Are Hedge-Fund UCITS the Cure-All?

Are Hedge-Fund UCITS the Cure-All? — March 2010

3. Structuring HF Strategies as UCITS

In this chapter, we will first describe the constraints faced by sophisticated UCITS funds (3.1) and then describe how hedge fund strategies can cope with these constraints (3.2). 3.1 Background: UCITS ever friendlier for hedge fund strategies UCITS funds are bound by the UCITS directive. Although UCITS IV has been passed by the European Parliament, the UCITS regulation currently in force after its transposition into national law is the so-called UCITS III directive (European Council 2008). In addition, two important regulatory texts have introduced the notion of sophisticated UCITS, which have paved the way for packaging hedge fund strategies as UCITS: •  The CESR advice on eligible assets (CESR 2007) has increased the number of assets in which UCITS may invest. •  Recommendation EC/2004/383 has expanded the possibilities for leverage. In general, for hedge fund strategies to be classified as UCITS, the following criteria must be met. Leverage: The so-called 2004/383/EC recommendation clarifies the measure of leverage to be used by sophisticated UCITS, a self-explanatory word that designates UCITS that have the adequate expertise, risk management and risk measurement tools. It introduces the notion that Value-at- Risk can be used to gauge leverage, and it recommends the following criteria: •  Absolute VaR limit: there should be an absolute monthly 99% VaR limit of 20%. In

other words, the UCITS must control that the worst possible loss over a twenty-trading- day holding period, at a 99% confidence interval, does not exceed 20%. •  Relative VaR limit: the monthly 99% Value-at-Risk should be less than twice the VaR of a derivative-free benchmark. Box 4: Slightly varying implementations of the EC recommendation 2004/383 in Europe Not all countries have acted on the EC recommendation. Some, largely as a result of the absence of industry demand, have not defined sophisticated funds at all. The measurement of leverage differs slightly from one country to another, although the general EC guidelines (99% VaR with a one-month holding assumption) are adopted by most. In Ireland the holding period must be no more than one month, which suggests that a less restrictive weekly or daily holding period can be assumed. However, industry codes of practice are such that a monthly holding period must be input. Austria, Denmark, Germany, and Spain (on paper at least) require a ten-business- day holding period. In that sense, they are less restrictive (by a factor of the square root of two if one assumes twenty business days a month). Less restrictive again is Portugal, which requires a ten-day holding period and a 95% confidence interval. France, by contrast, requires a 95% confidence interval and a one-week period, but a 5% maximum VaR limit that makes VaR restrictions more restrictive than in neighbouring countries.

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An EDHEC Risk Institute Publication