Matthew Feargrieve blog

Welcome to the Matthew Feargrieve blog. Matthew Feargrieve provides fund managers with all of the key documentation required by their investment funds, including the prospectus and offering documents, sub-fund supplements, Key Information sheets, the fund's constitutional documents, investment management and advisory agreements, and investor side letters.

What is insider trading?

Insider trading is a term you’ve probably heard before. It’s associated with illegal conduct. Alternatively, insider trading made major headlines back in 2003, as a result of the infamous Martha Stewart scandal that sent her to federal prison.

An insider is a person who possesses either access to valuable non-public information about a corporation or ownership of stock equaling more than 10% of a firm's equity. This makes a company's directors and high-level executives insiders.

• Legal Insider Trading

Insiders are legally permitted to buy and sell shares of the firm and any subsidiaries that employ them. However, these transactions must be properly registered with the Securities and Exchange Commission (SEC) and are done with advance filings.

• Illegal Insider Trading

The more infamous form of insider trading is the illegal use of non-public material information for profit. It's important to remember this can be done by anyone including company executives, their friends, and relatives, or just a regular person on the street, as long as the information is not publicly known.

What happens when you get caught? 

Depending upon the severity of the case, insider trading penalties generally consist of a monetary penalty and jail time.

Section 16 of the Securities and Exchange Act of 1934 requires that when an "insider" (defined as all officers, directors, and 10% owners) buys the corporation's stock and sells it within six months, all of the profits must go to the company. By making it impossible for insiders to gain from small moves, much of the temptation of insider trading is removed. Company insiders are also required to disclose changes in the ownership of their positions including all purchases and dispositions of shares.

Check back for more!

Matthew Feargrieve is a qualified financial services lawyer in the UK and as a commercial lawyer in the Cayman Islands and the Eastern Caribbean. He is also familiar with the regulation of investment funds and management companies based in Luxembourg and Ireland. Learn more about Matthew Feargrieve on his website here. You can also join Matthew Feargrieve's professional network by connecting on his Linkedin page here. Alternatively, you can also read Matthew Feargrieve's news here and watch the Matthew Feargrieve video here

The Woodford Equity Income Fund ("WEIF") was placed into liquidation in October 2019, after having suspended redemptions in June. The fund had been managed since its 2014 inception by Neil Woodford, an investment manager widely credited with "star" status following a successful career in the City. Fast-forward five years and Woodford's funds are in wind-down, Woodford is removed as the manager, and his reputation is in ruins.

In the first part of this two-part blog, we looked at how Woodford's failure came about and asked how the FCA could have allowed it to happen. In this, the second part, we offer some further reflections on this saga and its implications for the future of UCITs for investors. We start with a consideration of the role of the regulator. 

The Bigger Regulatory Picture. The FCA's omissions and its basic failure to accord WEIF investors with the sort of basic protections that they believed (or were told by IFAs and other middlemen) they would be afforded by the UCITs product is symptomatic of the attitude of European financial regulators to the UCITs model. The genesis of UCITs was as a liquid investment product, highly regulated and regarded as "safe" for investment by small, retail investors. But for more than a decade the UCITs envelope has been pushed by EU states and regulators to allow managers more and more able to replicate, sometimes in a synthetic way, riskier investment techniques traditionally available only to managers of hedge funds. Under UCITs rules, Illiquid investments have a very circumscribed place in the fund's portfolio, but increasingly financial regulators in Luxembourg have permitted the shoehorning of illiquid assets into UCITS and UCITs wrappers. The FCA, keen for London as a centre of asset management to keep step with Luxembourg, has followed suit and has played its part in the significant divergence of the current iteration of the UCITs model from the original incarnation. See my blog, "UCITs and Hedge Funds: Not a Match Made in Heaven" for a more detailed treatment of this point. 

One positive outcome of the Woodford saga would be a wholesale revision by regulators, including the FCA, of the UCITs rules and an attendant evaluation of the risk analysis that ought to be applied to a series of model UCITs portfolios and investment strategies within the parameters and constraints of the current UCITs rules. The fact of the matter is that the things some managers are allowed to do (or not do) with UCITs - like Woodford and the WEIF - materially shift the position on any objective risk spectrum of this supposedly safe, regulated, retail investment product.         

Non-UCITS to the Rescue? Some commentary in the immediate aftermath of the closure of WEIF has asked whether the standard disclosures in a fund's prospectus  - such as those pertaining to the circumstances in which redemptions may be suspended - go far enough to ensure that investors are sufficiently informed before investing. Other commentators have asked whether the daily liquidity posited by the UCITs model should be subjected to some sort of qualification.

Our view is that the answer to the problems highlighted by the Woodford story may be found in the non-UCITs (NURs) regime. These illiquid or semi-liquid investment funds have traditionally mainly been used for real estate portfolios, but the regulatory framework is capable of revision and expansion to accommodate investors with the appetite and risk tolerance for some  - intentional - illiquidity in a fund's portfolio, and who understands the liquidity profile of his shares, which may be redeemable monthly or quarterly, as opposed to daily.

Had the NURs model been sufficiently evolved in this regard from the version that was available to Neil Woodford back in 2014, when he had his illiquid investments in mind, the fund product duly structured and sold to investors would have been a lot better suited to his investment style and strategy than the (supposedly) liquid UCITs that WEIF ended up being. In this sense, then, the UK's investment fund regime, and its legal and regulatory parameters failed both Woodford and his investors.

UCITs and the Myth of Active Management. Neil Woodford came under very heavy criticism for not waiving or suspending his asset-based management fee during the time that redemptions in WEIF were suspended, from June 2019 until his removal as a manager in October 2019. Investors asked, "if the value of our shares in WEIF is diminishing by the day, because of investment decisions and other faults on the part of the manager, and our ability to redeem out of the fund is being blocked, why should we still be liable to pay the manager his fee on the assets remaining in the fund?". It was a good, and fair question, one which widely resonated across not just the asset management industry but in mainstream and social media as well. It was a question that led to the fatal ebbing of whatever diminished confidence investors and the industry had left in Neil Woodford. It was a question that, in its being left too long unanswered by him, led ultimately to the administrator stepping in and relieving him of his management mandate.

Woodford's failure - or refusal - to waive his asset-based fees, and to refund fees previously taken, while WEIF tanked and his investors' savings remained trapped inside, was seen by many as redolent of the "because I'm worth it" attitude displayed by many "star" fund managers. The existence of this mentality in the asset management industry is incontrovertible, although its extent and the role it plays in how funds are managed by individual managers is debatable. This mindset is, more fundamentally, a component of a common misconception about retail funds like UCITs (and WEIF), one that managers and investment advisers are scarcely keen to debunk: that these investment products are "actively" managed. They are not.

Active management is a non-passive form of management, which by definition goes beyond passive tracking of indices and embraces active, alpha-generating techniques such as short, use of sophisticated financial instruments, and dynamic use of leverage. The point of active management is that, by generating returns that are uncorrelated to markets, it produces profits for investors even in down-markets. This is traditionally the realm of the hedge fund and the correspondingly high fees that hedge fund managers charge their investors.

 In retail funds like UCITs, no shorting or dynamic use of leverage is permitted. Managers of UCITs in effect are mandated to place long-only bets on liquid (safe-ish) stocks. This is not active management in its true sense. True that Woodford's strategy for WEIF was not passive index-tracking. But nor was it hedge fund-style, active management; he was too constrained by the retail-friendly UCITs regime for that. This fact did not, however, prevent him and other investment professionals from heavily promoting his "active" management as being worth a premium. It wasn't.

Hargreaves Lansdowne and the Role of the Middlemen. Enter at this point Hargreaves Lansdowne ("HL"), a platform promoter of investment funds. Neil Woodford featured regularly in HL's "Top Fifty" list of the "best" fund managers. This "best-buys" selling technique came under heavy criticism following Woodford's removal by the administrator of WEIF, particularly after it emerged that HL had continued to promote Woodford, his ability and his funds following the suspension of redemptions in WEIF.

Woodford and his right-hand man took around £100 million in fees from WEIF since its inception in 2014. Clearly, HL would have received a healthy percentage of this revenue in return for promoting WEIF in what is now seen to have been manifestly an inappropriate manner. Retail investors were fed a large amount of compellingly -hyped sales puff. There is now anger at HL's close commercial alignment with Woodford, and their apparent complicity in the taking of money from vulnerable retail investors. The reality of HL's involvement in WEIF is quite probably somewhat less sinister than some critics at the time of writing are keen to suggest, but there is nonetheless a morally compelling case for HL to be encouraged (some would say legally obliged, if required) not to hide behind the defensive mantras of "Caveat Emptor" or "Investors Capital is Always at Risk".It also seems likely that the role of platforms like HL will be susceptible to future review by the FCA. But investors would be wise not to hold their breath.       

The Woodford Saga: Lessons to be Learned? The shoehorning of non-retail type assets and investment techniques into a retail envelope like UCITs was a trend that was apparent as early as 2008 and which we warned about in our blog from that time (see "UCITs and Hedge Funds: Not a Match Made in Heaven"). To some extent, a UCITs blow-up like Woodford was an accident that has been waiting to happen for some time.

The story of Woodford and the experiences of all Woodford stakeholders will hold some upside, some of which we have suggested here, like the tightening of the retail-friendly protections of the UCITs model, the expansion of the NURs regime to suit managers and investors alike, and the regulation of middlemen like Hargreaves Lansdowne. Whatever lessons industry professionals  - including fund managers - may learn from Woodford, it will be duly-chastened investors who will be doing the teaching, having learned, the hard way, a three-fold truth: (i) you can never believe the hype about a fund manager, (ii) your capital is always at risk in an investment fund, and (iii) if you cannot afford the risk of losing that capital, DO NOT INVEST!

ABOUT THE AUTHOR

Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom,  Luxembourg, Ireland, and the Cayman Islands.

The Woodford Equity Income Fund ("WEIF") was placed into liquidation in October 2019, after having suspended redemptions in June. The fund had been managed since its 2014 inception by Neil Woodford, an investment manager widely credited with "star" status following a successful career in the City. Fast-forward five years and Woodford's funds are in wind-down, Woodford is removed as the manager, and his reputation is in ruins. This, the first part of a two-part blog, offers some reflections on this saga, and its implications for the future of UCITs for investors. 

From Hero to Zero. WEIF was structured as a UCITs, a retail-friendly, regulated product that is open-ended and strictly required by the regulatory regime to permit investors daily liquidity. Note those two words: daily liquidity. They would come to haunt Woodford and his investors. The regulatory regime permits managers of UCITs to place long-only bets on liquid stocks. But Woodford's investors were soon in for a surprise. Within two years' of WEIF's launch in 2014, it was apparent that the fund's portfolio comprised substantial allocations to mid-cap stocks with high yields, small caps and significant positions in unlisted - illiquid - companies.

In its first two years of trading, WEIF enjoyed a fair market tailwind, delivering performance that bettered the FTSE All-Share index. By May 2017, WEIF's AuM (assets under management) had a value in excess of £10 billion. Then, things started to change. Companies in which WEIF had questionably large positions issued well-publicized profit warnings. Investor confidence in Woodford's investment decisions started to wane; and investors submitted requests to redeem their holdings in the fund, which they were perfectly entitled to do. As WEIF experienced outflows of investor money, and this turned the fund's exposure to small caps and unlisted, illiquid stocks into a real problem. In order to meet redemption requests, the fund's most liquid holdings were disposed of. But as the redemption requests continued to flow in, Woodford was left with no alternative but to try to dispose of the fund's illiquid assets. And this proved difficult, precisely because of their illiquidity. As the liquid assets were disposed of, so the illiquid assets became an ever-bigger component of WEIF's portfolio. This, in turn, caused the fund to breach the value limits that the UCITs regime places on illiquid portfolio investments. Which in turn spooked investors further, who continued to redeem out of the fund.

Woodford was trapped in a vicious cycle, the stuff of nightmares for any fund manager. The vortex was contained in June 2019, when redemptions in WEIF were suspended. This meant that investors were effectively trapped inside the fund, unable to withdraw their investments. After considerable mainstream and social media outcry, expressed by investors and industry commentators alike, WEIF's administrator and corporate director decided in October 2019 to remove Woodford as the manager, and wind-down the fund with the assistance of two investment advisers appointed for the purpose. As at the time of writing (October 2019) those investors who failed to exit prior to the redemption suspension imposed in June remain trapped in the fund, with an exit date of January 2020 being indicated by the administrator.

The Role of the Regulator.  WEIF is a UCITs established in the UK, and is subject to regulatory oversight by the FCA. UCITs are investment products designed to be suitable for retail investors, offering "daily liquidity", meaning that investors may withdraw their investment on any business day. So why were investors in WEIF unable to redeem out of the fund, and why did the FCA permit this state of affairs? Investors wishing to redeem out of WEIF found themselves faced with two problems, one of Woodford's making, the other an unfortunate feature of being invested in an investment fund:

1. Woodford's investment decisions led the fund's portfolio to be dangerously misbalanced, with a preponderance of illiquid positions, ie small-cap, unlisted companies. Because the shares in these companies were unlisted, there was no objective valuation for them, and there was no market available to Woodford on which to sell the shares. He needs a willing buyer. And because these companies were issuing profit warnings, and found themselves in other difficulties, no buyer was forthcoming. In short, Woodford was stuck with these investments. And because he was unable to dispose of them, he was unable to raise funds to honour the redemption requests being submitted by worried investors in WEIF.

2. All investment funds like UCITs issue investors with a prospectus. Legally, the prospectus is essentially a contract between investors and the fund; commercially, the reality is that the investors have a contract with the fund's manager. The terms of these contracts permit the fund to suspend redemption requests - in other words, to stop honoring redemption requests - in prescribed circumstances. This provision always - always - favors the manager, not the investors. A standard catch-all is that the fund may suspend redemptions "when it is in the investors' best interests to do so".   

Both of these dynamics came to bear on Woodford's investors. WEIF suspended redemptions in June 2019 because of the panic surrounding the fund, the loss of confidence in its manager and the sell-off of assets (the "fire sale") that was ongoing as a result of the pressure to pay withdrawing investors. They were locked in because curtailing redemptions removed the pressure on Woodford to sell portfolio assets, meaning (in theory at least) that he could take more time and realise a better price for them: and so the suspension was "in the investors' best interests".

So, as unfortunate as the suspension was for WEIF investors trying to exit, was (on the face of it) imposed in a proper way. The liquidity of the fund's portfolio, however, which originally caused investors to head for the exit, was far from proper. Woodford, as manager of a UCITs product like WEIF, was subject to strict legal and regulatory rules that required him to keep a fixed percentage of the portfolio's value liquid, ie, invested in liquid positions capable of being sold in order to honour the central rule of UCITs that they must permit investors with daily liquidity: investors must be able to redeem their investments on any business day. Woodford invested in excess of this value limitation in stocks which he knew to be illiquid - small-cap, unlisted companies. The FCA, as the overseeing regulator, did not detect these breaches. By the time the breaches were detected, the outflows from WEIF were already reaching terminal velocity. The regulator came onto the scene too late to protect Woodford's investors.

Join us for the second part of this blog, in which we consider the role of the FCA in the Woodford saga, as well as the possible lessons that can be learned from it.

ABOUT THE AUTHOR

Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom,  Luxembourg, Ireland, and the Cayman Islands.

You can also subscribe to the Matthew Feargrieve YouTube channel here

Within a delegated mandate, a customized investment strategy is developed for each plan, with various implementation options available to plan sponsors. An investment strategy can be implemented in different ways. We look at this from three perspectives:

• The choice between pooled funds and customized implementation
• Liability hedging implementation
• Accessing diversity

Matthew Feargrieve tips for a new hedge fund manager 

If you are looking to expand your startup hedge fund business and tips from leading hedge fund manager and experts, read on. Hedge fund manager work revolves around unusual, innovative methods to yield uncommon results. It is also about sustaining the business during a crisis. Learn all about the interesting hedge fund management tips and tricks to keep you ahead in trading. It will also lay the foundation for a stronger startup which will be robust enough to bear the ups and downs of the market.

The Power of Informed Decisions. Hedge fund manager needs to set realistic goals and important schedules. Rushing to start a hedge fund can have disastrous consequences. Take your time to make effective strategies and select the best service providers for growth. If you are looking to providing new hedge fund exposure to investors, it is important to engage in capital introduction

Always Be Cautious While Considering Liquid Alternative Investments. The hedge fund manager has to make well-informed decisions about registered products and investment services. Hedge fund manager needs to reflect and take a hard look in the mirror before jumping on to the bandwagon.

Technology is Your Best Friend. Startup Hedge fund Manager are now choosing cloud-based solutions rather than traditional on-premise solutions. The benefits are many from cost containment to enhanced flexibility and simplification of IT management solutions. On-premise IT or cloud, security is the main concern here. Protecting the information of the organization is vital. The hedge fund manager should focus on disaster recovery plans in the event of crisis as well.

Valuation of Operational Risk Has Its Rewards. Emerging hedge fund manager need to be concerned about the operational risk involved in hedge fund creation. Valuation of the risk is an essential step forward- the aim should be on discovering if holdings of the fund are accurately valued and can be so during each dealing period.

Do Your Research. Being ready with the homework before you get to class is important. You need to be clear about the risks involved in the hedge fund industry from the inside out and have concrete knowledge regarding commodities and the manner of the unfolding of the investment process.

Strategize to Succeed. You need to be aware of what you bring to the table. Once the business is launched, it will take a strong and independent strategy to sustain it.

Steps to be a Successful Hedge Fund Manager

• Implementing risk controls, growing assets, hiring staff and running the fund
• Competitive advantage must be offered by your hedge fund manager and this could be any of the following advantages- marketing advantage, information advantage, resource advantage or trading advantage. 
• Defining the strategy is equally important.
• Capitalization and seed capital are crucial considerations for any hedge fund startup.

 Hedge Fund Owner Mark Mobius Says Gold Is Going Up

In the whole world, there is not enough gold to fill two Olympic sized swimming pools. It is one of the rarest and sought after commodities that exist. Gold’s drop from last week’s six-year high is attracting some bargain hunters, but one hedge fund manager is advising investors to ignore the price and buy the precious metal at any level. It is, in fact, making a come back.

Mark Mobius, founder of Mobius Capital Partners LLP
In an interview with Bloomberg TV Tuesday, veteran investor Mark Mobius, who created Mobius Capital Partners LLP last year, reaffirmed his bullish outlook for the yellow metal.

“Gold’s long-term prospect is up, up and up, and the reason why I say that is money supply is up, up and up,” he said. “I think you have to be buying at any level, frankly.”


Mobius also reiterated his recommendation that investors should hold about 10% of physical gold in their portfolios.

According to commodity analysts, the gold market has seen unprecedented investor demand as bond yields have dropped due to growing expectations that the central banks are on the cusp of a new global monetary easing cycle to stimulate economic growth.

Although gold has been hit with some technical selling pressure after last week’s six-year higher, the yellow metal has managed to hold critical support above $1,500 an ounce. December gold futures last traded at $1,514.60 an ounce, up 0.20% on the day.

Markets are currently eager to hear from Federal Reserve Chair Jerome Powell, who will be speaking on Friday at the annual Jackson Hole Central Bank Symposium. According to some economists, Powell is expected to signal another rate cut at the central bank’s next monetary policy meeting in September.

The CME FedWatch Tool shows that markets all but expect a rate cut next month. Markets are also pricing in a 10% chance of a 50 basis point move.

But it’s not just the Fed that is easing rates. Mobius said that he expects China to fully embrace lower interest rates.

In an environment of global monetary easing, Mobius said that there will be a strong demand for hard assets, which he expects will leave cryptocurrencies out in the cold.

“You have all these currencies, new currencies coming into play,” he said. “I call them ‘psycho currencies,’ because it’s a matter of faith whether you believe in Bitcoin or any of the other cyber-currencies. I think with the rise of that, there’s going to be a demand for real, hard assets, and that includes gold.”

Matthew Feargrieve has extensive experience of advising fund managers makes Matthew a valued member of the boards of investment funds in various jurisdictions, on which he acts in a non-executive capacity. Learn more about the work of  Matthew Feargrieve online here. Read more about Matthew Feargrieve legal news here. You can also follow Matthew Feargrieve on Facebook for more legal news and advice.

About Matthew Feargrieve

Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom,  Luxembourg, Ireland and the Cayman Islands. He is qualified as a financial services lawyer in the UK, and as a commercial lawyer in the Cayman Islands and the Eastern Caribbean. He is also familiar with the regulation of investment funds and management companies based in Luxembourg and Ireland.

Fund managers of closed- and open- ended funds (UCITs and non-UCITs) operating in all asset classes and across a spectrum of investment strategies (both retail and alternative) rely on Matthew for counsel in legal, compliance and operational matters and on a wide range of lifecycle issues ranging from domicile choice and vehicle structuring, to capital raising and liquidity management and ultimately to wind-down, as well as on crisis management and reputational issues relevant to investor relations and capital preservation in times of draw-down and illiquidity.

Matthew provides fund managers with all of the key documentation required by their investment funds, including the prospectus and offering documents, sub-fund supplements, Key Information sheets, the fund's constitutional documents, investment management and advisory agreements, and investor side letters. He also works with the manager's third-party vendors and fund service providers when reviewing the fund's administration, custody and prime brokerage agreements. With a background in M&A, Matthew can also advise on portfolio transactional activities, and has a particular interest in commercial aviation contracts and associated regulatory matters.

His extensive experience of advising fund managers makes Matthew a valued member of the boards of investment funds in various jurisdictions, on which he acts in a non-executive capacity.  Before becoming an independent financial services consultant, Matthew worked for leading law firms in the UK and in Switzerland. Find out him online. You can follow his latest updates on the Matthew Feargrieve Twitter page and also connect with him on the Matthew Feargrieve Crunchbase page. Read the latest Matthew Feargrieve updates here.

Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience in the industry. His extensive experience of advising fund managers makes Matthew Feargrieve a valued member of the boards of investment funds in various jurisdictions, on which he acts in a non-executive capacity. Before becoming an independent financial services consultant, Matthew worked for leading law firms in the UK and in Switzerland.

Find out more about Matthew Feargrieve here. Discover more business information about Matthew Feargrieve's Crunchbase page here. We love sharing what we do and we do this successfully through our twitter feeds. You can also follow Matthew Feargrieve's Twitter page to keep up to date with what's going on in the hedge fund industry.

Wealth management in Switzerland is evolving with investment fund solutions for private clients. Matthew Feargrieve explains why.

In addition to its primary characteristic as the jurisdiction of the choice for private banking, Switzerland is growing in significance as a centre of fund management. The country boasts around 15% of global assets under management, making it the third the largest global centre of asset management after North America and the United Kingdom. In this light, it is perhaps not surprising that there is a growing fusion between the traditionally separate spheres of bank-led wealth management and professional fund management.
The growing development of private investment funds (aka ‘private label funds’) by banks and family offices in Switzerland as alternative tools of wealth management are increasingly complementary to the more conventional techniques of wealth management which revolves around trust structures. Trusts and their manifold structural variations are the established tools of wealth planning, preservation, and consolidation. The trust provides the means of retaining control over the asset management ensures confidentiality of ownership, permits family advisers a degree of oversight and management of the assets, ring-fences assets from other asset classes and - perhaps most importantly - enables a bespoke, self-managed investment product delivering better value than arm’s-length products offered by professional managers.

There is a downside, however. The trust is effectively an Anglo-Saxon product, not widely or truly understood in nonEnglish speaking, civil law jurisdictions. A trust can be a highly complex creature that is not widely intelligible to clients or their professional advisers. The notion of surrendering control of assets to a third party is anathema to some clients. A trust entails the maintenance of salaried trustees, many of whom lack the legal and professional ability to carry out or oversee active management (as distinct from passive holding) of assets. And trust is quintessentially a very private creature, not capable of wider funding or investment.

Enter the private investment fund. The realization has dawned on banks, family offices and professional managers in Switzerland that the primary benefits conferred by the trust can be replicated, often at a lower cost and without compromising autonomy, confidentiality or tax integrity, by using a vanilla investment fund. The fund will be structured as a private company limited by redeemable, participating shares that will be held by the client or nominated family members. A special purpose management company, owned by the family office and staffed with trusted advisers, will frequently retain corporate control of the fund through a holding of voting, non-participating shares.

Assets are monetised or otherwise housed in the fund, thereby becoming ‘portfolio assets’ which are then actively managed. As the value of the portfolio assets fluctuates, so does the value of the participating shares, which will have a net asset value (assuming the portfolio assets are capable of a market-to-market valuation) or other book value. The management company, whether run by the family’s advisers or independent managers, may be paid a fee based on asset values and/or increments thereof. The product is typically indistinguishable, to the outside eye, from a professionally managed investment fund. The use by private clients of a private investment fund solution is influenced by the following additional drivers:

• Facilitates the client’s overall control of investment strategy
• Reserves to the client the power to remove and replace nonperforming investment managers and control their fees
• Avoids liquidity management and insolvency risks associated with arms-length investment products
• Enables pooling of discrete classes of family assets, and their division amongst family members
• Provides the means of opening the fund to outside investment, in order to grow assets and charge third-party investors commercial fees.

Banks and professional managers in Switzerland are increasingly being asked to implement this type of product for private clients, either in addition or as an alternative to the conventional suite of trust solutions. From the bank’s perspective, the structure is effectively a white-labeled product, being effectively owned and controlled by the family investors, bearing the name of their choice and serviced on an arms-length basis by the bank custody and administration units.

The ‘private label fund’ thereby opens up for banks revenue streams not typically available to them under traditional trust structures. Investment funds of this type are established predominantly in the Cayman Islands, as well as the British Virgin Islands and Bermuda, thanks largely to the tax neutrality and the breadth of seasoned professionals afforded by those jurisdictions. EU domiciles such as Luxembourg are increasing in popularity with European clients, but are generally less flexible and more costly than the traditional ‘offshore’ jurisdictions.

Check back for more.

Matthew Feargrieve is a qualified financial service lawyer in the UK, and as a commercial lawyer in the Cayman Islands and the Eastern Caribbean. Contact Matthew Feargrieve today with your questions about investments here. You can also access Matthew Feargrieve latest news story here.  More investing tips and how to avoid mistakes on Matthew Feargrieve's Facebook page here.

*The views expressed here are the author’s own.

In a world that professes itself chastened by the excesses of the pre-2007 era, transparency and liquidity is sacrosanct. Regulators and political bodies in the EU and US are responding to the new financial world with legislation that will circumscribe the freedoms previously enjoyed by banks and fund managers.

 The Alternative Investment Fund Managers Directive in the EU, and the HIRE Act and Frank-Dodd Bill in the US, all unprecedented pieces of wide financial reform, have serious implications for financial institutions on both sides of the Atlantic. Meanwhile, the economic outlook for the US and eurozone remain uncertain. Enter UCITS. The EU regime for Undertakings for Collective Investment in Transferable Securities has been around for years, but UCITS (or “Newcits”, to use the current, sensational sobriquet) are apparently what everyone now talks about over dinner.

The financial press is crammed with a comment about UCITS. Seminars are held to discuss UCITS. Fund managers launching UCITS products are hailed as pioneering visionaries. UCITS has been transformed from a boring retail brand to the vehicle of choice for managers pursuing the most “alternative” of investment strategies. The hyperbole shows no signs of abating.

According to Matthew Feargrieve, many professionals advising hedge fund managers on the choice of vehicle for their investment funds will have difficulty suppressing a groan when reading much of the excitable commentary about UCITS. True that UCITS is a brand that has attracted billions of investment. True that some hedge or “alternative” strategies can be replicated in UCITS. Here we take a contrarian view: the drawbacks of UCITS outweigh the merits. So, what of the UCITS upside? From a manager’s viewpoint, this can be summarised in a single word: distribution. Being an EU regulated investment product, UCITS can be sold throughout the EU to both institutional and retail investors. This automatic “passporting” is particularly attractive given the barriers to EU entry erected under the draft AIFM Directive. More importantly, UCITS facilitate capital raising by hedge fund managers in the EU, by opening up a previously verboten client base: retail investors.

From an investor’s viewpoint, the benefit of UCITS is found in the built-in protections that are normally associated with investments sold to widows and orphans. So a manager of a UCITS product must observe strict rules about liquidity and portfolio diversification. Direct borrowing is not permitted, only synthetic leverage achieved with derivatives. Similarly, physical short selling is not permitted (and naked shorting is totally out of the question); instead, the manager must use derivatives to replicate short exposure.

Leverage, shorting, derivatives; these are some of the key tools at the disposal of a hedge fund manager in the pursuit of the hedge holy grail: uncorrelated returns, or alpha. Restrictions and prohibitions on them bring us to the first serious downside of UCITS: lower investment returns. Achieving returns not correlated to any index is harder in a regime intended for long-only, retail products.

The impact on performance, compared to a similar non-UCITS hedge fund product, can be as much as 50 basis points per month. And here is the second drawback of UCITS: lower fees. Whilst good news for investors, a manager who is not achieving the kind of returns possible in a non-UCITS model will not be able to command the same level of fees. So, whilst the traditional “2 and 20” fee structure is theoretically possible in a UCITS, the reality is that a manager will be charging significantly lower fees.

The problem of lower returns and lower fees is compounded for investors and managers alike by the higher organizational costs involved. A UCITS with a vanilla equity long/short strategy can cost up to EUR100k to set up. A complex strategy, with the additional regulatory burden involved, can boost costs to EUR200k. The same strategy could be launched using the traditional offshore model (in The Cayman Islands, for example) at a significantly lower cost. Time to market becomes an issue for the manager keen to exploit market opportunity. A UCITS product conservatively takes 2 to 6 months to launch. Offshore, that time is dramatically reduced.

Ultimately, of course, UCITS is just one product in a universe of investment products. If investors and managers have an appetite for relatively lower returns, lower fees, and higher costs, then so be it. But what is worrying is that these drawbacks are accepted as the price of “better” regulation. The higher level of regulatory oversight is considered by many investors as a guarantee of the safety of a UCITS investment. The paradox is that the UCITS regime is in fact a relatively untested model for hedge or “alternative” investment strategies.

Whilst core alternative strategies like equity long/short, market neutral and absolute return is being replicated (at a higher cost) in the UCITS the framework, the prohibitions on shorting and restrictions on leverage, derivatives and other tools, combined with the liquidity requirement, mean that some core alternative strategies – those focused on commodities managed futures, distressed and fixed income arbitrage, for example - are difficult if not impossible to replicate.

This stems partly from the prohibition on investing in commodities or commodity derivatives, which are not sufficiently liquid to satisfy the UCITS requirements or which contravene the exclusion of physical assets. These restrictions are forcing managers to create or invest in indices which are regarded as the asset per se, and which reference the underlying physical assets or financial instruments, including traditional offshore hedge funds and other types of “risky” products. In this way the UCITS product becomes a “wrapper” for multiple underlying assets. This is a far cry from the retail, long-only product that UCITS was originally intended to be.

Managers and regulators alike are pushing the UCITS envelope. New UCITS regulation is pending to keep pace with this evolution. But the alternative, risky and potentially illiquid strategies are being forced into the UCITS model. The liquidity requirements will not protect retail investors in UCITS if some market risk materializes to render an investment illiquid, or difficult to value. Indeed, it is liquidity that will harm smaller investors if the institutional investors withdraw their money, and move the market with them. There is a growing feeling that a UCITS failure is likely. Such a failure could trigger the exodus of billions out of the brand. Here we make our final and most serious health warning.

 The regulators in the main UCITS jurisdictions, Ireland and Luxembourg, are relatively inexperienced in matters pertaining to hedge funds. A UCITS blowup of any size will severely test their ability to respond. And with 700 pieces of Madoff-related litigation eating up court time in Luxembourg, the capacity of the judicial the system there to deal with a large fund failure is questionable. Contrast the Cayman Islands, with thirty years of regulatory experience and a legal system underpinned by the courts in England.

Ultimately investors and managers will need to decide in whose the legal system they wish to place their trust. UCITS is not a tried-and-tested regime. Its continuing development will be driven by the needs of managers more than investors. Managers big enough to be able to absorb the higher costs of UCITS (like Brevan Howard, BlueCrest, Cheyne Capital and Jabre Capital, to name a few) will continue to use the model in addition to their existing offshore products, at least until the economic cycle improves and raising retail monies becomes less important.

The majority of managers will dip them toe in the UCITS waters by using distribution platforms set up by investment banks like Deutsche and Merrill Lynch. For the vast majority of hedge fund managers, UCITS will continue to be too expensive and too restrictive. This will forge a divergence (that has already begun) between managers of vanilla equity long/short strategies, who will seek to use UCITS, and managers of more complex, more truly “alternative” strategies, who will use offshore funds in the Cayman Islands and other leading offshore domiciles.

Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom,  Luxembourg, Ireland and the Cayman Islands. Read more about Matthew Feargrieve legal news here. You can also follow Matthew Feargrieve on twitter for more legal news and tips.