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Digital Subscriptions > The Hedge Fund Journal > Issue 136 – Nov 2018 > 7th FERI Hedge Funds Investment Day

7th FERI Hedge Funds Investment Day

13 September 2018

UCITS versus Offshore Hedge Funds

Still David versus Goliath?

Marcus Storr, Head of Hedge Funds, FERI AG “UCITS”or Undertakings for the Collective Investment in Transferable Securities are investment funds regulated at European Union (EU) level. In recent years, UCITS funds that follow hedge fund strategies have enjoyed a strong increase in number and assets under management. The low-yield environment and the efficient distribution of UCITS funds in the EU lend themselves as main reasons for the Alternative UCITS’current popularity. They have to fulfill more stringent requirements than traditional hedge funds with regards to liquidity, instrument eligibility, leverage, position concentration, short-selling, as well as transparency, operational and internal controls, and conflicts of interest.

These requirements affect the way in which hedge fund strategies can be implemented within this framework. For example, the main obstacle for UCITS funds when implementing any Equity Long/ Short or Fixed Income Long/Short strategy is the framework’s ban on outright short positions – ie implemented by borrowing cash securities. While single name short positions can still be achieved indirectly via such cash-settled derivatives as CFDs, swaps, and options, such workarounds are generally less cost efficient in terms of trading costs than outright shorts, arguably biasing the UCITS manager towards index shorts or a higher net exposure altogether.

Liquidity requirements bias UCITS funds towards equities of larger market capitalisation (Stefanini et al. (2010), p. 121) and towards bonds of larger issue size. While a contested issue, it is routinely argued that due to better analyst coverage, higher liquidity and higher transparency, large-cap equities are more efficiently priced than equities of smaller market capitalisation, which would reduce risk-free return through stock selection skills (“Alpha”) as a potential source of return. Furthermore, the regulation poses fundamental challenges to the pursuit of Event Driven strategies.

First, restructuring situations are difficult to exploit within the framework due to their impending illiquidity. Infante (2015) estimates that the great majority of distressed securities do not reach the UCITS-required liquidity levels. Bank loans and private securities are principally banned by the regulation, which makes it difficult for UCITS funds to provide financing in the form of loans during a restructuring. Holding large portions of a firm’s stock in the context of lengthy activist campaigns is irreconcilable with both the concentration rules and the required provision of at least semi-monthly fund liquidity ie twice per month. Popular substrategies within the Relative Value category are Fixed Income Long/Short, Convertible Arbitrage, Statistical Arbitrage and Volatility Arbitrage.

Statistical Arbitrage and Volatility Arbitrage. Difficulties for Convertible Arbitrage UCITS hedge funds include the lower liquidity of convertible bonds and the fact that most of the strategy’s trades involve a short position in the underlying stock. Statistical and Volatility Arbitrage are restricted by the framework’s leverage limits.

Managed Futures UCITS funds (CTAs) are hampered by the framework’s ban on direct investments in commodities and its position concentration limits. We hypothesise that a possible consequence of these obstacles is that Alternative UCITS are more exposed to the risks of traditional asset classes than hedge funds and Alternative UCITS funds are biased towards a more diversified portfolio of long positions in more liquid, exchange-traded securities. More than traditional hedge funds, Alternative UCITS funds should thus exhibit returns more similar to those on indices of liquid stocks and bonds.

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