It was only a matter of time before 130/30 products started to appear under the UCITS III banner. While the current volatile market environment may put a temporary dampener on activity, industry participants believe these types of funds will become an integral part of the fund management landscape in the next year or so. One of the biggest challenges, though, will be configuring technology, systems and procedures to meet the arduous UCITS compliance regulations.
It is no surprise that it is the larger, resource-endowed fund management houses, such as Henderson Global Investors, Fortis, Scottish Widows Investment Partnership, Threadneedle, UBS and JP Morgan, that are either planning or have launched products. They are well versed in hedge funds, derivatives and long-only practices, and have heavy-hitting infrastructure engines, including information technology compliance, legal, accounting, reporting and trading resources, in place.
The small to medium-sized firms or those embracing the concept for the first time could struggle with the back and middle office burdens. They are accustomed to the plain-vanilla world of equity investing and the learning curve may prove too steep. In fact, a recent report by Investit, a UK-based investment management consultancy, points out that at least a third of fund management companies in Europe that want to offer these funds face technological, operational as well as cultural barriers that may prevent them from doing so.
Paul Martin, head of global compliance for Fortis Investments, also believes that UCITS III will give the 130/30 industry a boost. “However,” he adds, “there are a lot of considerations that should be taken into account on the compliance and risk management front. Fund management groups will need systems and processes in place that comply with all the restraints under UCITS. These types of funds are different in that the regulations are designed to protect the retail investor and minimise the risk as much as possible.”
Rick Lacaille, chief investment officer Europe at State Street Global Advisors, agrees, adding, “The UCITS label is like a badge of confidence in and outside of Europe, which is why I think these 130/30 funds structured in a UCITS III framework will be popular. However, in the past UCITS products have been dominated by physical equity while the 130/30 funds will use derivatives. As a result, the same operational risk procedures they may have followed will not be sufficient with an over-the-counter (OTC) swap contract. “
UCITS III is the latest incarnation of the original 1985 UCITS directive and was only fully implemented in February after a two-year adoption period. Its most striking feature is that managers have the flexibility to use derivatives - up to 100% of the original UCITS and leverage within funds - up to 200%. This is why 130/30 funds have come on to the radar screen. They do not allow fund managers to go physically short but they can use listed OTC products such as contracts for difference (CFDs) when structuring these funds.
The tenets are basically the same whether they are spun out of the UCITS or the unregulated sphere. There are also variations on a theme with 120/20 or 140/40 bias, depending on the risk profile and appetite of a fund. A 130/30 typically involves putting 100% into an index and selling short 30% in stocks expected to underperform the market. The proceeds from the short sales are then used to go long stocks likely to beat the index.
“The UCITS III rules do not allow you to leverage like a hedge fund but in effect to go synthetically short and use the proceeds from that to go additionally long,” says Celeste Dias, head of product development at Threadneedle in London. “It’s also important to highlight that these 130/30 funds are not an absolute return product, rather they are aggressive, beta 1, relative return products. This means that the main risks come from market exposure and stock selection.”
All agree that the additional risk reporting required under UCITS III poses some of the greatest challenges. In general, UCITS funds using derivatives must have a derivatives risk management process and document in place that corresponds to the risk and complexity of the strategy being implemented. Managers have to explain how the derivatives are being used, the risks involved and how such risks are being controlled and monitored. They need the appropriate risk management frameworks to monitor, measure and manage at any time the risks of the positions and their contributions to the overall risk of the portfolio.
This is no easy task. There is a lack of standardisation in the derivatives world, which means that the investment strategies are often bespoke by nature, with high levels of customisation around them. Although the International Swaps and Derivatives Association (ISDA) has a standard document that lays out terms, counterparties often negotiate bilateral agreements which depart from these conditions. As a result, custodians are obliged to review separately the documentation of every OTC derivative agreed by a client with a counterparty.
Moreover, OTC products call for daily net asset values as well as pricing. This can be challenging, even for those who have dealt with hedge funds before, as these prices were often weekly. Jim Connor, partner and investment management and systems specialist at UK-based consultancy Morse, notes: “Many traditional institutions may be entering into this world for the first time and their current models may be geared up only for long-only funds. Some managers are struggling as their systems are not designed to process the information and pricing around a derivative or CFD contract. For example, they may not have the front office systems that can group long and short positions together in their portfolios It also means a sharper focus on collateral management and perhaps entering into a relationship with a prime broker for the first time.”
The Investit report reiterates these points, noting that compliance issues will also prove thorny to tackle. This is because current systems only focus on long only checks and do not understand the difference between gross and net exposure and do not neutralise long positions against short. They may also not be able to produce sufficient reporting to allow compliance departments to check shorts are not front-running underweights in other client portfolios. As for the back office, Investit notes that systems do not have the capability to record short positions and check that they are covered. NAV calculations whether via selling stocks or using OTC are difficult not only to calculate but also to check.
While the list of obstacles may sound daunting, there is, of course, an army of prime brokers and fund administrators ready to lend a helping hand. Both have been amending their systems to handle the new crop of funds and they have been actively educating the pension fund public about the alpha-generating attributes of a UCITS 130/30.
Typically, all three parties work together in some capacity. “Although fund managers have different set-ups with their administrators and prime brokers, the most important thing is communication between all parties,” notes Kevin Scollan, vice-president of product development at JP Morgan Asset Management. “Everyone needs to be talking to each other in order to know the value of their swaps, whether their portfolios are compliant and how they are behaving and that they can execute instantaneously if they wish to.”
Looking ahead, there is already talk of UCITS IV and V, although the fund management community is only just coming to terms with UCITS III. Industry participants believe that just including the use of derivatives was seen as a huge leap forward, and few are ready to tackle physical shorting.
“For the next few years, notification, cross-border mergers and acquisitions and asset pooling will continue to top the agenda,” says Simon Vernon, head of fund regulatory strategy at Schroders. “As for shorting, the political will needs to be there and I think the regulators are not yet comfortable with it. There is still a suspicion of hedge funds and private equity activity and it will take time for things such as physical shorting to be considered. It is important to remember that it took about 10 years for the recent changes to come through as UCITS III after the initial discussions in the early 1990s.”