We have expanded our platform recently to encompass new funds belonging to a category known as alternative UCITS or liquid alternatives, which can offer access to a wider range of hedge fund-style strategies combined with the investor protection and transparency of the UCITS regime. What are their origins, benefits and limitations?

Undertakings for Collective Investment in Transferable Securities, better known as UCITS, is a regulatory framework, first established through a 1985 EU directive and subsequently updated regularly, with the aim of harmonising the European cross-border fund market while ensuring investor protection. Over more than 30 years it has become the brand of reference for funds under professional regulated management throughout Europe and beyond.

Traditional investment strategies use instruments including listed stocks, bonds and cash, while so-called alternative investments in the broad sense include private equity, hedge funds, real estate and commodities. More narrowly, the expression ‘alternative investments’ refers to hedge funds that adopt techniques different from linear market access and whose managers follow different strategies to obtain active returns.

Hedge funds have become popular with sophisticated investors because of their low correlation to traditional asset classes and their goal of achieving ‘absolute returns’ – in contrast to the relative returns sought by traditional fund managers that measure their performance against a benchmark. For prudent investors, however, some features of hedge funds, including less liquidity, less regulation and less transparency, can be problematic.

Growing demand from investors to obtain greater diversification in their portfolios led to the UCITS III directive in 2002 and the Eligible Assets Directive in 2007, both of which expanded the range of assets in which UCITS funds can invest. Derivatives became an eligible asset, enabling UCITS managers to leverage positions and obtain short exposures through derivatives.

Borrowing as such is subject to a maximum of 10% and directly shorting the markets is completely forbidden under UCITS rules, but derivatives make possible the synthetic replication of such techniques and the creation of different types of return stream. This made various hedge fund-style strategies available to UCITS managers and gave birth to a new asset class: alternative UCITS funds.

While intuition might suggest that the cost of regulation would reduce flexibility for managers of alternative funds, empirical research has shown that UCITS regulation does not hinder the risk-adjusted performance of alternative funds by comparison with traditional strategies or offshore hedge funds. Alternative UCITS thus aim to offer the best of both worlds: a hedge fund-like absolute return stream with lower correlation to equity and bond markets combined with a regulatory framework that imposes liquidity, transparency, regulatory oversight and strict risk management.

Of course, there are some differences. Not all types of hedge fund strategy are feasible in UCITS format. Underlying investments for some strategies, for example event-driven approaches focusing on distressed securities, or arbitrage strategies with asset-backed instruments, are simply not liquid enough to comply with the requirements of most alternative UCITS fund frameworks, which usually offer daily pricing and trading. Others often use instruments or assets that don’t fit the UCITS framework, such as short-only managers and commodity traders.

Despite the absence of these highly diversifying strategies, the market for alternative UCITS has been increasing rapidly, both in the number of funds and assets under management. The demand side has seen a shift in the mindset of investors in favour of alternative returns to diversify their portfolios. On the supply side, old-school hedge fund managers have been quick to package their strategies for the more transparent and regulated UCITS format in order to appeal to traditional investors and offer their funds as part of broader liquid instrument portfolios.

Going forward, we see still plenty of room for sustained growth in the alternative UCITS space. At €400 billion, alternative strategies still represent just 5% of total UCITS fund assets of currently €8 trillion.

Thank you to our friends at LuxHedge for their assistance in writing this article.

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