Investors in Ucits III funds warned of risks

Private investors can now access more than 100 funds that pursue “absolute-
return” or hedge-fund strategies, according to a database launched this week. But the compilers have warned that the performance, risk profile and fee structures of these funds are highly variable.

Kepler Partners, a fund marketing company, has collated data on 116 funds that aim to deliver positive returns in all market conditions by making use of the Ucits III regulations – which allow funds to trade derivatives but require them to be more liquid and transparent than hedge funds.

Many of these have been launched in the past two years. Advice firm AWD Chase de Vere reported that 13 absolute-return funds were set up in 2009, compared with only two in 2007. So far this year, another five have come on to the market from GLG, Blacksquare, RWC and Legal & General – taking the total invested in Ucits III funds to £21.1bn.

S&P Fund Services recently estimated that the number of funds has more than doubled since 2004. More are set to follow, with a survey by KdK Asset Management finding that 80 per cent of managers intend to launch so-called Newcits funds in the next 12 months.

However, Kepler has concluded that buying a Ucits III fund does not limit exposure to risky strategies. “Contrary to common perception, Ucits regulations are fairly flexible and could allow quite a breadth of strategies,” it said in a report this week. “We do expect some managers to push the boundaries of what is possible and, therefore, potentially expose investors to undue risks.”

It identified four funds that used total return swaps – derivative contracts that pay returns in line with an index but that rely on a counterparty’s solvency.

Venkat Chidambaram, investment manager at Towry Law, said: “Investing in a fund governed by a tighter regulatory umbrella does not take away the risk of the strategy.”

But it is now more difficult for private investors to assess the risks taken by an absolute-return fund. “Many funds are doing entirely different things under the same generic heading,” said Patrick Connolly of AWD Chase de Vere.

Last month, the Financial Services Authority raised concerns over the way hedge fund managers marketed these products to private investors, suggesting some were “getting on what is beginning to look like a Ucits III bandwagon”. Collins Stewart also warned against jumping into any new fund, noting: “Buying an absolute-return manager will far from guarantee investors positive returns.” Kepler found that managers with a track record of more than a year “performed well” but noted that returns had been flattered by last year’s strong markets and came with “high volatility”.

In the three previous years, AWD Chase de Vere calculated that the average performance of absolute return funds was -2.4, +4.8 and +4.6 per cent. “Other than in the last year, these funds have struggled to beat cash-type returns,” said Connolly. “They need to consistently outperform cash to go some way to justifying the high level of charges.”

Charges can be as high as 2 per cent a year plus a performance fee of 15 or 20 per cent of any outperformance of a “hurdle rate”. But S&P Fund Services warned that these “hurdle rates” varied enormously.

“Some have a Libor hurdle rate, some have an index hurdle, some have an inflation hurdle,” explained Kate Hollis, S&P’s head of fixed income and alternatives. Connolly said many fees kicked in at too low a level. “A more reasonable hurdle would be the return on top-paying cash accounts,” he argued.