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Will alternative Ucits ever be loved enough to replace hedge funds?

Tuesday, October 05, 2010
Abstract
This article analyses a new data base on Ucits "hedge funds", or alternative Ucits funds. These are EU regulated investment vehicles allowing for a rela- tively large degree of latitude for fund managers which makes them attractive for hedge fund-like strategies. The asset under management of alternative Ucits funds has seen large capital inows, in contrast to the hedge fund in- dustry as a whole, and was in Q1 2010 managing euro83 bn ($121 bn). We examine the performance of these alternative Ucits and compare them to the performance of hedge funds. We do not find any conclusive evidence that the less regulated hedge funds outperform alternative Ucits funds on a risk adjusted basis, even though we nd some cross-sectional evidence. We also nd a signicant difference in level of risk between hedge funds and alterna- tive Ucits funds with the latter bearing less risk. This is anticipated due to the limits on risk and leverage under the Ucits regulation.

1. Introduction
The European Union's (EU) directive on Undertakings for Collective In- vestment in Transferable Securities (Ucits) is a regulatory framework which permits hedge fund-like investment strategies. The Ucits framework has grown to become popular as an investment vehicle for hedge fund strategies. For sake of clarity we distinguish hedge fund-like strategies launched under the Ucits framework by referring them as alternative Ucits funds. We nd in this article that the aggregate asset under management (AUM) of this segment have grown 500% during the last 4 years to reach euro83 bn in 2010. This can be compared with the overall hedge fund industry which according to Hedge Fund Research (HFR) grew only 2% over the same period to euro1240 bn.

The Ucits brand has become somewhat a seal-of-approval for alternative investments and there is anecdotal evidence that institutional investors focus exclusively on alternative Ucits funds in favor of hedge funds. Furthermore, there are reports that the Ucits brand enjoys much attention outside of Eu- rope from regulators and investors alike.

Launching hedge funds under the Ucits framework is, however, not with- out dispute. While no precise definition of hedge funds exists, one central concept of this investment vehicle is that they should have large flexibility and few restrictions on when and which investment instruments they use to achieve high positive returns.

Despite the large attention alternative Ucits funds have received in the investment community no research has to our knowledge been conducted on the performance of alternative Ucits funds. This article gives a tentative answer by in particular analyzing the difference in performance between al- ternative Ucits funds and hedge funds. We focus on three areas for which the Ucits framework may affect the returns. Firstly, restriction on the level of risk and leverage alternative Ucits funds are allowed to take is likely to result in different risk and return levels as compared to hedge funds. Secondly, lim- itations on eligible investment instruments for Ucits should result in dierent risk exposures as compared to hedge funds. Thirdly, higher regulation should provide an investment opportunity set which is less prone to contain funds with extreme returns, to this end we analyses and compare the distribution of return and risk measures of alternative Ucits funds and hedge funds.

Our research is closest to the article by Agarwal, Boyson, and Naik (2009) which examine a dataset of US hedge mutual funds. These are mutual funds which employ hedge fund like strategies but, as in the case with alternative Ucits funds, are under higher regulatory scrutiny. They find hedge mutual funds to underperform lightly regulated hedge funds and they attribute this to less regulation and more flexibility in fee structures which creates better incentive structures for hedge fund managers. There are, however, signicant difference with their database and the one we use. Alternative Ucits funds in our database have no restrictions on incentive structures. Furthermore, our database is significantly larger in terms of number of funds and AUM.

Our research is similar to that of Koski and Ponti (1999), Deli and Varma (2002) and Almazan et al (2004) which investigate the differences in performance of mutual funds which use and do not use derivatives. Koski and Ponti nd that performance and risk levels are similar between funds with and without derivatives. Furthermore they nd that the added exibil- ity through the use of derivatives enhance the management of risk exposure.

Deli and Varma in particular confirm the added efficiency gained by the use of derivatives. Almazan et al. which nd that restricting manager invest- ment latitude minimize the agency costs by preventing the manager form strategically altering the fund's risk and increasing the value of future com- pensation.

Finally, our research also belongs to the large literature on hedge fund performance evaluation. E.g. Liang (1999), Agarwal and Naik (2000), Fung and Hsieh (2001, 2004), Fung et al. (2008), Brown, Goetzmann and Liang (2004), Hasanhodzic and Lo (2007), Wallerstein, Tuchschmid, and Sassan (2010), and Gibson-Brandon and Wang (2010).

The primary contributions of this research are as follows. First we provide with empirical data on the alternative Ucits fund universe. As mentioned above the growth has been large in absolute terms and huge on relative terms with traditional hedge funds.

Secondly, we document the differences in the return and risk of alternative Ucits funds and of hedge funds. We find absolute returns to be higher for a composite alternative Ucits index as compared to composite hedge fund indices. Risk-adjusted performance, or alpha, is slightly lower for the Ucits index at 2.6% annually to be compared with 2.9% for the composite hedge fund index. However, the alpha of alternative Ucits index is significant unlike the alpha for the hedge fund index. We do, however, find cross-sectional evidence that hedge funds outperform alternative Ucits both in absolute and risk-adjusted terms. Risk levels of alternative Ucits funds are at a 3 to 4 order of magnitude lower than for hedge funds. We furthermore find alternative Ucits funds to have lower exposures to more risky assets and more illiquid assets than hedge funds.

Finally, we analyze the distribution of various measures on cross-sectional samples of alternative Ucits funds and hedge funds. We use this as a proxy for the characteristics of the investment opportunity set of alternative Ucits funds as compared to the investment opportunity set of hedge funds. Our results support the assertion that there are signicant differences in the in- vestment opportunity set where the sample of alternative Ucits funds exhibit signicantly lower dispersion in return and risk characteristics than the sam- ple of hedge funds.

This article has the following structure. Section 2 gives an overview of the Ucits regulation. Section 3 presents the data and some empirical data on the industry. Section 4 presents the performance evaluation of alternative Ucits funds. Section 5 concludes... Corporate website:Source

-KM

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