As a new report by Eurekahedge reveals further contraction in the European hedge fund industry, MATTHEW FEARGRIEVE explains the failure of Alternative UCITS as a vehicle for truly “alternative” strategies, and why managers in Europe are increasingly looking to the Cayman Islands as a hedge fund domicile.

The financial crisis of 2008 left in its wake a chastened world in which transparency and liquidity were held aloft as sacrosanct. Hedge funds came in for much of the blame, despite being exonerated of any systemic role in the global financial meltdown (remember the German government describing hedge funds as “locusts”?) and the offshore financial centres, which in 2008 were home to the majority of hedge funds, were subjected to sustained attacks by governments, in particular the Cayman Islands which were (and still are) the largest offshore hedge fund domicile.

Alternatives managers in Europe faced a perfect storm over 2008 and 2009: a tsunami of new EU laws and regulations, all designed to curb their supposed excesses and risk-taking, together with unprecedented outflows by spooked and dissatisfied investors. These managers needed a product capable both of housing their alternative strategies, by providing them with the tools they needed (leverage, derivatives, shorting), and of being eligible for promotion and distribution in the EU.

Enter UCITS. The EU regime of “Undertakings for Collective Investment in Transferable Securities” had been around for years as a regulated, long-only retail investment product. In the aftermath of 2008, though, alternatives managers, helped by European financial regulators and a political drive in Europe to grab a bigger market share of global financial services, came together to transform UCITS from retail product into a model for alternative investments. This revamped UCITS regime was at the time colloquially referred to as “Newcits”, and is today more commonly known as “Alternative UCITS”. It was UCITS on steroids. UCITS had been transformed from a boring retail brand to the vehicle of choice for managers pursuing the most “alternative” of investment strategies.

The charm of Alternative UCITS

From a manager’s viewpoint, the main attraction of UCITS could be summarised in a single word: distribution. Being an EU regulated investment product, UCITS could be sold throughout the EU to both institutional and retail investors. More importantly, the UCITS regulatory regime facilitated capital raising by hedge fund managers in the EU, by opening up a previously verboten client base: retail investors.

From an investor’s viewpoint, the attraction of Alternative UCITS was found in the built-in protections normally associated with mutual funds. Correspondingly, the manager of the UCITS had to observe strict rules about liquidity and portfolio diversification. Direct borrowing was not permitted, only synthetic leverage achieved with derivatives. Similarly, physical short selling was not permitted (and naked shorting was totally out of the question); instead, the manager had to use derivatives to replicate short exposure. But these burdens were accepted by alternatives managers as a trade-off for being able to access a wider, retail, customer base in Europe.

The limitations of Alternative UCITS

Leverage, shorting, derivatives; these are some of the key tools at the disposal of a hedge fund manager in the pursuit of uncorrelated returns. Restrictions and prohibitions on these techniques brought managers to rub up against a serious downside of UCITS: lower investment returns.

Achieving returns not correlated to any index is naturally harder in a regime intended for long-only, retail products. The impact on performance, compared to a similar non-UCITS hedge fund product, can be as much as 50 basis points per month. This this in turn impacted the manager’s fees.

The problem of lower returns and lower fees was compounded for investors and managers alike by the higher organizational costs entailed by UCITS. A UCITS with a vanilla equity long/short strategy was costing up to EUR150k to set up, back in 2008–2010. A complex strategy, with the additional regulatory burden involved, could easily boost costs to EUR200k. The same strategy could be launched using the traditional offshore model (in the Cayman Islands, for example) at significantly lower cost.

Time-to-market quickly became an issue for managers keen to exploit market opportunity, with a UCITS fund conservatively taking 2 to 6 months to launch, with a raft of legal and regulatory hoops to be jumped through. Offshore, that lead time could be reduced to practically zero.

Strategy restrictions

Hedge fund managers flooded into Alternatives UCITS over 2018–2010. The paradox is that the UCITS regime was an untested model for hedge or “alternative” investment strategies.

Whilst core alternative strategies like equity long/short, market neutral and absolute return were being replicated (at higher cost) in the UCITS framework, the prohibitions on shorting and restrictions on leverage, derivatives and other tools, combined with the liquidity requirement, meant that some core alternative strategies- those focused on commodities, managed futures, distressed and fixed income arbitrage, for example- were difficult to replicate. This stemmed partly from the prohibition on investing in commodities or commodity derivatives, which were not sufficiently liquid to satisfy the UCITS requirements or which contravened the exclusion of physical assets.

These restrictions forced managers to create or invest in indices which were regarded as the asset per se, and which referenced the underlying physical assets or financial instruments, including traditional offshore hedge funds and other types of “risky” products. In this way, the UCITS product became a “wrapper” for multiple underlying assets with wildly different risk profiles.

Pushing the UCITS envelope

This was all a far cry from the retail, long-only product that UCITS was originally intended to be. Managers and regulators alike were pushing the UCITS envelope. The UCITS regulations went through several iterations over 2008–2016 to keep pace with this evolution. But the bottom line was that alternative, risky and potentially illiquid strategies were being shoehorned into the UCITS model, and with the blessing of financial regulators in the United Kingdom, Ireland and Luxembourg.

These regulators blinded themselves to a fundamental truth: that the UCITS liquidity requirements, designed to protect retail investors in the event that some market risk materialised to render an investment illiquid or difficult to value, would be powerless to protect those investors if the fund’s portfolio investments were in fact illiquid.

UCITS failures

A high profile and recent UCITS failure is the Woodford Equity Income Fund (“WEIF”), managed by UK active manager Neil Woodford. Although not a hedge fund, WEIF was a UCITS fund that went from GBP10 billion to zero, because of liquidity breaches by its manager. A run of redemptions by institutional investors exposed the illiquidity of the portfolio, which led to a fire sale of liquid positions and, ultimately, to the suspension of redemptions and the appointment of a liquidator.

We describe the failure of WEIF and its implications for the asset management industry here:

Eurekahedge Report

Eurekahedge has published (April 2020) a report on the current condition of the European hedge fund industry with regard to Alternative UCITS:

This infographic shows two things very clearly:

(1) the majority of Alternative UCITS are domiciled in Luxembourg, with the remainder mostly in Ireland; and

(2) the number of UCITS closures has been consistently greater than the number of launches every year since 2016.

The negative ratio of launches- to- closures is reflective of the continuing contraction of the hedge fund industry in Europe (as elsewhere), a result of higher operating costs and reduced performance during a long-running US bull market. Managers of Alternative UCITS have learned the hard way that uncorrelated returns are harder to achieve, even in down markets, because of the restrictions that the UCITS model places on techniques like shorting and use of leverage and derivatives; in fact, the best performing Alternative UCITS since 2015 have been those that referenced an underlying offshore fund (unencumbered by such restrictions) via a total return swap.

The traditional hedge fund fee model of “2 and 20” has been dwindling for some years, and again fees for managers of Alternative UCITS are harder to come by, partly because of underperformance and partly because of the significant drag on the manager’s bottom line that UCITS operating costs impose. We discuss the evolution of the hedge fund fee model here:

These dynamics can only have one net effect, and that is to drive managers of Alternative UCITS to close them down. The trends demonstrated in Eurekahedge’s infographic demonstrates this.

Cayman Comeback

There is another trend evident in this infographic from Eurekahedge:

This shows that, as at Q2 2020, around a quarter of hedge funds managed out of Europe are domiciled in the Cayman Islands, with another quarter domiciled in Luxembourg. Between 2008 and 2016 alternatives managers in Europe, desperate to curry favour with European regulators and to access capital in Europe, redomiciled their Cayman hedge funds into the EU or else shuttered them and set up replacement UCITS in the UK, Luxembourg and Ireland. Cayman as a domicile for alternatives managers based in Europe barely featured until the later stages of the ten years to 2020, by which time the relentless underperformance of the hedge fund industry in Europe (and elsewhere) was painfully evident.

With their regulatory restrictions on alpha generation, and their higher TER, Alternatives UCITS have been increasingly out of favour with managers, and the Cayman Islands, the traditional default domicile for hedge funds, has made a big comeback in the last three years. Indeed, the divergence between managers of vanilla equity long/short strategies (who have thusfar persisted, by and large, with UCITS) and managers of more truly “alternative” strategies (who have been making increasing use of offshore funds) began around 2016 and is set to continue.

We can expect the 25% share of hedge fund domiciliations currently held by Cayman to increase over the next five years as the alternatives industry continues to contract in Europe, as the EU and the Eurozone come under increasing fragmentary pressure (with attendant slackening of EU distribution rules) and as managers abandon Alternative UCITS in favour of the freedoms available offshore.

BY MATTHEW FEARGRIEVE