Analysis: Funds of hedge funds seen fending off "Newcits"

By Martin de Sa’Pinto

GENEVA (BestGrowthStock) – Investors in a fashionable new breed of EU-regulated hedge fund portfolios could end up being frustrated by hidden costs and restricted strategies that mean returns fall short of those delivered by unregulated peers.

Clients have flocked to UCITS-compliant hedge funds, or ‘Newcits’, amid predictions they will steal market share from offshore rivals still recovering from a financial crisis slump which has left them looking a poor bet.

Assets in Newcits have doubled to $90 billion in the last year and growth is accelerating, while assets in funds of hedge funds have stalled at around $500 billion after falling by almost a third during the financial crisis.

Regulated funds have strict liquidity requirements, leverage limits and clear asset prices.

That makes them attractive to retail investors seeking a cheap and supposedly safe entry point into hedge funds, but restricts diversification and squeezes returns, specialists said.

“They’re not going to blow up, they’re just not going to make any money,” said Richard Travia of $1.1 billion invest management firm Tradex, which manages a fund of funds.

Newcits have returned an average 1.89 percent year to date, the Hedge Fund Journal’s UCITS Hedge Index showed. Hedge fund researcher HFR said the average offshore hedge fund was up 4.8 percent, with funds of hedge funds gaining 2.01 percent.

“UCITS’ fund of hedge fund fees will be more expensive since the compliance is more laborious and costly,” said hedge funds specialist Peter Meier of Zurich University. “Furthermore, the performance will be inferior because UCITS have restrictions in terms of liquidity and transparency which reduce opportunity.”

COMFORT ZONE

Supporters of Newcits argue investors will accept weaker performance and higher costs in return for lower risk.

“(These) are things people are happy to pay for, like ring-fencing and proper administration,” said Chris Wyllie, a portfolio manager at fund manager Iveagh.

But Louis Zanolin of investment adviser Nara Capital said investors’ tolerance would wane if underperformance was worse than an annualized 1 percent or 2 percent in a bull market.

Some investors are still angry that many fund of funds restricted or blocked access to their money during the financial crisis, often infringing liquidity terms.

The liquidity and transparency of Newcits look attractive in comparison, and are luring institutions such as pension funds, said fund manager Gottex, reporting strong interest in its UCITS III fund of hedge funds launched in July.

But many institutions still prefer offshore funds.

“UCITS buy investors a higher level of comfort, but higher costs dilute performance. The more sophisticated the investor, the less they feel they need UCITS,” Charlotte Bonde Tamm, head of capital introduction at SEB’s investment banking arm, said.

Also, the liquidity of Newcits is untried and could falter in tough markets, Martin Kloeck, partner at funds group Signina Capital, said. Trading in even widely held securities plunged at times in the 2007-2008 liquidity crisis, he added.

COST CONTROL

Typical UCITS III hedge funds charge management fees of 1 percent to 1.5 percent and performance fees of 20 percent, the latter only if an agreed return — or hurdle — is reached.

That is lower than the “2 and 20” typically charged by hedge funds, said Magne Orglund, managing partner at private bank Wegelin, which offers Newcits.

But that does not count higher running costs for UCITS which industry insiders say could shave 1 percent a year off returns.

Also, the extra fee layer paid to funds of hedge funds is used to select the best talent and strategies and for due diligence, Pascal Woerlen of Pictet Asset Management said.

Due diligence has proved its worth — Bernard Madoff’s $65 billion fraud caught out few funds of funds outside of private banks, while the regulated Herald and Luxalpha funds were Madoff feeders, showing regulation is no guarantee against fraud.

“Blow-ups in UCITS are as likely as anywhere else … they bring a false sense of security,” said Heiko Zuehlke of $1 billion high-frequency trader Amplitude Capital.

While UCITS was a huge challenge to the industry, the best funds of hedge funds would prove their worth in time, Simon Rostron, of London-based consultancy Rostron Parry, said.

Others said UCITS were based on avoiding risk by limiting the use of the type of tools one looked for in hedge funds in the first place. Professional investors would avoid UCITS, and the best funds of hedge funds would survive, they said.

“The fund of hedge funds industry has had the kiss of death a number of times, and survived,” Werner von Baum, head of hedge funds at the $19 billion LGT Capital Partners, said.

“UCITS may seem a danger but (for people who invest in them) there’s going to be disappointment.”

(Additional reporting by Laurence Fletcher and Claire Milhench in London: Editing by Jason Rhodes and David Hulmes)

Analysis: Funds of hedge funds seen fending off "Newcits"