This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Michael Sanders, Chairman of the Board, Alceda Fund Management and Matthew Barrett of Kepler Partners discuss the merits of alternative UCITS versus offshore hedge funds
Traditionally, hedge fund strategies have been domiciled in offshore locations such as the Cayman Islands which offer light-touch regulation and place few restrictions on the investment manager. On the one hand this gives managers the flexibility to generate returns from a wide range of opportunities and asset classes. However, the flipside of the offshore structure is a potentially opaque and illiquid vehicle, as many investors found out to their cost in 2008.
The events of 2008 acted as a catalyst for the development of hedge funds run within UCITS structures and adhering to a much more robust regulatory framework. The Undertaking for Collective Investment in Transferable Securities (UCITS) directives are a set of European Union regulations that harmonise the rules surrounding the management of open ended investment vehicles with the aim of providing better investor protection. At face value the benefits of owning hedge funds in UCITS format are manifold – they are transparent, must offer bi-weekly liquidity or better, and have strict rules about the assets which they can contain. However critics of the structure argue that placing restrictions on managers ultimately leads to weaker performance and introduces unforeseen consequences.
What is Equity Long Short?
Equity long short was one the first hedge fund strategies to gain traction in the UCITS structure, with this cohort of managers accounting for 35% of the funds in the Absolute Hedge alternative UCITS database. Fig. 1 below shows that offshore equity long short funds have outperformed their UCITS peers since 2009, however when considered on a risk adjusted basis the two groups are on an even keel with both indices having a Sharpe ratio of 0.5. In our opinion the main reason behind this volatility differential are concentration rules in UCITS that limit a fund’s exposure. Leverage also plays a significant part and we have identified numerous examples where offshore funds and UCITS have the same positions however the offshore fund is more highly levered. This naturally leads to UCITS funds being somewhat more defensive resulting in outperformance in negative periods for equity markets and underperformance in rising.
What is Market Neutral?
The second strategy we compare is equity market neutral. In this strategy we would to see low performance differential between UCITS and offshore funds – by its nature the strategy is highly diversified and easy to implement in a UCITS format.
As with equity long short strategies, the performance of UCITS and offshore market neutral funds closely mirror each other however there was a notable period of UCITS outperformance in 2011. This market backdrop was particularly difficult for stock pickers with macro events driving – one of the most challenging environments for market neutral managers. Over the period UCITS funds are ahead offshore both in terms of absolute returns and on a risk adjusted basis with a Sharpe ratio of 0.7 vs. 0.5 for offshore funds. Again leverage was a driving factor with the lower gross exposure in UCITS funds clearly an advantage in difficult markets.
From an investor’s perspective, UCTIS funds offer a wide range of structural advantages relative to offshore funds, chief of which is the strict regulatory environment in which they must be managed. When examining whether they have underperformed offshore hedge funds the picture is mixed with UCITS fund underperforming in equity long short and outperforming in market neutral. The analysis by Keplar identifies leverage as the dominant differentiating factor between the two structures, which generally leads to UCITS to be a lower volatility subset of offshore funds. Importantly UCITS investors are not disadvantaged in terms of risk adjusted returns which should support the continued growth of the alternative UCITS market.
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