UCITS funds typically score well on risk management, leverage, compliance fronts, while they score poorly on documentation, reporting and transparency, notes SwissAnalytics.
After analyzing several dozen UCITS-compliant absolute-return funds, SwissAnalytics recently published a paper titled: “Good UCITS – Bad UCITS; What works, what doesn’t, and the dangers of investor acquiescence”.
UCITS vs non-UCITS
In its paper, SwissAnalytics compared results of UCITS-compliant absolute-return funds with more traditional hedge fund structures. The research firm’s exercise iidentifies similarities and differences between these two structures which alternative investment managers and investors are currently debating.
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The research paper notes UCITS funds are often cited as being superior to non-UCITS for a variety of reasons including enhanced transparency, enhanced liquidity of instruments, better risk management, better fund liquidity and settlement terms for investors. Moreover, the requirement that these funds appoint an Administrator, Custodian and Auditor are also cited as advantages.
SwissAnalytics’ methodology compares practices of UCITS funds with those they view in the current non-regulated, offshore market in practice. Interestingly, their comparison led to a mixed picture of the qualitative improvements to fund structures which are often cited as being “uniquely” UCITS.
Using its Silver Due Diligence framework between March and November 2010, SwissAnalytics studied 58 funds, including 20 compliant funds. The study reveals there is little distinction between the profile of identified flags at the highest level, neither with regard to the absolute number of issues identified nor to their distribution between minor (yellow) or serious (red) risk identified through their Silver Due Diligence process.
The SwissAnalytics report highlights that UCITS funds and their managers tend to more clearly delineate lines of responsibility and define procedures and position limits than do their non-compliant counterparts. Thanks to required leverage limits in the regulation, the study has identified fewer issues within the leverage and degree of freedom category among UCITS funds.
Similarly, UCITS scores well on the compliance front. The SwissAnalytics’ study didn’t identify a single issue of concern among compliant funds, while their non-UCITS peers did have a substantial average number of total flags at 0.97.
However, the SwissAnalytics’ study points out that in terms of documentation, the UCITS funds are much less forthcoming than their non-UCITS counterparts in certain areas, particularly with details relating to their outsourced functions. Moreover, the SwissAnalytics’ study also found little difference between the quality and frequency of investor reporting and the transparency + insight provided:
The report also raises concern that portfolio valuation for compliant funds tends to be conducted by related parties or the methodologies are less explicitly defined than those of non-UCITS funds. Moreover, the UCITS funds in their sample are more often dependent on related parties with regard to fund directorship, which is particularly problematic considering that these are the primary source of investor protection in terms of corporate governance.
The report points out that thanks to restrictions on the purchase of certain assets in the UCITS framework, some funds gain exposure to these assets synthetically. However, while doing so, the fund purchases a basket of eligible assets and enters into a total return swap with a counterparty for a calculated index return, which can be an index of ineligible assets. While examining a UCITS with the total return swap in place, the SwissAnalytics research team identified a troubling trend that the investor may bear the default risk on the bond portfolio:
The SwissAnalytics report concludes that one has to wait to see how many investors who have traditionally obtained their hedge fund/absolute return exposure through offshore vehicles will seek comfort in the regulated, European UCITS framework.