Alternative investment opportunities are opening up in Europe, with UCITS absolute returns particularly standing out

Robert Street, CFA and Managing Director of Byron Capital Partners

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European investor demand for accessing alternative investment exposure through liquid, regulated onshore vehicles, continues to grow. With equity markets at record highs and fixed income yields near or even at record lows in the case of Europe, investors are looking to gain access to alternative sources of return. It is against this backdrop that undertaking for the collective investment in transferable securities (UCITS) absolute return continues to gain traction among both institutional and retail investors.

In June this year, assets in absolute return UCITS funds increased to around €184bn (see Fig. 1), up from approximately €159bn at the end of 2013. This was underpinned by the general popularity of the UCITS brand, which now represents one of the fastest-growing segments of the fund management industry.

Particularly in Europe, regulation relating to alternative investments continues to become more onerous and often limits the investment universe and eligible assets available to investors. For example, AIFMD and Solvency II regulations in Europe are pushing more institutional investors to allocate to alternative investments in regulated onshore fund structures, in a bid to minimise capital charges. Furthermore, wealth managers continue to allocate client capital to UCITS absolute return, as clients, still affected by 2008, want exposure to liquid, regulated investment products.

Given the well-documented problems experienced by hedge fund investors in 2008, the popularity of absolute return UCITS funds has increased. For hedge fund investors, UCITS-compliant vehicles address some of the more prominent concerns of investors including, but not limited to, liquidity, custody of assets, regulation, transparency and risk management.

Liquidity is particularly valued by investors following the financial crisis. Most offshore hedge funds offer monthly or quarterly redemption frequencies, but, under UCITS legislation, UCITS funds are compelled to offer redemptions at least with a bi-monthly frequency with most UCITS funds offering daily or weekly liquidity. Given the high-profile scandals relating to fraud that affected certain offshore hedge funds during the financial crisis, the drive to regulate hedge funds has increased, with UCITS addressing this particular concern.

A UCITS fund, including all documentation relating to the fund, needs to be approved by the local regulator at launch, for example, by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg or the Central Bank of Ireland in, you guessed it, Ireland. Regulatory monitoring post-fund inception is particularly focused on the use of financial derivative instruments (FDI) by the UCITS fund as well as general risk management processes employed.

Independent service providers (trustee, custodian, administrator and auditors) are another pre-requisite for UCITS funds and have to be selected by the fund and approved by the local regulator.

Portfolio concentration limits that form part of UCITS limit the ability of the investment manager to take large idiosyncratic exposures and reflect one of the principle concepts of UCITS, namely diversification. Adherence to these portfolio concentration limits, such as the well known 5/10/40 rule are monitored by the trustee and have to be respected by the investment manager. Exposure limitations are also in place, for example, no more than 20 percent of net assets can be invested in cash deposits with any one-credit institution and the maximum exposure to a single OTC derivative counterparty is five percent (increasing to 10 percent for certain credit institutions).

Leverage is also limited to 10 percent of net assets and can only be used for short-term liquidity purposes. Transparency, another deficiency unveiled by the financial crisis, is also facilitated through UCITS by means of the Key Investor Information Document (KIID) that discloses risks and investment objectives of the UCITS fund to the investor. This is important, as although UCITS provides increased investor protection, the regulations do not aim to ensure that all UCITS-compliant products have the same risk/return objectives. Not all UCITS funds are made equal.

The UCITS framework also defines eligible and non-eligible assets. For example, real estate and private equity investments are not eligible assets. The Eligible Assets Directive also prohibits the holding of physical commodities. Critics argue that these limitations are a negative for UCITS, as not all absolute return strategies are replicable within the UCITS framework. Certainly less liquid strategies, such as distressed investing are less suited to UCITS, but even in the case of commodity strategies, although the holding of physical commodities is not feasible, alternative UCITS funds can gain commodities exposure through indexation strategies, which are highly liquid and meet other UCITS rules relating to diversification.

Further criticisms have also focused on the limitations of short selling, which is a fundamental element of hedge fund investing and traditionally a source of a large amount of returns and alpha generation for hedge funds, as well as serving simple hedging purposes. While the UCITS directive prohibits even covered shorting where stock is legitimately borrowed before selling in addition to naked short selling, synthetic shorting can be executed through the use of cash-settled derivative instruments that are entirely permissible under the UCITS directive. The shorting element of a traditional offshore equity long/short fund, using securities lending can be easily replicated by instruments such as correct for difference (CFDs) or equity swaps within the UCITS structure.

Alternative investments are increasingly on the radar of both institutional and retail investors as traditional classes such as equities and bonds are generally regarded as expensive, certainly from a cyclical perspective and even from a historical view. For example, a survey by BlackRock in December 2013 of 87 of the worlds largest institutional investors, representing over $6trn of investable assets, found that 28 percent of respondents said they intended to increase allocations to hedge funds in 2014. Yields on 10-year German bonds dipped below one percent in August 2014 and with German inflation running at 0.8 percent year-on-year for the month of July, this barley results in a positive real return even with an investment maturity of 10 years (the German two-year note yield actually went negative in August 2014).

This dearth of yield is forcing traditionally conservative investors to look at unconstrained strategies and diversification to their long-only allocations in an overall portfolio context. It is against this backdrop thatByron Capital Partnersbelieves that absolute return fixed income and relative credit strategies, structured within a UCITS wrapper, can offer superior risk-adjusted returns.

Byron Capital Partners launched the UCITS-compliant Byron Fixed Income Alpha Fund in November 2010, to respond to traditional fixed income investors requirements to look for uncorrelated sources of return to global bond indices. This year the Byron Fixed Income Alpha Fund went up approximately 3.43 percent for the year through mid-August. In contract the Byron Fixed Income Alpha Fund returned 3.47 percent in 2013. The ability to achieve alpha on the short side particularly manifested itself last year with gains being made in short US Treasuries for example, that sold off as of May 2013 following former Federal Reserve Chairman Ben Bernankes taper talk.

Furthermore, against the broader hedge fund universe, the fund has performed well with the HFRX Global Hedge Fund Index up only 0.9 percent for the year to date through August 15 2014. Since fund inception, credit risk has been tightly managed with the fund running an average credit rating of BBB, and duration has averaged approximately two and is currently 1.8.

While the fund has the ability to take sub-investment grade exposure, as per the prospectus, exposure is limited to 40 percent. These limitations serve the fund well as reflected by the recent sell off in high yield bonds with the Lipper High Yield Bond Index declining (1.29 percent) over the month of July 2014. In contract the Byron Fixed Income Alpha Fund returned 0.22 percent over the same month. Byron Capital Partners sees one of the larger risks in credit markets currently being secondary market liquidity.

The credit research team at RBS recently estimated that liquidity in secondary credit markets has fallen by 70 percent since 2005. Since the financial crisis, large banks have reduced bond inventories substantially following regulatory changes that discourage prop trading and increase required capital charges. Dealer inventories of US corporate debt have been under $70bn for two years in comparison to mid-2007 when that number was $250bn (these statistics also do not reflect outstanding US corporate bonds increasing by approximately 30 percent to $6.5trn over the past two years). As a result, a potential shortfall in liquidity may be required when needed most and raise volatility.

Against this backdrop, theByronFixed Income Alpha Fund continues to exhibit high levels of diversification (in excess of UCITS requirements) with the aim of keeping the portfolio as nimble as possible and responding to changes in market conditions. The ultimate goal of the fund remains a focus on the generation of absolute returns with low volatility over different cycles in fixed income and credit markets.

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