to Merrill Lynch Fixed Income index is higher than its peers. ​After analyzing the purposes of the UCITS regulatory requirements about protection of investors’ capital and interest, it would be interesting to examine if investors lose from the implementation of UCITS. It should be mentioned that the comparison between the strategies is indicative and not robust due to the different level of fee structures, liquidity, leverage and concentration. The comparison becomes more complex if we account for the biases existing in the hedge fund industry. Table.2 Summary Statistics Across Examined Strategies From 2012-2015, Stone Mountain Capital Research, 2016. Figure 2. Risk-Return Profile Of Strategies For 2012-2016, Stone Mountain Capital Research, 2016. Table 2 and Figure 1 illustrate the lower return-risk profile of UCITS funds, which are concentrated on the lower left corner of Figure 1. Fund of funds and fixed income funds confirm the claims for lower returns associated with lower risks, whereas alternative UCITS equity and macro/CTA funds seem to be a good bet for investors providing high returns with lower risk levels. All of them underperformed the traditional indices for equity and fixed income in terms of returns, with the Credit Suisse fixed income and equity indices appearing to be the most attractive investments on the basis of risk-return profile selection. The table and the figure show a good positioning of UCITS funds regarding their return generating ability and in terms of risk as shown in the figure below. Figure 3. Drawdown Profile For The Examined Strategies From 2012 to 2015, Stone Mountain Capital Research, 2016. The elimination of extreme risks is obvious in the above figure with most of the UCITS funds to be close to the x-axis of the graph, indicating their ability to stop losses, while their traditional and alternative peers seem to struggle. HFRX funds are concentrated in the area from -4% to -8%, while UCITS funds marginally exceed -4%.   ​The above are just illustration of UCITS performance relative to offshore hedge funds and traditional indices, but the actual challenge that remains is the comparison of offshore funds that changed their structure to UCITS. And most importantly, UCITS funds need to be tested during a crisis environment to realize if it offers protection to investors or poses more problems to their investments. This perspective is neither an offer to sell nor a solicitation of an offer to buy an interest in any investment or advisory service by Stone Mountain Capital LTD. For queries please contact Alexandros Kyparissis under email: alexandros.kyparissis@stonemountain-capital.com and Tel.: +44 7843 144007.   For further information around our research and advisory services please contact Oliver Fochler under email: oliver.fochler@stonemountain-capital.com and Tel.: +44 7922 436360. The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, Stone Mountain Capital LTD. Readers should refer to the Disclaimer.    Stone Mountain Capital LTD (FRN: 729609) is an Appointed Representative of LNG Capital LLP (FRN: 454402), which is authorised and regulated by the Financial Conduct Authority (‘FCA’). Copyright © 2016 Stone Mountain Capital LTD. 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