It has been a period with conflicting news stories – first there were the stories about hedge fund managers who had failed to achieve the promised distribution by launching UCITS funds (referred to as Newcits). Then there was the story of a survey, that contrary to expectations, showed that Newcits had outperformed their hedge fund counterparts and now there are reports of a major hedge fund closing its UCIT structure and returning capital to its investors because reports suggest that the tracking error was widening.
Newcits were supposed to be the hedge fund managers insurance policy against the AIFMD and the way to get distribution in Europe. They have been marketed as better regulated, less risky and more liquid products than their hedge fund equivalents.
These claims need to be treated with some caution because it is distribution and regulatory arbitrage with the AIFMD that are the real drivers that attempt to make a virtue of the Newcit.
I have heard many cite the example of the UCIT structure used as a feeder fund to invest in Madoff, others cite the trade off they are prepared to pay for in the form of lower returns in return for reduced volatility and the enhanced liquidity of these products.
The great danger with Newcits is that marketing spin would have you believe that through the use of these structures investment risk can be replaced with improved liquidity risk. It cannot. An illiquid investment remains an illiquid investment regardless of whether it is housed in a Newcit or a hedge fund. Just because NAVs are prepared fortnightly do not make the product more liquid – the manager still makes judgements on the amount of liquidity that will be necessary and it will still be the more liquid part of the portfolio that will be realised first in the event of redemption notices. It may be true that regulatory requirements force more of a focus on liquidity requirements and indeed valuations – but it is investment strategy and markets that determine liquidity and not choices of investment vehicles and domicile. UCITS can gate redemptions and managers still need to manage liquidity by realising investments.
In so far as the claim goes that these products are less risky – one needs to ask what makes them less risky? Is it the counterparty concentration risk limits? The use of VAR as a risk assessment methodology? Valuation requirements? Restrictions on the use of derivatives limiting exposure to the net asset value? The nature of financing that may be permissible? Of themselves these strands are all good things to have – and many hedge funds have claimed the use of these for many years – Irish listed hedge funds have had similar counterparty exposure limits, many hedge funds claim to use VAR methodology (for what its worth) – so I am not altogether convinced about the significant improvements that Newcits provide – sure the requirements need to be adhered to and yes they do move towards a better framework for risk but they do not necessarily offer significant improvements on what hedge funds claim apart from being mandatory requirements.
How about better regulation? Unarguably there is more to deal with and monitor – but does this necessarily mean that it is better? I have visited enough investment managers in my time and observed large tomes of compliance manuals gathering dust on shelves. I have also as a chief operating officer been party to discussions on how to get around regulatory requirements that did not quite suit the hour of the day. It is the application of joined up proactive regulation that would be meaningful if it is done within a culture of real risk management – but that does not need rules – it needs attitude.
So what is it that you need in order to make sense of investments in Newcits? Everything. The due diligence needs to be as detailed as it should be for a hedge fund. The hurdles the Newcits must go through to comply, set, just that, hurdles. The investor must still complete its due diligence on both investment and operational aspects because structure and hurdles not withstanding the risk management, the liquidity and valuation claims, the investment strategy all still need thorough examination.
And if you remember that investment risk cannot be converted into reduced liquidity risk by changing the wrapper into a Newcit then you are streets ahead of some investors in Newcits and you may even be beginning to make sense of it all.
©Jaitly LLP