Driven by the need to attract a wider network of clients whilst also supporting new demands for absolute return, investment managers are increasingly providing more hedge fund-like strategies. In a monthly column, Investit’s Sarah-Jane Dennis provides insight into how the use of derivatives in UCITS funds is a key contributor to this major buy-side trend.
A recent trend that continues a pace is the convergence of traditional funds and hedge funds. What this means is that fund managers of traditional funds are moving more and more into strategies that include the use of derivatives, previously dominated by hedge funds. And hedge funds are becoming much more interested in presenting their products as UCITS funds in order to appeal to a wider audience than they traditionally courted.
Here, UCITS is a significant enabler as it has provided a kite-mark standard for funds that specifies the rules of engagement for derivatives. It is this kite-mark that has provided the confidence for investors to take the plunge and “get involved” with derivatives. Furthermore, as UCITS supports the use of derivatives, hedge funds can tailor their products to suit their requirements without having to re-invent what they do.
During our recent research on the converging industry at Investit, we have seen that fund managers are not just converging on UCITS simply because it increases the number of people their products can appeal to; they are also being driven by the demands of their clients who are no longer looking for benchmark plus basis points, but are looking for absolute return.
This has come about because old assumptions are no longer valid; the equity market is no longer one where buying and holding will deliver a positive return if you wait long enough. So clients don’t simply want to track or slightly outdo an index anymore, because the confidence in that index making a steady increase over time has disappeared. Clients are now defining what they want in terms of positive returns regardless of the market. In response, the diversified fund of today frequently has ‘absolute return’ as an additional element.
But for investment managers, it’s not as ‘simple’ as making an absolute return, because there is still a desire for returns to be achieved risk free or at least ‘risk controlled’. And, bearing this in mind, this all has to be achieved while also making a profit for the investment manager’s firm.
Therefore to achieve both a return for the client and for the firm, fund managers have to make more use of what they currently have by extending and developing their capabilities, and/or consider buying in knowledge and experience in a particular strategy (e.g. Liability Driven Investment, deploying short strategies).
Needless to say, it is not all investment in the front office. These strategies and increases in volumes will need to be accompanied by developments in the operational capability to provide the necessary support. It is all well and good to bring on board a front office team specialising in a particular derivative rich strategy, but if the operational part of the process cannot accurately capture the positions and then manage them appropriately, it is not going to bring positive returns to the firm – nor to the client.
Interestingly, the softer elements of bringing in teams (such as cultural fit) have an impact on the success of the process; and a particularly big impact when the fit does not work. The boutique approach seems to weather these storms more efficiently and is an approach well known to traditional managers, and that has been successfully deployed by some to extend their capabilities out to include hedge funds.
We are also seeing Exchange Traded Funds (ETFs) becoming more frequently traded or being added on to the new instrument list for project teams. These instruments are themselves the result of convergence of investment trusts, mutual funds and index/quantitative funds. They offer a practical route to a huge variety of exposures that would have previously been out of reach.
The next stage will be to deploy UCITS IV, which allows a single management company to support funds being sold in multiple countries rather than each country needing its own management company. Essentially it allows fund managers to distribute out to a global market without having to establish a global infrastructure.
For fund managers without an existing infrastructure spanning multiple regions or countries, making the change to take advantage of UCITS IV may by costly and a hard business case to sell. For fund managers with a limited infrastructure, we expect the absence of a legacy infrastructure to be a significant advantage, freeing these managers up to reap the benefits of UCITS IV more rapidly.
* Sarah-Jane Dennis is a consultant for the Operations and Systems practices at Investit.