The alternative UCITS market

Transcription

1 The alternative UCITS market The power of perception?

2 2 towerswatson.com

3 The alternative UCITS market The power of perception? Contents Introduction 4 Key points 5 Background 6 Section 1 UCITS development 8 Section 2 UCITS strategies 12 Section 3 UCITS funds 14 Section 4 Fees 16 Conclusion 18 The alternative UCITS market 3

4 Introduction The alternative UCITS (Undertaking for Collective Investment in Transferable Securities) universe has sprung to life. What was historically an appealing investment option for individuals, has attracted significant growth in assets over the past year, including from European institutional investors. Reasons for this demand ranged from a broadly improved investment appetite to tax incentives, but were also due to investors seeking protection under regulatory authorisation. We assess the factual details of these safety perceptions and present the realities which many investors are either ignoring or unaware of, paying special attention to fees, liquidity, transparency and regulatory oversight. We also consider the growth in the number of funds and question the suitability and attractiveness of strategies within the UCITS framework, as well as whether UCITS funds are set to overtake their offshore counterparts in Europe. 4 towerswatson.com

5 Key points: By the end of 2013, the alternatives UCITS universe stood at 160 billion; over 20% growth for the year. In the past year, institutions have become the largest investors, mostly due to solvency and regulatory requirements as well as tax incentives. Private banks and retail distributors remain signifi cant allocators. A greater range of strategies is available with a deeper pool of talent, particularly from the US. Continual evolution of regulation has occured in the space, however oversight measures are light in some cases. We prefer managers to keep to their core skill set and consider if they are sacrifi cing their true edge when fi tting a product into a UCITS framework. A number of funds have already reached capacity and are closing to further subscriptions. There is a broader range of fee structures than was previously available. Performance fee structures are sub-optimal in most UCITS funds and are not being given suffi cient consideration by investors. Investor perception of liquidity could pose the greatest risk with most funds having the ability to gate. UCITS investing does not directly help in achieving Solvency II requirements. Deep manager research remains key to assessing the quality of the strategy implementation, as relying on a well-intentioned regulator s stamp of approval is not suffi cient in protecting capital. The alternative UCITS market 5

6 Background The key benefits to investing in alternative UCITS-compliant funds are broadly considered to be: Regulatory oversight Greater transparency offered than traditional hedge funds Frequent liquidity, typically daily or weekly dealing Low minimum investment thresholds Efficient tax treatment in some jurisdictions The UCITS directives aim to subject open-ended EU-domiciled funds investing in transferable securities to the same regulation in every member state, promoting consistency across the industry. This regulation has applied to long-only mutual funds since 1985 but is now also applicable to hedge funds that wish to register. UCITS regulation has progressed through a number of iterations, with rules generally updated in consultation with market participants, including the larger asset managers. The current UCITS IV directive imposes the requirement for a new Key Investor Information Document which discloses risks and investment objectives in clear language. Versions V and VI are on their way with the focus depositary liability and eligible assets. Further regulation is also imposed by the European Securities and Markets Authority (ESMA) guidelines. Also very important for hedge funds is the AIFMD (Alternative Investment Fund Managers Directive) regulation which became effective in July (Note that AIFMD is focused on investment managers while UCITS is regulation aimed at the fund level.) There are a number of significant considerations for managers, but the one of most concern to us here, compared to UCITS funds, is the marketing ability in Europe. AIFMD stipulates investment decisions need to be made within the European Economic Area. This can be challenging for non-european based investment managers who do not want to shift key personnel to the continent from major financial centres such as New York. The UCITS route allows them to launch a fund, usually domiciled in Luxembourg or Ireland, which is then able to be passported to various European jurisdictions. 6 towerswatson.com

7 The hedge fund industry has been improving in health since 2008 and, very recently, assets in European hedge funds have returned to their 2007 peak, according to Eurekahedge. However, taking a closer look within the space, the trend has been that assets in offshore funds have been stable over the past couple of years, while assets in UCITS funds have risen rapidly and become a meaningful part of the market; in fact, almost equaling assets from offshore funds. Prior to 2013, the UCITS market was dominated by discretionary high-net-worth and retail allocators, particularly in the UK and Germany, where UCITS returns were taxed more favourably than in offshore products. Now, for many funds and platforms, the list of largest investors has been completely refreshed to Continental European corporations and pension funds. Statistics The UCITS universe stood at billion at the end of 2013, having grown 25 billion over the year, or 21%, according to Kepler Partners LLP. 1 Other databases quote higher numbers up to 220 billion. Some of the increase can be attributed to performance (average around 6% to 8% return), but the majority reflects inflows in investor capital. With regard to how many alternative UCITS funds these assets are allocated to, various surveys indicate a range of 600 to 800 existing today. It should be noted that the asset base is still somewhat concentrated at the top end of the asset management spectrum by size with single funds managed by four managers currently representing 50 billion. Figure 01. Comparison of assets in UCITS and non-ucits European hedge funds since 2006 AuM (USD billions) AuM (USD billions) Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Non-UCITS Funds (LHS) UCITSIII European Hedge Funds (RHS) Source: Eurekahedge Note: Eurekahedge defines European hedge funds as managers with European head offices as well as non-european based managers with European mandates. 1 Annual Review: UCITS Review of English Pound converted to Euros. The alternative UCITS market 7

8 Section 1 UCITS development Supply, demand and the future The three waves of supply A number of UCITS vehicles were eagerly launched between 2006 and Many of these were introduced by the larger European asset managers who were seeking to access more retail-oriented European clients. A pause ensued as the credit crisis and subsequent redemptions hit the fund industry, with managers taking time to recover their losses and waiting for a more stable environment to launch funds. In 2010, the fi rst draft of the AIFM Directive was released and US managers in particular were faced with the possibility of being blocked from accessing the European capital base. Consequently, a number of larger US players entered the market by launching UCITS funds. Meanwhile in Europe, many newly-established equity managers were launching their debut funds as UCITS products. There was another quiet period in new UCITS launches until more recently in 2013 when a number of factors have again accelerated the launch of UCITS funds. New factors were: Substantial assets being raised in the UCITS universe, which proved that real demand existed and UCITS was no longer just a promised opportunity. The growth of 40 Act alternative funds has made US hedge funds much more familiar with highly liquid offerings. These vehicles have been considered as a practical alternative since UCITS funds are outside of the scope of AIFMD rules. This has meant that there have been a signifi cant number of UCITS-compliant fund launches, not just in Europe but also from US-based groups, and with a much greater breadth of managers. The UCITS universe was once criticised for being fi lled by mostly mediocre managers, but that is changing with what are regarded as higher quality managers entering the space. 8 towerswatson.com

9 Heightening investor interest The rapid rise of UCITS assets in 2013 has continued into 2014, with growth still coming from continental European private clients but increasingly from large institutional investors, particularly in the second quarter of To illustrate the scale of interest, many UCITS funds were closed to further subscriptions in 2013 and early 2014 as they had grown to full capacity, many being $1 billion to $2 billion in assets under management. Moreover, two platforms have reportedly raised over $2 billion in a matter of weeks for two funds this year, one of which was a new launch. In some cases, UCITS funds have grown larger than their related offshore funds. Some of the reasons for the heightened interest in the institutional world are tax structures and regulatory/solvency requirements, for example: In Germany new capital gains taxes implemented at the end of 2013 made UCITS investing more attractive. In Spain, aside from lower tax rates when investing in UCITS versus offshore funds, investors are encouraged to keep reinvesting within UCITS products, paying taxes only when fully redeeming. In Italy the tax rate of investing in offshore products was recently raised. Tax transparency is offered by UCITS funds in a number of jurisdictions, such as the UK and Germany. In some countries, including Italy and Spain, insurance companies and pension funds have caps on how much exposure they can have to non-harmonised alternative funds (which includes offshore, non-ucits hedge funds) and as such are effectively encouraged to invest in UCITS funds. In some countries, insurance companies have managed to circumvent their capital charge limitations by investing in more liquid instruments and vehicles, which UCITS can satisfy. Other reasons can relate to behavioural aspects. For instance, discretionary managers and high profi le investors wishing to avoid situations of locked-up assets in illiquid holdings enjoy the comfort of a regulatory stamp to protect them against scrutiny; assured that their decisions were based on the belief that the funds are subject to higher regulatory oversight. Even non-european investors, particularly in Asia, South America and Canada have been attracted to the regulated nature of UCITS funds. Other aspects include the political infl uences in Europe, as the spotlight continues to shine on hedge funds, as well as greater awareness of environmental and social governance in investing. Another signifi cant reason for increased assets is the broadly improved market sentiment and investor appetite for alternative funds in general which is not necessarily a UCITS-specifi c phenomenon. From an investment perspective, a considerable number of private banks and wealth managers have moved capital from long-only to long/short strategies, finding the current environment to be more favourable to this type of investing, looking to execute through UCITS. Similarly, there has been a move by European institutional investors to reallocate their hedge fund exposures to more liquid investments, via UCITS. The popular equity long/short strategy in 2013 was accessed by many investors (who could also invest offshore) through UCITS structures indeed, assets have doubled in equity long/short over the past year. An observation by managers has been the (positive behaviour of) relatively subdued fl ows from individual investors that is, they are not subscribing in, and redeeming out of, funds on a daily/weekly basis, but holding onto investments for a longer duration. It should be highlighted that whilst some demand for UCITS funds has been regulatory driven, the opposite has also been true where greater solvency requirements have led to redemptions. In the dominant high-net-worth market, platforms in some countries, such as Germany and Italy, demand daily liquidity and as such UCITS have become popular investment vehicles. The alternative UCITS market 9

10 Will all managers launch UCITS funds? What about AIFMD compliant and US 40 Act funds? UCITS is not a trend that all hedge fund managers will follow. First the strategy must fi t within the required framework. Second it depends on how much the manager wants to attract European investors. Offshore fund providers argue that many of the advantages of UCITS funds are also now the norm in offshore funds. For instance, the appointment of independent service providers, as well as improved transparency and corporate governance, are at the forefront of operations. Regulators in jurisdictions such as the Cayman Islands have also tightened their grip, requiring more detailed and timely reporting. Therefore, there is the argument that operational and investment risks have somewhat reduced (or at least been addressed) in offshore vehicles. Funds with AIFMD status could appear to be a competitor to UCITS for being a route to market in Europe, although the overlap would only be if a fund strategy is eligible for UCITS. Two aspects a manager must consider when deciding which route to opt for are: The easier (for now) registration of UCITS and lighter demands on the investment manager from a business operations perspective. The unconstrained investment mandate allowance of AIFMD, since there are no leverage, concentration and instrument type restrictions with AIFMD. In the US, a parallel trend taking place is the notable growth of 40 Act alternative funds in the past year from both an asset and number of offerings perspective, albeit from a lower base. These are alternative funds which can be packaged within the format of a mutual fund, largely targeted at the US retail market. The products do not generally refl ect the more sophisticated hedge funds from which they are derived, unlike alternative UCITS funds. This is because of the high liquidity requirement (daily redemptions), but also because of the lack of a performance fee in most cases, which means that managers are less inclined to offer the same level of return target (or performance engine). The UCITS and 40 Act phenomena have recently merged in the form of a new opportunity for platforms and asset managers to offer a new breed of multi-manager products. These are UCITS-compliant funds which allocate sleeves to external investment managers, who sub-advise on managed accounts. Given the multi-managed account structure the flexibility of these products is low relative to for example, fund-of-funds, since it takes time to set up managed accounts and in most cases commitments are made to the managers for minimum asset levels. Nonetheless, the low cost, liquidity and risk aggregation ability (given the transparency into the managed accounts) will no doubt be appealing to some investors and we expect there to be product proliferation in this space. Many of the rules with regards to service providers and fi duciary duties will be similar for AIFMD and the new UCITS rules. 10 towerswatson.com

11 UCITS is not a trend that all hedge fund managers will follow. First the strategy must fit within the required framework. Second it depends on how much the manager wants to attract European investors. The alternative UCITS market 11

12 Section 2 UCITS strategies and the importance of manager research Over the past six years, the market has become more educated; managers are more practiced in managing a portfolio within the UCITS framework and investors have become more comfortable with the strategies and returns relative to offshore vehicles. A corollary to a growing number of funds has been a greater number of strategies being represented. UCITS platforms have commented on their strong pipeline of high quality managers with funds due to be launched in 2014, across a range of strategies. Nonetheless, one must be wary of the proliferation of new launches which may test the robustness of the UCITS framework. We have been mindful of the following when comparing UCITS funds to unconstrained, offshore vehicles: We have a preference for managers to stick to their core skill set. Has the edge of the manager been lost in excluding elements to meet the UCITS rules? This is most pertinent to macro, managed futures and credit managers, amongst others. If there is a tracking error in the performance of the two vehicles, can the manager truly blame the framework restrictions, or is there an allocation policy issue? Does the mind-set of the manager used to more unconstrained investing, mean that the offshore vehicles are preferred over UCITS? This tends to be an issue with multi-strategy and event-driven funds. How liquid is the segment of the universe traded during crises and how abnormal is the behaviour of asset classes and sectors within this space? For instance, in 2008, contrary to expectation, short-dated Investment Grade Developed Market bonds were the least liquid across the developed market spectrum as they were the most levered and were heavily sold. How much leverage is embedded in the derivatives used to execute the short exposure (for example, in CFDs and swaps)? Are tight risk management controls in place to avoid UCITS rules breaches and rapid de-risking? We are also increasingly seeing unconstrained portfolios being offered in a UCITS format via portfolio-level swaps. We are cautious of the extent to which some of these are adhering to the spirit of UCITS regulation, where the implied intent is to sidestep the rules. We believe that deep manager research remains imperative to assessing the quality of the strategy implementation, beyond the simple reliance on the regulatory stamp. High-level UCITS investment rules Below are a few of the investment restrictions enforced on UCITS funds, that do not apply to offshore funds. Can invest in defined eligible assets. In the case of long/short strategies, the strategy manager would purchase market listed investments for the long portion of the portfolio but physical shorting must be avoided, so shorts can be achieved through buying CFDs, swaps or options. Concentration limits. Leverage limits. Value at Risk (VaR) limits. There are further rules on the allowed net exposure and counterparty risk exposure. Investment in non-eligible assets (for example, commodities, property, private equity) is generally not permitted but exposure can be gained through derivatives and there are rules around the implementation through swaps and the valuation policies. Note that funds can opt for different sets of risk-reporting rules depending on their risk profi le (sophistication of instruments employed). 12 towerswatson.com

13 Table 01. Our views on the individual strategies Strategy Equity long/short Event driven Credit Macro Managed futures (CTA) Multi-strategy Smart beta Multi-asset Risk parity UCITS suitability Most natural fi t for the liquidity and instrument-type restrictions of the framework, as long as the portfolios meet the UCITS-imposed concentration levels. Dominates the space: 30% to 40% of the UCITS universe by number of funds. Broad selection in European space and increasingly in US. Track records show that there is very little tracking error between unconstrained, offshore equity funds and their mirrored UCITS versions. Usually liquid portfolio, but concentration levels can be limiting. Tend to be equity-heavy portfolios. Investment terms should match the investment horizon as much as possible. Unsuitable for activist-type strategies, which would suffer from a potentially unstable capital base. Simple liquid corporate credit is suitable; both Developed Market Investment Grade and High Yield. Many non-vanilla instruments are either too complex or too illiquid for UCITS rules. UCITS VaR limits are not restrictive (highly unlikely for the portfolios to reach the levels stipulated). Structured credit unsuitable. Distressed largely not suitable (on liquidity grounds). One danger of credit is the non-linear nature of liquidity in the markets; the liquidity is based on demand and not on the size or term of the bond. Choices are limited in the space. Most liquid instruments with low leverage can fi t the framework. Interest rates and FX most likely candidates. Concentration levels can be a limitation. Complex derivatives are unsuitable. Cannot trade commodity futures. May miss the trade structuring skill of managers as a result. Poor recent performance of traditional macro funds has dampened demand. CTA strategies have been limited due to the inability to trade commodities futures. Funds and platforms have devised various ways to replicate CTAs into UCITS models but few have been successful. Increasing UCITS regulatory scrutiny so likely to turn to AIFMD registration. Liquidity, concentration and instrument constraints. Tend to be mostly equity portfolios with ability to invest in other instruments in a limited manner. UCITS versions of unconstrained multi-strategy funds have usually removed some of the less-liquid credit exposure and reduced position sizes of concentrated holdings. Diffi culty to ascertain the effectiveness of the allocation policy with regards to managing an unrestricted offshore product alongside a UCITS product. Also diffi cult to assess the fl exibility afforded by the differences in the portfolio in treating the products with a different mindset (performance drags can always be blamed on framework restrictions). Very liquid portfolios with mostly daily-dealing funds. Combining strategies which are not widely available from traditional UCITS products such as reinsurance, momentum, and currency carry. Liquid portfolios. Illiquid (unlisted) asset classes unsuitable. Limitations on investing in other funds. Liquid portfolios, mostly passive, futures strategies. Leverage and commodity futures restrictions apply. The alternative UCITS market 13

14 Section 3 Common perceptions of UCITS funds Lower quality product Some strategies do not, and should not, fi t the UCITS model and those that are being forced into such structures result in sub-optimal outcomes. The recent growth in managers electing to offer UCITS products has broadened investor choice, potentially increasing the quality of some available options. The view that some UCITS products are lower quality may be drawn from their inferior returns, which may be as a result of higher costs and fees. We seek to understand from where the manager s true skill is drawn, and if it is able to be translated into UCITS. Highly regulated UCITS regulations continue to be updated as lessons in implementation are learned along the way. Regulators assess funds in detail before allowing them to obtain their UCITS licenses. Detailed explanations and justifi cations of fund investment policies are demanded and the registration process can be drawn out (usually taking much longer than for most offshore jurisdictions). Once set up and in motion, UCITS funds report their positions to the relevant regulators semi-annually, via their auditors. Leverage is also reported. The regulator has the power to fi ne and charge the investment managers if any signifi cant deviations or breaches occur. We recognise that there are some shortfalls with the regulatory framework. The portfolios presented are snapshots on a lagged basis and are therefore less relevant and perhaps misrepresentative of the typical profile. They also show actual holdings and not economic exposures, so some factors can be hidden, for instance by the use of swaps. In terms of adhering to rules on an ongoing basis, these can be breached passively or actively. For example, a passive breach may occur if a stock price rises rapidly, meaning that a fund exceeds the concentration limit. In this case, the regulator is satisfi ed by timely reporting of the issue and rectifi cation within a matter of days. An active breach is more serious and must be rectifi ed by the fund immediately, refunding the investors of any expense incurred and informing the regulator through the auditor. Whilst there is a possibility that a manager could hide this, the independent administrator and/or custodian would be able to fl ag the issue to the regulator under their responsibilities within the relevant jurisdictions. The recent growth in managers electing to offer UCITS products has broadened investor choice, prospectively also potentially increasing the quality of some available options. 14 towerswatson.com

15 Highly liquid Liquidity is possibly the greatest danger of UCITS funds. The actual liquidity of the funds may be tested in an extreme market shock. Daily and weekly dealing funds will be a challenge for investors placing redemptions at arguably the worst time to be liquidating a portfolio. This measure is not required to be regularly reported but could potentially be a problem in the future. A strategy particularly prone to a liquidity drift is in credit, where managers could creep into instruments that become less liquid. This would not be picked up until the audit and requires close monitoring. A feature that many investors do not concentrate on is the ability for UCITS funds to gate and suspend redemptions, a concept prevalent in offshore hedge funds but in this case being taken from the long-only UCITS practices. Gates usually range from 5% to 30% at the fund level (as opposed to investor level). However, depending on the jurisdiction, there are generally limits on how long the fund can suspend redemptions usually two or three dealing dates. UCITS rules do require that portfolios are managed to meet reasonable redemptions. Whilst this is a rule, the interpretation of reasonable can be relatively wide. Side-pocketing is also not explicitly ruled out in UCITS directives. High transparency The Key Investor Information Document required of funds certainly aids in highlighting risks which may be borne by an investor in a more simplifi ed format. Given the liquid nature of UCITS portfolios, managers are broadly willing to provide transparency on their entire portfolios, but not necessarily any more so than offshore managers, particularly given pronounced investor demands post Where a manager runs a UCITS fund alongside a similar offshore product, they would be mindful of treating investors fairly, so again, transparency is not necessarily enhanced in the UCITS format. Clearly, less liquid strategies or those where there is limited transparency during certain periods (such as when building large positions in activism) would not be eligible for UCITS due to the instruments and concentration levels employed. From that standpoint, the UCITS rules fi lter out the less transparent strategies, but do not necessarily offer better transparency in the universe which remains. A feature that many investors do not concentrate on is the ability for UCITS funds to gate and suspend redemptions... Can UCITS funds help to address Solvency II requirements? UCITS funds can address Solvency I requirements, however Solvency II can be more diffi cult as the regulation requires transparency through to the underlying positions (some managers will provide snap shots of portfolios with a lag, whilst others provide no transparency) and loss limitation. For clients seeking full transparency, the most effective means of investing in hedge funds remains through managed accounts, however this is not a path generally open for small allocations. Another route for adherence is through the application of swaps, notes or other derivatives around the fund products which currently meet regulatory approval, although the experience of those instruments in 2008 remains a signifi cant hurdle for some investors. The alternative UCITS market 15

16 Section 4 Fees UCITS institutional share classes tend to charge management fees comprised of a 1% to 2% base fee and a 0% to 20% participation rate, with the terms evenly distributed across these ranges. There are a number of additional cost considerations when comparing UCITS funds to relevant offshore hedge funds. The most significant additional expenses in UCITS funds relate to administrative and statutory services: Fund accounting, custody and transfer agency costs can be comparable to offshore funds, particularly at larger asset levels, but at lower levels can generally be bps higher per annum due to the greater frequency of operations such as portfolio valuations, cash transfers and so on. Statutory/cross-border costs can be significant legal and tax burdens (which are not incurred by offshore hedge funds since they are sold on private placements). These can amount to an extra bps. Where relevant, local jurisdiction transaction tax, for example in Luxembourg. The above three are included within a total expense ratio calculation, which also takes account of base fees. Platforms and providers have different revenue streams, but usually their distribution fees are taken out of the management fee, and whilst not disclosed to investors, can be bps. Platforms may also charge for other structuring offerings, such as additional portfolio swaps. Beyond the above factors, managers and investors have had to consider whether greater liquidity and greater regulatory oversight would warrant higher fees for UCITS investors. There has been a significant shift in the viewpoints, from certainly higher fees a few years ago to a much wider perspective today. Some of the arguments, relative to offshore structures, are presented below: UCITS funds should charge more In order not to penalise offshore investors who are tied in for longer/to avoid cannibalising offshore funds. There has been evidence of disgruntled investors redeeming from offshore products where UCITS funds have even the same fees, but this is not as common as might be expected. 16 towerswatson.com

17 UCITS funds should charge the same One UCITS platform recently publicly announced they do not believe investors should pay more for liquidity, if the portfolio can adhere to the daily or weekly dealing, and if the vehicles with different liquidity are separated. Managers prefer to have a UCITS product in order to protect themselves against losing European investors, rather than to worry about cannibalisation. UCITS funds should charge less In the case where the strategy has been watered down, for instance with a lower leverage or narrower remit. This strategy-adaptation has been used either where the full portfolio is not UCITS compliant or to justify a need for different fees. So, while in the past UCITS funds tended to be more expensive, warding off many fee-sensitive institutional investors, offerings are changing as managers recognise the need to attract the larger European-based investors. Examples of options tendered beyond institutional share classes include: Lower fee early-bird share classes for a limited capacity in new launches. Step-down management fees as assets rise. Rebates through sideletters (these are permitted in UCITS, contrary to popular belief). Application of hurdle rates at some point, the UCITS fund can become cheaper than the offshore. Our view on fees remains guided by the impact on alpha share: net of fees, we believe investors should be left with the bulk of alpha generated. While in the past UCITS funds tended to be more expensive, warding off many fee-sensitive institutional investors, offerings are changing as managers recognise the need to attract the larger European-based investors. Focus on performance fees For completeness, we should also discuss one of the limitations of UCITS investing: the majority of UCITS funds accrue a performance fee at the share class level, rather than at the investor level. This means that an investor below its high water mark may continue to pay performance fees, even though losses are being recovered. Various methodologies are prevalent in calculating the performance fee, some being performance across the average number of shares in issue, average performance across the full number of shares or daily accrual including asset debits and credit. Other methods also exist but none of the smoothing methods are perfect and NAVs are in some way or another impacted by asset inflows and outflows. In some cases, these can work in favour of the manager and other times the investor (for instance where investors can avoid paying any performance fees by trading in and out of a fund as it attains its blended high watermark). Hedge fund-like series accounting or equalisation principles are also not applied to UCITS funds, largely due to the previously retail nature. Nonetheless, this has not been an area which investors have spent much time considering. Some funds and platforms have been looking to improve the issue more recently. For example, some are crystallising fees earlier than annually to prevent any free rides. However, quarterly and annual performance fees pose their own conflicts of alignment. A few managers have also been offering institutional investors zero-fee share classes with regular invoicing, which can be tailored. Understanding the impact of performance fees on UCITS funds is important and while solutions for fair calculations can be administratively burdensome where the number of investors are high and flows are very frequent, some attention should be drawn to this area. Further fee considerations Some managers have applied swing pricing or anti-dilution levies to protect investors in the funds when there are notable subscriptions and redemptions, which add trading costs. It is important to consider how the managers are adjusting for these measures as there is usually very little transparency around the methods employed, which can be quite punitive. The alternative UCITS market 17

18 Conclusion In many ways, UCITS directives have promoted processes and principles that have considerably improved practices in the hedge fund industry, iteratively improving the governance to address real investor issues. As such, the UCITS market has sprung to life and is likely to grow further, with the impression of safety being increasingly alluring, for both certain regulators and institutional investors. In a world of heightening demand for protection, this framework seemingly fi ts all requirements. Nonetheless, the practicalities of adhering has meant that divisions have occurred between actual UCITS fund propositions and what investors believe they are getting. As such, caution and pragmatism must be applied in transparency, liquidity and fee expectations. Regulators should also be aware of the realities of both framework limitations and of strong incentives to drive capital into a limited capacity space. We would emphasise the importance of deep manager research before selecting UCITS funds for investment as we believe that reliance on a well-intentioned regulatory stamp alone is insuffi cient to protect capital. 18 towerswatson.com

19 Further information For further information, please contact your Towers Watson Consultant, or: Sara Rejal The alternative UCITS market 19

20 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Towers Watson 71 High Holborn London WC1V 6TP This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. To unsubscribe, eu.unsubscribe@towerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2014 Towers Watson. All rights reserved. TW-EU September towerswatson.com /towerswatson