NEWCITS Are Dominating The Hedge Fund Space
Tuesday, January 12, 2010

The launch this week by Veritas of a UCITS III hedge fund is merely 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.

The Veritas fund is based on their Real Return Global Fund, targeting an annualised return of 6% over the medium and longer term by investing long and short in global equities, bonds, cash and derivatives. Veritas says that it first selects companies for entry into its ‘universe of investable companies’. The selection process encompasses idea generation, research and valuation. The second stage is portfolio construction, adding stocks from the list according to the specific mandate. Under UCITS rules the fund will have a maximum gross exposure of 200%. Hedging will be achieved by the use of index futures and options. Currency will be actively managed.

There is no upper limit on AUM. The fund, domiciled in Ireland, will be marketed mainly to UK investors. The performance fee is 20% on outperformance greater than UK CPI + 2%. The yearly management fee is 1% for the institutional class and 1.5% for retail investors. The UCITS fund will be available to institutional investors with a minimum investment of GBP30,000 and to retail investors at GBP7,000. HSBC is the fund administrator and custodian.

These numbers are fairly typical of the more accessible types of hedge fund which have been launched since the hedge fund sector met its high noon in 2008 and early 2009, with asset values tumbling as markets crumpled and investors fled the rigid, unfriendly structures which seemed to benefit only their managers.

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.