Many institutional investors in Alternative Ucits see the protections offered by the Ucits framework as a gold standard; a brand in which they have absolute trust.
Invest first, ask questions later seems to be the maxim. In this article I will look at some of the ‘protections’ that many investors hold so dear in justifying their lack of oversight.
Alternative Ucits funds offer hedge-fund-style absolute return strategies within the Ucits regulatory framework. Successful funds deliver consistent and attractive returns with low correlation to financial markets. As investors in Alternative Ucits it is up to us, and other institutional investors, to ensure that the brand remains untarnished.
The interesting thing about gold-standard brands is not so much their rise to power but their potential to fall into obscurity. There are many examples: Nokia, Atari, Kodak, Arthur Andersen... Volkswagen? Market giants swiftly brought to their knees, destroyed by scandal or eroded to nothing by failing to evolve. The Ucits brand is not immune.
Many investors believe that regulators, transparent portfolios, liquidity, safekeeping of assets, transparent fees and oversight are enough to protect their investment from harm, exempting them from the requirement for due diligence.
We cannot rely solely on regulators to protect investors. Yes, they have put the rules of the road in place, but you simply cannot trust everyone to play by the rules.
Operational due diligence is an examination of unrewarded operational risk. Looking under the bonnet and asking the tough questions to understand the inner workings of a fund. There are many institutional investors that, like Aurum, express dismay at the lack of operational due diligence taking place.
As investors in the hedge fund sector for over 20 years we have plenty of hands-on experience – and not all positive. One thing we’ve learned is to always approach unconstrained investing with scepticism from both an investment and operational perspective.
Aurum’s first foray into Alternative Ucits was in early 2012. Early last year we began more intensive research in preparation for the launch of a dedicated multi-manager, multi-strategy Alternative Ucits fund planned for the beginning of 2016.
Over this time, we have seen many industry participants fall down on operational due diligence.
While for standard Ucits funds portfolio transparency is a given, this isn’t always the case with Alternative Ucits vehicles. Ucits IV brought many formerly constrained strategies into the mainstream, permitting the use of derivative instruments to synthetically short stocks.
Instruments such as total return swaps (TRS) allow Alternative Ucits to access a hedge fund manager’s strategy without physically replicating the portfolio. We have seen a number of Alternative Ucits funds where the assets on the balance sheet are merely collateral, bearing no relation to the economic exposure and performance of the fund.
This isn’t necessarily a problem; indeed this development has broadened the range of strategies available to investors in Alternative Ucits funds. Suddenly though, that prized transparency, the ability to ‘look through’ the portfolio, becomes meaningless.
The swap ‘reference’ is held elsewhere and investors have little scope to evaluate it. It worries us how many investors fail to understand that the fund’s balance sheet does not represent the performance interests of the manager.
Another problem TRS potentially introduces concerns fee transparency. The cut paid to a swap counterparty is often wrapped up in the performance of the swap return, meaning it is not disclosed in the fund’s TER or financials. These fees will, of course, impact the NAV, though.
We uncovered one manager using a TRS structure within a Ucits wrapper who was paying the swap counterparty 1% on the notional swap balance. Although 1% is a little steep, there is nothing necessarily untoward here.
What was untoward in this instance was that, of the 1% fee paid to the swap counterparty, half of it was being rebated back to a related management entity under an ‘arrangement’ or ‘introducer’ fee.
The manager was effectively picking up an additional 50 basis points on top of their disclosed management fee, to the detriment of investor performance. Without thorough due diligence, how can you know what your manager is earning from your assets? We need to open the bonnet to identify such potential conflicts of interest.
Preventing a rush
Although Ucits investors may look with a degree of smugness at the gatings and side pocketing of assets that hit offshore hedge fund investors in 2008, the next liquidity crisis will undoubtedly affect some Alternative Ucits investors too.
Redemptions on any dealing day can generally be limited to 10% of the fund’s NAV to prevent a run on the fund in times of market stress. When liquidity starts drying up we expect many funds to apply this gate; something that will come as a surprise to many Ucits investors.
More importantly, we could see a rush to the door with huge ramifications for prices that may be gapping down, which will significantly affect performance. Ucits IV sought to bring about liquidity analysis of portfolios, but the assumptions used for monitoring could be shattered by a crisis.
Safekeeping Of Assets
The offshore industry was badly tarnished by Madoff, but the Ucits world did not escape his reach – although this seems to have passed many Ucits advocates by.
One group of Ucits investors who know the reality is those who together held $1.4 billion in the LuxAlpha Ucits fund.
LuxAlpha’s investment advisor, Access International Advisors, fed almost all investors’ assets directly to Madoff. The prospectus listed UBS as LuxAlpha’s custodian, but UBS was not securing investors’ assets, despite the wording of the prospectus. Unbeknown to investors, UBS had signed an agreement with Access International Advisors, indemnifying themselves from the responsibilities of custodianship, instead simply acting as a facilitator of client funds.
Eight years on from Madoff, this summer the highest legal court in Luxembourg ruled that investors do not have the right to sue UBS over their lost assets.
Ucits V, which is due to be implemented in early 2016, will impose greater responsibility on custodians and prevent a large amount of the current sub-delegation of responsibilities. We are likely to see custodians charging significantly higher fees to carry out their enhanced duties.
Open Your Eyes
As an industry we need to protect ourselves from within. Ucits legislation has allowed for the development of innovative funds that meet investors’ requirements, but we cannot blindly trust the regulators to protect us.
We have a fiduciary duty to our clients to secure their investments and this means not shirking the responsibilities of operational due diligence. By fulfilling our duty to our clients we will also defend the Ucits brand from those who seek to use it inappropriately.
Let’s make sure the action needed to protect the Ucits brand does not become the afterthought of a crisis that destroys it.
Bryn Sandison is a senior operational due diligence analyst at Aurum Research Limited.