Many institutional investors in Alternative UCITS funds have built up the perceived protections offered by the UCITS framework into a gold-standard brand; a brand in which they place their total trust.
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, because whilst it is a gold-standard brand, it is not unimpeachable.
The interesting thing about gold-standard brands is not so much their rise to strength, but their potential to fall rapidly from positions of power and respect into relative obscurity. There are many noteworthy examples: Nokia, Atari, Kodak, Arthur Andersen...Volkswagen? Market dominant giants swiftly brought to their knees, destroyed by scandal or disintegrated to nothing by failing to evolve. The UCITS brand is not immune.
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. There are many institutional investors who, like Aurum, express dismay at the lack of operational due diligence that other institutional investors seemingly forget about when it comes to their fiduciary duty in managing their clients' money.
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. 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 of due diligence. As investors in the hedge fund sector for over 20 years we have long been exposed to some of the more unconstrained strategies traded across the investment arena. This history has brought much experience, not always positive, but one thing it has taught us over the years is to always approach unconstrained investing with scepticism from both an investment and operational perspective.
Aurum's first foray into the Alternative UCITS world 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 performing weak levels of operational due diligence. Invest first, ask questions later; rather than conduct a rigorous due diligence process. In this article I will look at some of the 'protections' that many hold so dear in justifying their reasoning for a lack of oversight.
Portfolio transparency
Whilst for standard UCITS funds portfolio transparency is a given, this can be far from the case with many Alternative UCITS vehicles. UCITS IV brought many formerly constrained strategies into the investment foreground, permitting the use of derivative instruments to synthetically short stocks. The use of instruments such as total return swaps (TRS) allows the UCITS fund to gain access to 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 sheets 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, the transparency that investors prize about Alternative UCITS funds, the ability to "look through" into the portfolio, becomes meaningless. The swap 'reference' is held elsewhere and investors have very scant access 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 to whom they have entrusted their capital and their future returns.
Fee transparency
We uncovered one manager using a total return swap structure to effect their strategy within a UCITS wrapper, paying the swap counterparty 1% on the notional swap balance. Perhaps 1% is a little steep, but there is nothing necessarily untoward here. It is worth noting that these fees can often be wrapped up in the performance of the swap return and so not disclosed in the fund's TER or financials. It will, of course, impact the NAV though. 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 50bps on top of their disclosed management fee, to the detriment of investor performance and again not disclosed in the financials or the prospectus. Without thorough due diligence how would you know what your manager is earning from your assets? We need to get into the weeds to identify such potential conflicts of interest.
Liquidity
Although UCITS investors may look with a degree of smugness at the gatings and side pocketing of assets that happened in the offshore hedge fund space in 2008/09, the next liquidity crisis will undoubtedly hit some within the Alternative UCITS space hard. 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 of assets to the door with huge ramifications for prices that may be gapping down, which will significantly damage performance. UCITS IV sought to bring about liquidity analysis of portfolios, but the assumptions used for monitoring could be severely and rapidly challenged 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 advocates of UCITS by. Ask the investors behind the $1.4bn invested in the LuxAlpha UCITS product whether they still believe that they were protected? LuxAlpha's investment advisor, Access International Advisors, fed almost all of investors' assets directly to Madoff. The prospectus listed UBS as LuxAlpha's custodian; however, UBS were 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 custodian, instead simply acting as a facilitator of client funds. Eight years on from Madoff, this summer the highest legal court in Luxembourg has ruled that investors do not have the right to sue UBS over their lost assets.
UCITS V, 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 costs in order for them to carry out their enhanced duties.
Conclusion
As an industry we need to galvanise ourselves to protect from within. UCITS legislation has allowed for the development of innovative funds which meet many of investors' requirements, but we simply cannot put blind trust in 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 full and proper operational due diligence to identify unacceptable practices. 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 that the galvanisation we need to protect the UCITS brand does not become the afterthought of a crisis which crumbles it.