The Global Crisis and the regulation of alternative investment funds
In the aftermath of the Global Crisis, there has been a plethora of regulatory initiatives targeting financial institutions. One such type of initiative relates to the regulation of investment funds, in particular, the push towards more tightly regulated and liquid alternative funds and away from lightly regulated offshore alternative investment funds. However, relatively little research has been carried out quantifying the effect of regulatory constraints, such as liquidity requirements, on fund performance. This is surprising since tightly regulated onshore funds are the main access route for savers – be it as retail investors or through their pension funds – to alternative investment strategies which, according to their proponents, offer diversification benefits and superior risk-adjusted returns. In an era of historically low bond yields and widespread underfunded pension plans, it is important for savers and policymakers to understand whether such liquid alternative funds potentially offer solutions to the problems faced by savers or whether onerous regulation erodes away any return advantage that such investments may, in principle, have over traditional assets.
Although in 2009 there were calls by the G20 (an international finance minister and central bank governor forum) for coordinated international financial regulation, regulation continues to vary widely by country. With regard to alternative investment funds, regulatory responses – for example, the US Dodd–Frank Act and the European Union’s AIFMD – also display significant geographic differences with regard to liquidity requirements, risk limits, and remuneration rules.1 In Europe, access to alternative funds is possible via the so-called UCITS fund format, while the American version of the European ‘hedge-fund lite’ UCITS funds are liquid alternative funds registered under the Investment Company Act of 1940.2
What are the main differences between regulation governing hedge funds and UCITS funds?
- First, to enhance transparency and protect investors against misreporting, UCITS regulation imposes tight net asset value (NAV) reporting requirements and valuation rules for UCITS-compliant funds while offshore hedge funds are not subject to such requirements.
- Second, to address the operational risks, the UCITS directive imposes strict requirements for organisational and internal controls and for conflicts of interest.
- Third, UCITS funds are required to have a separate risk management function and are subject to leverage limits, and value-at-risk limits that do not explicitly apply to equivalent hedge funds.
- Fourth, several UCITS rules constrain the investment opportunity set and possible portfolio weights by placing restrictions on eligible assets and short-selling.
- Fifth, UCITS funds have to provide bi-weekly liquidity for investors, while hedge funds do not have any restrictions regarding notice, redemption or lockup periods.
There are thousands of research articles on the US mutual fund industry which manages around $11.6 trillion.3 What may be surprising to many readers is that the UCITS universe – at $8 trillion– is almost equally large, but has received much less attention. A second reason why UCITS funds matter globally is that they are recognised – and can be marketed – in 75 countries worldwide. Outside the US, UCITS funds account for more than half of fund assets worldwide, and about three fourths of the funds publicly sold in Asia are UCITS funds.4 Finally, the impact of UCITS is felt also by non-European investors and managers. For instance, Paulson & Co (a renowned US hedge fund management firm) launched a UCITS version of its flagship offshore hedge fund with Deutsche Bank in 2010.5
Yet, packaging hedge fund strategies in a traditional format is far from straightforward, and it raises many challenges both for managers and for the regulatory format’s brand. The following extract from a recent Investment News article provides a real-world example of such concerns:
“SkyBridge Capital, a top authority on hedge-fund managers, said Friday it has given up for now on trying to export that industry's exotic investment strategies to the mutual funds sold to mom-and-pop investors. Ray Nolte, chief investment officer of the New York-based $13 billion bundler of hedge fund strategies, said his firm simply hasn't been able to figure out a way to build a strategy that meets the strict liquidity requirements imposed on mutual funds without compromising the underlying investment strategy.”6
Thus, both from the perspective of savers and from the point of view of investment managers, it is crucial to determine whether structuring hedge fund strategies through vehicles that are more regulated will yield the same level of returns or rather compromise those strategies – given the constraints imposed by regulations: investment restrictions, liquidity requirements, operational requirements, and risk limits.7
Research on alternative investment funds
There is a growing literature on hedged mutual funds and UCITS funds. Agarwal et al. (2009) compare the performance of hedged mutual funds to traditional mutual funds. In a recent working paper (Joenväärä and Kosowski’s 2015), our focus is on UCITS and non-UCITS hedge funds because these two groups are more likely to allow alternative investment strategies.8 We gather data on UCITS-compliant hedge funds, also known as absolute return UCITS, and compare them with data from a large global hedge fund database. We distinguish between these absolute return UCITS (abbreviated ARUs) and other, non-UCITS hedge funds abbreviated HFs, for expositional convenience, even though UCITS funds are also hedge funds. In 2013 the size of the ARU universe is estimated to be $230 billion, or about 12% of the $1,981 billion in global hedge fund assets; note that the number of ARU funds grew fivefold over 2003-2013.
In comparison with our paper, earlier studies of UCITS funds (Stefanini et al. 2010, Tuchschmid et al. 2010, Darolles 2011) use smaller samples of UCITS hedge funds and do not analyse the effect of UCITS restrictions on suspicious returns, operational risk, performance, or performance persistence.
Table 1 shows how fund characteristics differ between ARUs and HFs based on our sample.9 According to Table 1, on average, HFs are smaller, charge higher fees, and impose tighter share restrictions. The average ARU (with a mean size of $246.02 million) is larger than its average HF peer ($162.98 million). This finding seems counterintuitive until one considers that UCITS regulation imposes minimum capital requirements whereas the relatively smaller size of most HFs makes them generally much less subject to regulation. Furthermore, compliance and other fixed costs associated with running a UCITS fund are probably higher than for a non-UCITS hedge fund, as indicated by the many small HFs whose economic viability could be jeopardised by compliance. Regulations stipulate that ARUs provide at least bi-weekly liquidity to investors, so it is not surprising to find that HFs impose significantly tighter share restrictions than do ARUs.
Table 1. Summary statistics of fund characteristics
Notes: This table presents the summary statistics for fund size and age as well as compensation and share restrictions variables of Hedge Funds (HF) and Absolute Return UCITS (ARU). ‘Size’ denotes the fund’s size in millions of US dollars. ‘Age’ denotes the fund’s age in years based on the fund inception data. ‘Management Fee’ shows the management fee within a specific category. ‘Incentive Fee’ denotes the performance-based fee that fund charges. ‘High-water Mark’ indicates whether a fund imposes a high-water mark provision. ’Redemption’ denotes redemption frequency. ‘Notice’ is the advance notice period. ‘Restriction’ is the sum of redemption and notice periods. ‘Lockup’ denotes the length of period when investors are restricted to withdraw their initial investment. ‘Lockup Dummy’ denotes the proportion of funds imposing a lockup period. ‘Minimum Investment' is the fund's minimum subscription amount in US dollars.
Effects of disparate hedge fund regulation
In the paper, we economically motivate and then test a range of hypotheses regarding performance and risk differences between UCITS-compliant and other hedge funds. Some of the findings support the notion that regulation is successful in protecting investors and improving transparency, but others are not. We find, for example, that hedge funds exhibit more suspicious return patterns than do ARUs, but ARUs exhibit higher levels of operational risk. The study uncovers evidence of a strong liquidity premium. Hedge funds offer investors less liquidity than do ARUs yet exhibit better risk-adjusted performance. The findings are substantially unchanged under various robustness tests and adjustments for possible selection bias. The liquidity premium for ARUs and their lack of performance persistence have implications for both investors and policymakers.
Figure 1 below illustrates the lack of performance persistence and plots the performance persistence tests results across rebalancing horizons.10 The figure reports results from backtests in which portfolio of the top and bottom decile of hedge funds are formed and held over different horizons so that their performance over time can be evaluated. Whereas HF performance persists, ARUs do not deliver long-term performance persistence.
Figure 1. Performance persistence differences between ARUs and HFs
Notes: This figure plots the risk-adjusted performance (annualized 9-factor Fung–Hsieh alphas) for the ARUs and HFs. It displays the top and bottom quintile alphas across rebalancing frequencies.
Policy implications and conclusions
Our study sheds light on the debate over the costs and benefits of increased financial regulation. Given that such regulation is intended to protect investors, one of our main contributions to this debate is quantifying the cost of regulation and liquidity requirements. Estimates based on our data show that the indirect cost of UCITS regulation is around 2% per annum in terms of risk-adjusted returns. Because there is evidence of a substantial liquidity premium in alternative investment funds, policymakers should carefully consider the effect of higher liquidity requirements on the returns that alternative investment funds can be expected to generate. And since institutional investors (e.g., pension funds) are one of the largest groups of hedge fund investors, such requirements ultimately affect the growth of pension assets in Europe and other countries where ARU funds can be marketed. Similarly, the lack of performance persistence among ARUs should caution retail and institutional hedge fund investors against ‘returns chasing’.
Agarwal, V, N M Boyson, and N Naik (2009), “Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds”, Journal of Financial and Quantitative Analysis, Vol.44, No.2, Apr. 2009, pp. 273-305.
Cici G, S Gibson and R Moussawi (2010), “Mutual fund performance when parent firms simultaneously manage hedge funds”, Journal of Financial Intermediation 19(2), 169-187
Darolles, S (2011), “Quantifying Alternative UCITS”, Working Paper.
Deuskar P, J M Pollet, Z J Wang and L Zheng (2011), “The good or the bad? Which mutual fund managers join hedge funds?” Review of Financial Studies 24 (9), 3008-3024
Ineichen, A (2006), Asymmetric Returns: Future of Active Asset Management, Wiley.
Joenväärä J and R Kosowski (2015), “Effect of Regulatory Constraints on Fund Performance: New Evidence from UCITS Hedge Funds”, CEPR Discussion Paper 10577.
Nohel, T, Z Wang, and L Zheng (2010), “Side-by-side management of hedge funds and mutual funds”, Review of Financial Studies, 23: 2342-2373
Stefanini, F, T Derossi, M Meoli, and S Vismara (2010), “Newcits: Investing in UCITS Compliant Hedge Funds”, Wiley Finance Series, First Edition.
Tuchschmid, N S, E Wallerstein and L Zanolin (2010), “Will Alternative UCITS Ever be Loved Enough to Replace Hedge Funds, working paper”, Haute Ecole de Gestion de Genève.
1 The objective of this Alternative Investment Fund Manager Directive is to create a comprehensive and secure framework for the supervision and prudential oversight of such managers in the EU.
2 The acronym UCITS stands for Undertakings for Collective Investment in Transferable Securities, which is the European harmonised and regulated fund product. It can be sold on a cross-border basis within the European Union based solely on its authorization in a single EU member state.
3 See the ICI (2012) factbook and http://www.efama.org for information about the industry’s assets under management.
4 Carne Group, “UCITS Guide for Alternative Managers,” 30 June 2012.
5 Sam Jones, “Investment management: Europe’s changing face,” Financial Times, 10 May 2012.
6 ‘Hedge fund specialist SkyBridge pushes back against liquid alts trend’by Trevor Hunnicutt, Investment news, 12 June 2015.
7 Hedge funds have an absolute return objective – namely, achieving returns that are uncorrelated with the market (Ineichen 2002). The absolute return objective implies that risk reduction techniques (e.g., long–short strategies and taking positions in derivatives) are used to reduce benchmark exposure levels.
8 Other related studies include Cici et al. (2010), Nohel et al. (2010) and Deuskar et al. (2011).
9 Table 1 is based on Table 2 in Joenväärä and Kosowski (2015), which contains further information about cross-sectional differences and their statistical significance.
10 Figure 1 is based on Figure 3 in Joenväärä and Kosowski (2015).