Are Hedge-Fund UCITS the Cure-All?

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

3. Structuring HF Strategies as UCITS

restrictions on hedge funds, summarised as lockup provisions and redemption periods, account for a significant share of their returns: “Aragon finds that the annual return on a portfolio of funds with lockup provisions is higher than the return on a portfolio of funds without such provisions (within a multifactor model). The difference is 7%–8% for equally-weighted portfolios and 4%–5% for value-weighted portfolios” (Amihud, Mendelson, and Pedersen 2005). If Aragon’s estimate is still valid, the transformation of these illiquid hedge funds into UCITS will affect their performance significantly. Because of investors’ appetite for illiquid assets, UCITS regulation clearly has weaknesses. Because it allows funds to invest partly in illiquid assets without disclosing the illiquidity risks to investors, the UCITS regulation gives investors a false sense of security: strikingly, valuation and the redemptions of units in UCITS money market funds were suspended during

the sub-prime crisis in 2007. EDHEC has proposed that funds, such as regulated closed funds whose liquidation horizon would be equal to that of the assets in the fund, be made available (Amenc 2009). These regulated funds would naturally not be subject to liquidity constraints, and investors in these funds could trade their units on secondary markets to recover funds that cannot be redeemed. 3.2.3.2 Other costs from the UCITS regulation Views of quantitative restrictions Eighty percent of respondents think that compulsory diversification will distort hedge fund strategies. In addition, more than 70% of respondents think that limiting borrowing to 10% is less than optimal; 70% think the same about similar limits on counterparty risk. Ninety percent of respondents from AIFs (more than 95% if one excludes those who report they have no opinion) fear this distortion. Respondents located offshore have similar views.

Figure 27a: Views of quantitative restrictions (all respondents)

Limitation of borrowings to 10% involves the use of less appropriate synthetic or derivative instruments The limitation of counterparty risk to 5%, 10% for a credit institution, is not as good as more sophisticated risk-management Compulsory diversification means many hedge fund strategies will be unable to comply with UCITS regulation or will be heavily distorted Collateral management is more demanding than needed

11%

50.7%

27.9%

10.3%

16.7%

44.1%

29.6%

9.6%

8.7%

49.9%

31.4%

9.9%

27.3%

40.9%

13.2%

18.6%

0

20

40

60

80

100

Not at all Somewhat

Very much so I don't know

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An EDHEC Risk Institute Publication