UCITS: Certifiable Challenges

Since its initial adoption by European Union regulators in 1985, the Undertakings for Collective Investments in Transferable Securities (UCITS) set of directives for pooled investment funds has attracted buy-side and hedge fund adherents at a healthy clip, especially in recent years as investor requirements for greater transparency, more frequent reporting, and demonstrable risk management processes have increased. According to the European Fund and Asset Management Association in Brussels, UCITS assets totaled $6.4 trillion as of April of this year.

UCITS compliance has become a sort of seal of approval managers have found useful in attracting capital, and allows them to market their funds across the EU provided they domicile those funds in a member state—Ireland and Luxembourg in particular have proven popular bases.

The current iteration of the UCITS regulation, UCITS III, requires that any fund seeking compliance must have liquidity and diversification, and maintain an open-ended structure. Compliance also means investing only in UCITS-approved instruments such as listed securities, money-market vehicles, funds of funds and derivatives.

UCITS III’s allowance for investing in a wider array of instruments has, in turn, attracted a broader variety of investment managers, including hedge fund shops eager to efficiently tap into European markets and asset managers eager to expand into more complex instruments and strategies without forsaking the “safe bet” sense of propriety they have been able to cull for themselves.

Of course, the advantages of UCITS compliance go hand in hand with proving to regulators that your infrastructure, processes and procedures can effectively meet their requirements targeting transparency. And managers interested in gaining UCITS certification must also realize that compliance is a moving target—the latest iteration of the UCITS regulation, UCITS IV, goes into effect in July 2011, and any firm hoping to keep in good stead with EU regulators will have to meet additional compliance requirements in order to do so.

Buy-Side Buy-In

Although UCITS began as a Euro-centric regulatory framework, international buy-side interest has grown steadily, particularly under UCITS III. But what factors have driven so many investment managers to pursue UCITS certification?

“We have seen a tremendous number of managers launching UCITS products in the last six months,” says John Alshefski, senior vice president and managing director of fund administration and technology provider SEI’s investment manager services division.

“The UCITS product has become an internationally recognized standard for the fund business outside the US.”

Alshefski explains that SEI has seen significant uptick among its US investment management clients for new distribution avenues, and in order to do so they are getting into the regulated fund arena.

“We have seen a push even among institutional investors to invest in regulated fund products, and UCITS has definitely received international acceptance as a highly regulated fund product,” Alshefski says.

According to Michael Blakley, director of product development at risk management and trading system developer Imagine Software, UCITS compliance has become a persuasive method of reassuring investors and addressing their due-diligence concerns.

“UCITS is fast becoming a badge of respectability for investment funds, and getting that badge has become a priority for managers because a lot of investors are using it as a proxy for a certain level of due diligence,” says Blakley, adding that if nothing else, UCITS compliance forces a manager to be able to accurately describe what instruments it owns, how much of them it owns, and what exposures the firm has, both with the issuers of those instruments and the entities from which the manager bought them.

“That covers the vast majority of what UCITS does, and the implication is that if you don’t have a total picture, you can’t answer those questions very well.”

Heavy Lifting—Perhaps

How much infrastructure and technology work is required to achieve UCITS compliance can prove a matter of relatively minor efforts with legal and administration service providers or more significant undertakings depending on a manager’s existing operating structures.

Montag & Caldwell, a $10 billion equity manager based in Atlanta, recently launched a UCITS fund in Dublin with outsourcing help from SEI. David Watson, vice president at the manager, describes his firm’s motivation for launching the fund as well as the technology and operational efforts involved.

“We wanted to expand European and Asian access to our US large-cap growth product, which has a 30-year track record in the US,” Watson says.

“We had to do some fairly routine back-office programming to feed through to our custodian, Brown Brothers Harriman—that was a simple programming addition of another account.

“We have a Boson contact as well as a Dublin contact, and they have straight-through processing, so that was fairly straightforward,” Watson continues. “As a back-up failsafe, we do manually send an encrypted Microsoft Excel spreadsheet of our trades every day to SEI, and that’s not a big deal.”

Cost and communication issues led Montag & Caldwell to choose Dublin as the site of its UCITS fund, Watson explains; the manager relied on SEI as well as an Irish law firm to ensure UCITS compliance as interpreted by Irish regulators.

“We had considered Luxem­bourg as the place to launch our UCITS fund, but we had friends on the ground in Dublin who were able to point us to a couple of legal and administration firms, including SEI,” Watson says. “It seemed to us that SEI’s reputation here in the US is decent, and we have done some work with them before.”

Technology-related efforts involved setting up an account with the manager’s custodian; there were also rigorous frameworks to address pertaining to business plans and independent boards of directors.

“We simply outsourced that regulatory menu to our law firm in Dublin—Maples and Calder—and our senior compliance officer here is also on the UCITS fund’s board,” Watson says. “There is quite a bit of reporting required, but Maples and SEI take care of the bulk of that. SEI is well versed in that their reports are highly formatted.”

Watson emphasizes, though, that Montag & Caldwell’s business focuses on long-only equity investments; managers seeking to launch more complex UCITS funds, or to convert existing funds to the UCITS framework, could face more challenges getting up and running.

Hedge vs. Asset Management Challenges

To a large extent, infrastructural work required to achieve UCITS compliance depends on whether you are managing a hedge fund or a more traditional asset management vehicle. Both types of managers have become involved in UCITS-governed activities, but for somewhat different reasons.

Robert Park, president and CEO at derivative analytics software provider Fincad, explains: “Transparency is really at the core of UCITS, so from the standpoint of hedge funds, especially if they are using complex derivatives, there is a requirement that they strengthen their technology platforms and deal with the challenges of regularly reporting the values of over-the-counter (OTC) derivatives.”

Asset managers, on the other hand, typically have stronger reporting processes, but may not have the proper capabilities to deal with complex derivatives.

“UCITS is the mechanism that will enable the convergence of investment managers and hedge funds,” Park argues. “UCITS gives hedge funds a stronger case to be made to institutional investors who are now more risk-averse and interested in higher standards of compliance, reporting and risk management. UCITS will allow hedge fund managers to compete more effectively for institutional investors.

“On the other hand, traditional asset managers also have advantages here, including the distribution power they have to attract retail investors,” Park continues, adding that these managers will retain an advantage over their hedge fund brethren thanks to their more well-developed distribution networks.

All fund managers launching UCITS vehicles, however, will need to pay careful attention to valuation processes, Park advises. Independent pricing processes have long been pushed by various regulators, and the UCITS regime is no different in this regard.

“Valuations that may well have been accepted in the past by hedge fund investors are now going to have to become more rigorous and independent,” he says, adding that methods for reporting and valuation will require reevaluation to ensure compliance.

“Are market data assumptions coming from reliable sources? Are they managed using a clear and open process? Are the models managers are using to price these products accepted models, and are they properly documented?”

UCITS-compliant managers must ensure their valuation processes have audit trail, and that contingency processes are in place in the event of data-related disruptions, Park adds.

Conversions: Added Hurdles

For managers interested in UCITS compliance and the technology efforts involved, distinctions should also be made between launching new funds and converting existing vehicles to meet regulatory requirements. The latter case often proves much more challenging.

So argues Blakley at Imagine: “There are two types of UCITS funds coming online that we’ve seen. The first are new launches, or simple cases, and then there are conversions, when a manager wants to take an existing hedge fund and effectively re-launch it as a UCITS-compliant fund.”

Conversions bring up various historical performance challenges, according to Blakley, such as proving that a manager’s historical value-at-risk (VaR) figures did not breach UCITS limits over the previous year.

“That’s part of the prerequisite to have a mirror UCITS fund of a hedge fund,” he says. “These are not easy things to do.”

But for many hedge fund managers eager to retain the reputation their existing funds have earned in terms of performance, they see conversion as necessary to keep that luster in tact as well as to continue to have access to investor capital, he explains.

“We have had a number of clients considering a UCITS conversion, and they have been looking at it for a number of months and are aware of the difficulties involved,” adds Hans Crockett, product specialist at Imagine. “In particular, if they haven’t been recording a VaR time series, it is very difficult to back-test not having run that previously.”