The Ucits mess

When the European Economic Community was founded after the Second World War, in 1957, hedge funds were very much in their infancy - an Australian by the name of Alfred Jones developed the first one in 1949.

Few could have foreseen back then the coming together of the two worlds again almost 50 years later, in 2005. Maybe not so much 'coming together' as a 'clash' of the two worlds.

As our feature on pages 10-12 shows, the financial manifestation of the European dream of unity - as embodied in the diabolically complex Ucits III provisions - is far from a happy one, at least for hedge funds.

The Ucits III Directive allows, at least in theory, any fund that has been authorissed in any one EU member country as compliant with the Directive to be distributed to the retail market in any other EU member state.

Traditionally, hedge funds have fallen outside the Ucits III boundaries, as they have normally exceeded the 10% limit compliant funds can invest in derivatives. Regulators have thus kept hedge funds from one jurisdiction out of their own populations' retail hands.

SOPHISTICATED PRODUCTS FOR THE LESS SOPHISTICATED?

This looks set to change. Those against retail investors holding hedge funds could point the finger at a new structuring of a hedge-fund vehicle where a fund linked to hedge funds is being found Ucits compliant, and therefore permitted to be distributed to the European retail market.

In reality, the climate around hedge funds and retail investors has been changing. Ireland and Switzerland have lowered minimum investments in funds of funds, and Germany has thrown the doors for these products open to all.

The latest innovation, however, has been a fund that invests up to 10% of its assets in hedge funds via a total return swap. It is the swap that is the 'derivative' that brings the fund in under the 10% rule, regardless of what that swap is linked to. Ucits compliance follows, and regulators are left wondering how to stop local distribution if the promoter demands it.

We said above that retail selling was possible 'in theory' because, in practice, regulators can erect other barriers to deter a promoter from distributing sophisticated products to Joe Public, such as stipulations on local operations in the market in question, translations of documents and local distribution agents.

Nevertheless, if a promoter insists on persisting - and the regulator in law must let the Ucits fund pass - one could envision the ludicrous situation where an investor with $500 invests in a Ucits-compliant product that has 90% exposure to long equities and 10% via a total return swap to a basket of CTA hedge funds, each levered many times.

This would surely be unacceptable to most, if not all, regulators, but is still possible under Ucits rules.

While promoters may put their own brakes on sophisticated products being distributed too widely - fearing potential for mis-selling claims and litigation from disgruntled investors - the regulators need either to accept that a fund of hedge funds-linked product is acceptable for retail investors within certain parameters, or do something about this scenario in which, quite clearly, the law has become an ass.

BLURRING OF WORLDS

It is not just the retail/sophisticated boundary that is blurring for hedge funds. It is also the private equity/hedge fund delineation.

But as our feature on pages 16-17 shows, hedge fund managers would do wisely to think carefully before entering private equity type deals.

How are you to pay out redeeming investors if part of your portfolio is in such an illiquid strategy? Do you have the expertise to nurture a venture capital or mezzanine deal through to maturity?

And do your investors expect such investments, or are their risk/return models of your fund based on it not getting involved in off-market deals?

If you have been previously involved in liquid instruments, how will you handle NAV valuations - an academic exercise for venture capitalists until their funds' closure after seven to 10 years, but a very real challenge at each month's end for hedge fund managers?

Private equity in the form of UK venture capital trusts attracts with the returns, which have been harder to come by for hedge funds recently as volatility has fallen and arbitrage squashed.

But the promise of jam tomorrow may not entice investors who wanted you to trade more often in defined instruments, while pure private-equity investments comprised a quite different portion of their total portfolio.