Arden: AIFMD driving investors to alternative Ucits

Managers faced with a choice of how to operate funds going forward

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Ian McDonald, chief investment officer, Arden Asset Management and director, Arden Asset Management (UK)
A host of regulatory and market factors is leading to a significant rise in demand for registered liquid alternative funds in both the US and Europe. Institutional and private investors alike are seeking alternatives to provide diversification away from equities and fixed income. However, they are also demanding greater liquidity, better transparency and lower fees than what is typically available from traditional hedge fund offerings.

At the same time, pensions are gradually shifting from defined benefit to defined contribution and self-directed plans, which are restricted to investing only in registered investment vehicles under the ’40 Act or Ucits, with limited exceptions.

Changes in regulatory regimes, most notably with the introduction of the alternative investment fund managers directive (AIFMD) in Europe, are pushing investors away from offshore funds towards onshore registered vehicles such as Ucits funds. Arden has one such Ucits fund that gives non-US investors access to hedge fund managers in a format that offers daily liquidity and is outside the scope of the recently enacted AIFMD.

Arden initially got the idea to create a registered liquid alternative mutual fund in the US following a request from a defined benefit pension fund client that had taken over responsibility for a self-directed (401k) programme. After spending considerable time educating a selection of leading hedge fund managers how to establish which strategies would fit into the more regulated and liquid structure, Arden was able to launch its first multi-manager, multi-strategy ’40 Act fund in 2012.

At the beginning of this year Arden launched a second ’40 Act fund and a similarly structured Ucits vehicle. In both cases, these vehicles incorporate event driven, global macro, equity long/short, relative value and credit strategies.

For the investor, the Ucits or ’40 Act fund structure is designed to deliver certain benefits compared with private hedge funds: there are no lock-up periods, the fees are typically lower, as are the investment minimums, and transparency is better. At Arden, we believe that the value-added proposition of such funds is even greater when they use a multi-strategy, multi-manager approach.

Having different managers appointed as sub-advisers within a single fund structure allows us to not only keep the operational expenses of the fund down, but to also dynamically adjust our strategy allocations and overall risk levels in the fund in response to the market environment. Efficient portfolio diversification has always been, and always will be, at the heart of the search for a high-quality investment alternative.

Ed Gouldstone, head of hedge fund product management, Linedata
Many hedge fund managers are now faced with a choice in how they will operate their funds going forward. You may not have to choose today but sooner or later, as a European-based operator of funds, there will be a time when you must pick between Ucits and AIFMD. Eventually they will dictate many of the key aspects of how an asset manager runs the business. This includes remuneration, risk management processes to be followed, how to interact with counterparties and what reporting must be done regularly. The Ucits way is to comply with the limits and rules on investments and offer funds to anyone on standardised terms. Or there is AIFMD: trade anything, disclose everything and offer funds to accredited investors on your own terms. For some, this choice will be easy. If your strategy cannot feasibly be traded within a Ucits structure, then AIFMD is probably the solution. But for many hedge fund strategies, Ucits will be a viable option.

Winning institutional money has long been a key goal for many hedge funds, so what will be most attractive to the big allocators? There is a potential conundrum here. Many firms that have received big-ticket investments from US institutions say that those organisations take comfort in the restricted liquidity terms that can be applied under the Cayman hedge product. They are in it for the long run and they want to know others in the fund are too.

But for many emerging managers, perhaps seeking EU institutional investors, the Ucits ‘badge’ is actually a benefit. Many who would not consider a traditional hedge fund structure will consider these Ucits funds. Some firms will need both in the long term.

One thing I think is certain though. Running an EU-based hedge fund has changed forever. Over the coming years all of us will have to get used to the new world of check, report, comply.

David Burnside, head of business development, Finisterre Capital
There has been a surge in client demand for alternative Ucits products. For all the hostility to alternative investment styles from many in continental Europe, the bottom line is there is a continuing search for yield. Many institutional investors, particularly in the insurance world, need novel ways to add return and the regulated Ucits world is one obvious route. Regulated institutions are putting a lot of money to work and, intriguingly, it is coming out of their core allocations, not their alternative bucket. That is a big shift in itself. We have clients and prospects from the UK, continental Europe and Latin America who, for internal governance or local compliance reasons, do not want to buy offshore funds and are happy to buy a Ucits fund because it is badged as regulated and so gets straight through their internal governance and compliance structures.

We launched our Ucits fund based on a request from an existing UK insurance client who, for internal compliance reasons and in preparation for the eventual implementation of Basel, was moving out of Cayman hedge funds and asked us to set up a regulated product. Since then, we have seen investments – both from other insurers and groups – looking above all for onshore products.

I do not yet have a strong sense for what the demand will be like for Qualifying Investor Alternative Investment Funds (QIAIFs) offered under AIFMD. However, I would note that trends do not have to be purely rational. There is an argument that says the Ucits brand is very well established and known to sometimes conservative supervisors and others, who do not blink when a Ucits vehicle is proposed, but they will have to get used to what a QIAIF is. It is therefore likely there will be a higher hurdle to the adoption of QIAIFs, whatever their technical merits.

Todd Gibson, Sean Donovan-Smith, Mark Perlow, partners, K&L Gates
Liquid alternative funds have been one of the fastest-growing categories of investment vehicles for the past several years, both in the US and globally. These are funds registered and regulated under the Investment Company Act of 1940 in the US (‘40 Act) or the Ucits directive as retail funds that use investment strategies generally associated with hedge funds. The proliferation of registered products has been in direct response to investor demand, more from retail than institutional investors.

Historically, because of private placement rules, access to alternative investment strategies was limited to high-net-worth individuals and sophisticated institutional investors. Retail investors often relied on the traditional cash/stock/bond mix to achieve returns and diversification, until recent market events showed that allocation of their investments among these asset classes might not always provide protection or limit downside risk.

After 2008, with bond yields and interest rates at historic lows and stock market volatility at record highs for extended periods, retail investors began looking for assets that provided returns and income that might be less correlated to the returns in the stock or bond markets. To address this need, many sponsors of separately managed account programs have allocated a portion of their model or managed portfolios to liquid alternatives.

The aftermath of the global financial crisis caused some institutional investors in Europe and the US – and, in many cases, their government overseers – to reconsider their investments in unregulated pooled vehicles. These investors were not satisfied that they could manage their investments and risks given the level of information available about the investments and risks that were being assumed by fund managers.

In addition, during the peak of the financial crisis and the related credit market illiquidity in 2008-09, some hedge fund managers suspended or imposed gates on redemptions, making it difficult to redeem investments in a timely manner. Some institutional investors began requesting products subject to a regulatory regime that would meet their revised expectations and investment parameters.

The key attractions of registered alternative funds, beyond a fund’s investment strategy and results, are transparency and liquidity. These funds are required under the ’40 Act and the Ucits directive to provide transparency through the periodic publication of portfolio holdings and the daily determination of net asset values calculated. The rules place clear limits on investments in illiquid securities, and the time frame within which an investor’s shares must be redeemed by the fund by request of the shareholder. Both laws restrict the amount of leverage a fund may take on through borrowing or derivatives and, under both regulatory regimes, funds and their managers are subject to regulatory examinations and supervision.

In both the US and the EU, the recent implementation of new regulatory regimes on hedge fund managers has lessened the differences between the regulatory barriers to entering the hedge fund and registered alternatives markets. After the Dodd-Frank Act, most hedge fund managers are now subject to a comprehensive compliance programme, a principles-based transparency and disclosure regime, and SEC examinations.

AIFMD imposes a depository supervision requirement similar to that under the Ucits directive, valuation and liquidity rules, and a transparency and regulatory reporting regime, as well as additional capital requirements and the ability for regulators to impose leverage restrictions on funds managed from an EU location. Given these extensive regulatory burdens, the additional costs of managing registered alternative funds are less than they have been; the diminishing of these regulatory differences has encouraged many hedge fund managers to explore the registered fund market.

Liquid alternatives still only account for a small percentage of the alternative strategy market and of regulated fund assets under management, but their growth rate is higher than that of either category. As alternative investments become part of the standard asset mix and many financial advisers’ asset allocation models, growth opportunities will remain significant. The market will expand further as these funds make their way into defined contribution plans. These trends all suggest that liquid alternatives are becoming a permanent feature of the investing landscape.

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