More Good News For Hedgies
Thursday, January 21, 2010

Further evidence has emerged of the recovery of the hedge fund sector in 2009 with the publication of figures by The Eurekahedge Report this week showing an eighth straight month of asset growth, although inflows accounted for only a small part of total gains of USD4.6bn. Total assets reached nearly USD1.5 trillion, said the Singapore-based firm, showing growth in the year of nearly 20%, matching or exceeding equity and bond market gains. Chicago-based Hedge Fund Research Inc. concurs with this figure for hedge-fund sector growth.

It's a case of a rising tide lifting all boats, and the sector has changed: gone are the days when investors freely accepted lock-down restrictions imposed by over-mightly funds and the over-generous reward schedules given to managers. The reluctance, and in many cases, inability of hedge funds to pay out redemptions during the melt-down in 2008 and early last year have permanently scarred investors, and the growth now being shown is happening because of the emergence of more friendly types of fund such as NEWCITS (hedge funds which conform to the EU's UCITS III Directive).

The Credit Suisse Tremont Index says that more than 10% of assets were being restricted at the end of 2008, oft-times through the use of 'side-pockets', although the figure has now halved. A secondary market has developed in restricted holdings in London and the Bahamas, allowing investors to bail out if they themselves become cash-strapped.

Recent NEWCITS launches include Thames River Capital's Absolute Return Fund and Veritas's Real Return Global Fund, both based in Ireland. They are the latest in a long line of 'hedge-fund-lite' products to have hit the market in the last few months as investors warm to the idea of a transparent, less risky instrument that combines the transparency of a UCITS product with the more adventurous investment style of a hedge fund. UCITS-based funds are particularly attractive to less adventurous investors, evidently, and this definition very much include the institutions, who probably represent the future of growth for the sector. They had already begun to emerge as the focus for new asset formation before the crunch, and the tendency for funds to market towards institutions can only accelerate in future, according to many commentators.

UCITS (Undertakings for Collective Investments in Transferable Securities) have been around for more than twenty years, providing an EU-wide investment framework, which allows a product to be set up and approved in one European jurisdiction and then marketed to retail investors in all other EU countries subject to a simplified registration process. Also, it is convenient for European fund of funds managers to invest in other managers’ funds if they are constituted as UCITS funds, when Europe-wide distribution is the goal. The UCITS III rules allow up to 100% investment in other funds provided that these funds are regulated to a standard equivalent to a UCITS, subject to a maximum of 20% in any one investment.

The investment managers are subjected to regulations restricting investment and borrowing powers. There are other restrictions; for example, no more than 10% of the Net Asset Value may be invested in any single security. However, as the product develops, a much broader range of Financial Derivative Instruments (FDIs) has become permissible and the derivatives can leverage these funds by up to 100%. Under the UCITS III rules, investment managers can be long up to 100% in directly held equity securities and short up to 100% using stock specific derivatives such as contracts for difference (CFDs) or stock specific futures.

The regulatory framework provides a degree of reassurance to investors that fund managers wish to tempt back into the alternative investment markets after the shocks of the economic crisis, and yet they are exempt from the scope of the European Commission's controversial draft Alternative Investment Fund Manager directive. In addition, as far as the UK is concerned, the reduced rate of capital gains tax has worked to the detriment of offshore hedge funds, which do not qualify for capital gains tax treatment in contrast to UCITS onshore funds.

According to an Investment Fund Industry Fact Sheet published by the European Fund and Asset Management Association (EFAMA) in December, total net sales of UCITS and non-UCITS reached EUR 159 billion in the first ten months of 2009; inflows into long-term UCITS (UCITS excluding money market funds) increased to EUR 27 billion in October, compared to inflows of EUR 21 billion in September.