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Authorised funds for hedge strategies

Authorised funds for hedge strategies

  • United Kingdom
  • Investment funds and asset management

14-11-2019

 

When it comes to hedge strategies, onshore FCA-authorised fund vehicles may offer some unique advantages with fewer drawbacks than you might think.

When it comes to authorised funds - as in a fund authorised as a product, by a regulator – you might think of the ubiquitous UCITS brand. This would be fair; UCITS are, by far, the most popular variety of authorised funds in the UK and EU. You might also picture a daily dealing, long-only securities fund. That would certainly describe major portions of the market.

What comes as a surprise to some is that UCITS can be quite flexible – certainly more flexible than straight securities funds - indeed the phrase ‘NEWCITS’ was briefly used to describe UCITS with an alternative strategy when the rules on eligible assets were relaxed years ago. But if we see UCITS as the ‘vanilla’ option when it comes to authorised funds, there are more exotic flavours besides.

This article focusses on the UK authorised fund market but there are similar options available in Luxembourg and Ireland. If these are relevant options, do get in touch as we have expertise across these jurisdictions.

We will look at authorised funds’ competitive advantages but first we should get the limitations and show stoppers out of the way because there are, inevitably, some restrictions.

Non-negotiable UCITS characteristics

  • Open-ended

UCITS and all UK authorised funds are open-ended. They can be single or dual priced with spreads, dilution levies, dilution adjustments, swinging pricing and some restrictions on redemption rights but ultimately their price reflects the NAV. Of course hedged strategies are typically implemented in open-ended vehicles in any case.

  • No gearing

Although, as discussed below, UCITS and other authorised funds can use derivatives (and, on some measures, have ‘leverage’), their positions should be covered. There is a limited ability to borrow; UCITS can borrow up to 10% for liquidity, NURS and QIS can borrow structurally (10% for NURS, 100% for QIS - and can use scheme property as security).

Less rigid parameters

Eligible assets

Authorised funds have a specified menu of constituent asset classes, with specific parameters around diversification and the proportion of an asset that can be held.

We have set out a (very) simplified list of the requirements below. There are other requirements besides which need to be considered at the planning stages.

 

Authorised funds

Unauthorised funds

 

UCITS

UK NURS[1]

UK QIS[2]

 

Transferable securities (e.g. equities, bonds (government or corporate), warrants and investment trusts) MMIs

100%

100%

100%

100%

Units in collective investment schemes

100% in other UCITS

30% in regulated non-UCITS

100% in regulated funds

20% in unregulated funds

100% in unregulated if dedicated to them

100% in unregulated

100%

Derivatives

100%

100%

100%

100%

Immovable property

0%

100%

100%

100%

Precious metals

0%

Gold 10%

Gold, silver or platinum 100%

100%

Commodities

0%

0%

100% if traded on recognised exchanges

100%

Others

0%

0%

0%

100%



[1]              NURS stands for a Non-UCITS Retail Scheme authorised by the FCA.

[2]              QIS stands for a Qualified Investor Scheme authorised by the FCA.

 

Techniques and strategies

Authorised funds can use derivatives for a variety of purposes, from simple synthetic investment in a single security/asset class to replication, swapping returns, hedging and speculative investment.

As noted above, authorised funds can borrow to different degrees. They can also lend their securities and accept or underwrite placings.

Of particular interest to hedge fund managers, UCITS are not able to physically short positions. However, derivatives can be used to provide shorting synthetically.

Taking the above together, the UCITS regime can legitimately claim to support a variety of classic hedge strategies, e.g.:

  • Long/short fund
  • Absolute return
  • Fund of funds
  • Managed futures
  • Tactical asset allocation
  • Commodity index based
  • Hedged index based

Additionally, since the restrictions for UCITS are broadly in line with those for US 40 Act companies, a hedge strategy that works under that regime should be workable within an authorised fund.

Liquidity

Liquidity in authorised funds in the UK has been under some focus since the Leave result in the UK Brexit referendum triggered suspensions in property funds in 2016 and the occurrence of further high profile suspensions in 2019. The recent suspensions have demonstrated rather colourfully that it is possible for UCITS and authorised funds to invest in securities that cannot immediately be realised (though expect some scrutiny if pursuing this in a meaningful way, and perhaps even if not). However, there is an obligation on UCITS to ensure that the liquidity of the transferable securities in its portfolio do not compromise the ability of the fund manager to meet redemption requests. As you will see from the eligible assets section above, NURS and QIS are able to invest into asset classes that are by definition less liquid (in particular immovable property).

Notwithstanding the previous paragraph, a misconception about UCITS (and other authorised funds to a lesser extent) is that they must be established as daily dealing. While it is the case that most UCITS are daily dealing, a UCITS can actually have weekly or even fortnightly dealing. NURS can have six monthly dealing and QIS could potentially have even longer as long as the fund remains properly ‘open-ended’.

But why pick an authorised fund?

If the above describes why authorised funds are not that bad for hedge strategies, where are their strengths?

  • Access to the retail market (incl. other authorised funds)

UCITS and NURS are eligible for direct investment by retail investors and, when sold in the UK, are considered to be ‘non-complex’ products for the purposes of MiFID II. This means that an appropriateness test does not need to be undertaken by the firms selling them. These funds are also eligible for investment by other authorised funds seeking indirect exposure through them opening up sales opportunities.

  • ISA eligible

UK UCITS and most NURS are ISA eligible, allowing access to the large amounts of capital in stocks and shares ISAs, Junior ISAs etc.

  • Single structure, single jurisdiction

Compared with offshore hedge structures, UK authorised vehicles generally do not require multi-tiered structures and can allow the fund’s management and domicile to be united in a single jurisdiction with obvious benefits.

  • Recognition / Status

The UCITS brand is well recognised domestically and internationally, is considered a known quantity and may trigger investment opportunities (e.g. pension and insurance firms with allocations to authorised funds). There is less international recognition of NURS and QIS but typically they are often considered to be in the same category of investment opportunities by institutions.

  • Passporting

Less of a boon for UK authorised funds than it used to be (given the UK’s anticipated departure from the European Union), a UCITS can be notified for cross-border marketing which allows it to be sold in other host EU Member States with no further need to seek authorisation in those host states.

  • Tax treatment without an offshore vehicle

UK authorised funds offer competitive tax treatment domestically and overseas. There are opaque and tax transparent structures available.

  • Service provider infrastructure

The UK market for authorised funds is well-developed and there are multiple providers for each service. In totality, there are options for all budgets, levels of regulatory control and desire to focus on management.

How Eversheds Sutherland can help

Eversheds Sutherland (International) LLP is widely recognised as one of the leading advisers to the investment funds industry, with one of the leading fund, asset management and regulatory teams in the City.

We have over 40 years' experience of investment funds work and, in particular, authorised funds. The funds team is the only team recognised as being top tier/band in both the Legal 500 and Chambers directories.

If you would like to arrange a meeting to discuss how an authorised fund structure might work for your strategy, please contact us.

For more information contact

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