Are Hedge-Fund UCITS the Cure-All?

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

3. Structuring HF Strategies as UCITS

In practice, then, UCITS are allowed to invest a fraction of their assets (at least 10%) in less liquid securities. These investments, however, require pricing policies and tools that enable accurate measurement of their values, as well as adequate risk management. Article 34 of the UCITS directive allows “competent authorities [to] permit a UCITS to reduce the [valuation] frequency to once a month on condition that such derogation does not prejudice the interests of the unit-holders”. This exemption has been taken advantage of most frequently during liquidity crises such as those of 2008-2009. Quantitative restrictions The UCITS directive sets out a number of quantitative restrictions that mainly require diversifying investments and controlling counterparty risk. Crude calculations are taken to measure these restrictions, 7 and Value-at-Risk, which serves solely to gauge the leverage of sophisticated funds, cannot be used. These restrictions can be summarised as follows (see appendix for a slightly more detailed description): •  Concentration risk, i.e. , the fraction of the net asset value invested with an issuer, is limited to 5% for a general issuer, to 25% for credit institutions and up to 100% for government bonds, provided that there are at least six securities and that none of them represent more than 30% of the asset value. •  Counterparty risk with a credit institution is limited to 10% •  A UCITS may invest in other funds provided that they are supervised; they

shall not invest more than 20% in any single fund; total investments in non-UCITS funds shall not exceed 30%. •  A UCITS cannot perform naked short sales; its borrowings of cash or securities are limited to 10% of the net asset value. Overall, most of the short sales should be performed synthetically. A 10% ratio allows funds to invest in “other assets”, provided they are not forbidden by the UCITS or domestic regulations. In some cases, the vague wording concerning this so-called trash ratio means that UCITS can invest up to 10% in unregulated hedge funds, in what seems to be in inexplicable contradiction with UCITS requirements. Reporting/transparency UCITS must be able to release net asset values (NAVs) twice a month; they must also publish annual reports and financial reports, both audited, in which actual transactions are described. In some countries, such as Ireland, a section provided by the depositary appears in the annual report (and could, if they take place too frequently, disclose breaches in diversification ratios or quantitative restrictions for which the asset manager is responsible). Last, the UCITS must report the nature of its strategy and the corresponding (financial) risk profile in the key information document (KID) given to all investors. 3.2 HF Strategies Likely to Be Structured As UCITS The requirements that must be met to qualify as UCITS are described in sub-section 3.1; we turn now to respondents’ views of the likelihood of each hedge fund strategy’s being structured as a UCITS.

7 - The commitment approach, that is, the delta-equivalent to direct investments in non-derivative assets, is looked at.

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An EDHEC Risk Institute Publication