Please mind the gap: Where the exciting growth in alternative UCITS really is

European investors are faced with a dilemma that has never been seen before.

Interest rates are in negative territory in Europe, are at record lows in the UK, and look as though they will go even lower in the aftermath of the Brexit `leave’ vote. Global equity markets saw sharp deleveraging during the first half of this year evidenced by sharp outflows from mutual funds and ETFs. Capital preservation can seem impossible in a world where oil prices collapsed to $30 per barrel in January, creating a world-wide deflationary panic, before rallying 80% to $50 in June. With the fallout from Brexit set to increase already elevated levels of volatility, how can a positive return be achieved in this environment?

There is a solution available. Alternative UCITS funds have brought investment strategies that were previously only available to high net worth and institutional investors within the reach of all European investors. With roots that can be traced back to the hedge fund sector, these strategies seek to achieve consistent, uncorrelated, absolute returns that provide downside protection during periods of market volatility. While not all manage to achieve this, the growth in Alternative UCITS has been well documented, with net inflows of 25% year on year since 2009, and sector AUM is now over $200bn*.

Until last year, much of this growth was skewed towards multi-asset products managed by household name managers such as Standard Life’s Global Absolute Return Strategies Fund and M&G’s Optimal Income Fund, which together total $42bn. The largest ten Alternative UCITS funds represent approximately 50% of assets in this sector. It is, of course, understandable that the biggest and most recognised managers will attract the greatest flows; after all you won’t get fired for investing in a product that other investors have entrusted over $20bn to. Allocation choices are easier to defend when investing with a widely recognised brand name. However, the most exciting area of growth in the Alternative UCITS universe is being largely overlooked by the wider market.

Growing numbers of established hedge fund managers are launching UCITS products. Having shunned European regulated vehicles in the past following the widespread confusion brought about by AIFMD, hedge fund managers have come to realise that UCITS restrictions, which in their earlier iterations had been more restrictive, have become more accommodating to their unconstrained strategies. Many can be effectively tailored to a UCITS format now.

Bank platforms have helped to drive this by actively seeking out hedge fund managers who can comfortably replicate their strategy in a UCITS format, while also offering a “turn-key” solution to managers, who can utilise existing legal structures and additional operational oversight. This has helped US managers launch UCITS funds by helping them to overcome the burden of establishing a physical presence in Europe if they don’t already have one.

Many of these newer entrants to the UCITS market bring a depth of experience and understanding of alternative strategies although, as with any rapidly growing market, there is the potential for opportunists to take advantage in order to make a quick buck or for mistakes to occur from eager new entrants operating without established and tested systems and processes in place.

The hedge fund industry has seen this all before; back in the early noughties net inflows into hedge funds achieved similar year-on-year growth, before operational failures and high profile blow-ups left their mark on investors and the asset management industry as a whole. This was compounded in 2008, when asset/liability mismatches exposed many hedge funds that were making investments in assets that were significantly less liquid than their own redemption terms.

A recent example of asset/liability mismatch in collective investment schemes has been the ‘gating’ of redemptions of UK commercial property funds following Brexit, giving rise to concern about daily trading funds with illiquid underlying assets. What has attracted fewer column inches is the impact that the suspension of redemptions has had on multi-asset funds. Amongst their dizzying array of underlying investments, many multi-asset funds have substantial holdings in these troubled property funds. Prudential manages a multi-asset product† which holds 13% of its NAV in the M&G Property Portfolio fund. If enough clients choose to redeem, the proportion of liquid assets will be rapidly depleted and may result in the suspension of redemptions in the fund. This demonstrates the serious concerns both informed investors and regulators have about asset/liability mismatches, particularly in times of stress. Investors should be wary of strategies that offer daily liquidity with short notice periods if the underlying assets don’t match this liquidity.

Aurum has been selecting hedge fund managers for 22 years. It takes time to research a strategy, to get to know the manager and perform investment and operational due diligence. Aurum applies the same rigorous process to fund selection for UCITS products as it does for hedge funds. Having monitored the universe of Alternative UCITS funds closely for many years, only now do we believe there is sufficient talent in the sector, with good quality, experienced hedge fund managers launching products pari passu to their offshore offering. This is an important development, as traditional hedge fund managers’ previous forays into UCITS, where watered down carve outs were offered, were somewhat underwhelming; notably underperforming their offshore counterparts. The ability to identify those managers who can produce consistent, non-correlated returns is key to fund selection.

Operational due diligence is also a significant factor in fund selection and should not be overlooked. The regulatory structure of UCITS funds can mean that they have more service providers than an offshore fund, creating more operational complexity. The platforms, custodians, depositaries and other service providers to UCITS funds are often not used to dealing with investor queries. Experienced hedge fund selectors can certainly help bridge the gap for investors with limited experience in investing in alternatives, helping them gain exposure to where the exciting growth in the market really is.

*Source: Barclays, The New Wave – October 2015]

†CF Prudential Dynamic 40-80 Portfolio