Are Hedge-Fund UCITS the Cure-All?

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

3. Structuring HF Strategies as UCITS

In an attempt to make the cost of this operational risk more transparent and to go some way to offsetting it, some banks charge the weaker counterparty to a contract for the net cost of the counterparty risk. For each of the counterparties, the cost of the risk of default is the likelihood of default of the counterparty multiplied by the average expected loss of a contract (which thus depends on collateralisation and on the likelihood of the contract’s being in the money at the moment of default). The net cost is the difference between these two costs, so the premium paid reflects an “average” cost and allows partial protection for the more highly rated counterparty. Ideally, one would want to extend the collateralisation practices so that counterparty risk is totally shed. The first step is not to allow excessive collateralisation to create “reverse counterparty risk”, i.e. , the possible immobilisation or seizure of excessive collateral entrusted to another party in the event of the failure of the counterparty. Tri-party collateral agreements make it possible to manage this risk. In these agreements, the collateral for a contract between parties A and B is safe-kept by an independent party C, usually a large depositary bank or custodian. Party C ensures that no more than the required collateral is ever paid out to either A or B. Tri-party collateral agreements thus also offer the possibility of over-collateralisation from both parties, so counterparty risk is shed. In addition, it makes it possible to post risky assets as collateral (as long as there are shave-offs,

i.e. , further over-collateralisation from both parties). The practice of using tri-party agreements to shed counterparty risk has not yet been evaluated by the industry, but, for asset managers, the development of central counterparty platforms should mitigate many of the problems of managing collateral and counterparty risk. Central counterparties should also prevent the counterparty risk that generally comes with leverage from forcing funds to enact more restrictive leverage policies. Conclusion It is likely that the risk-adjusted performance of hedge funds UCITS will be significantly altered by the rising costs of instruments and of asset servicing; the smaller pool of opportunities; diminished returns from artificial compliance with UCITS requirements, such as unfocused risk-spreading from strategies previously concentrated in highly defined choices; and reduced leverage. Reduced leverage has no influence in a world with no fixed fees, but when there are fixed fees, as with alternative investments, and, worse, when there is an additional inability to capture risk premia, reduced leverage leads to worse risk-adjusted performance. Risk-adjusted returns will, in all likelihood, fall sharply for hedge funds that exploit strategies that do not initially comply with UCITS requirements, such as those based on long-term, illiquid instruments.

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