Buy-side Awards 2016
Switzerland-based bank UBS has created a new solution that allows hedge funds to trade commodities in daily liquidity Ucits funds – without the high leverage costs that are associated with many commodity Ucits currently sold on the market.
UBS has signed up three big commodity trading advisers (CTAs) to launch a Ucits version of their flagship funds: a €350 million ($372.6 million) fund that opened last year; a €100 million fund opened this year; and one that will launch by the end of 2016.
"The task as we've seen it is how can we come up with a solution that allows the manager to deliver its investment strategy pari passu to their flagship fund, but in a UCITS framework,'' says Henrik de Koning, head of hedge fund structured sales at UBS."
More and more hedge fund managers are considering Ucits to wrap their strategies in, including big European quant houses that have traditionally shunned the structure.
The problem they face is Ucits rules ban direct exposure to commodity futures. The traditional ways around this are to trade an approved diversified commodity index or enter into a swap with a counterparty holding the commodity, but both are beset by difficulties.
"Some managers who want to express a view on oil, for example, will use equities that are correlated to oil. You can imagine how many other factors enter into the equation and may influence the investment result, but we know quite a few macro managers doing that," says de Koning.
Swaps trading and tracking an index were ruled out respectively as expensive and a dilution of the trend-following strategy by one European quant fund, which saw the appeal of UBS's solution.
"If we are trading a commodity index that is rebalanced only on T-minus-one, [because] all the commodities have different opening times, by the time you set your trade, already you are trading into an index that has a different allocation," says a portfolio manager at the fund.
The fund manager routinely has to tinker with his strategy to comply with Ucits rules, a solution that investors show some reluctance towards. Quant funds may simply remove commodities from their trend-following funds.
Banks have formulated a workaround whereby Ucits funds hold notes issued from a special purpose vehicle (SPV) with a leveraged exposure to commodities. But such an approach leads to higher costs and leverage risks.
The task as we've seen it is how can we come up with a solution that allows the manager to deliver its investment strategy pari passu to their flagship fund, but in a Ucits framework
Henrik de Koning, UBS
"The problem is that the leverage does not come for free, and in the context of structured financial instrument approaches, a so called gap risk arises," de Koning says.
Strategies with 10% invested in commodity indexes that are 10 times levered, for instance, cannot lose more than 10%, as it would wipe out all the capital. This gap risk is borne by the prime broker, leading to additional costs.
Such extreme market moves are possible. "[It] could prevent the manager from benefiting from the eventual market rebound, and in any case would create a significant tracking error compared to the flagship fund," he adds.
Under UBS's schema, the Ucits fund buys notes linked to the performance of the hedge fund's commodity-trading flagship fund. The notes are issued by an SPV, such that the fund bears no UBS credit risk. This is similar to other banks' notes-based solutions to the same problem but the structure is free of gap risk – a feature which is unique to UBS's proposition.
This shaved the annual cost by 20–25 basis points for one buy-side firm, compared with commodity exposure via swaps. It also cut the tracking error with the client's flagship fund to almost zero, compared with 70–75bp annually due to a lack of flexibility in execution.
David McIntyre, investment manager at Edinburgh-based fund manager Baillie Gifford, is aware of other commodity Ucits using notes, but tends to be reluctant to invest in these because of their costs: "We see some strategies that use [note] certificates and various other ways of trying to make themselves Ucits-compliant, but that almost always comes with some sort of cost. The vehicles become much more expensive."
Since Basel III and its costs on prime brokerage, which has seen cuts to direct and synthetic financing to hedge funds across the sector, UBS has focused on selling services to multiple levels of the hedge fund business.
The bank says it offers among the broadest prime brokerage in terms of asset classes. A knowledge of their business allows it to offer loans to both established and start-up hedge funds. It also provides advice on regulation, operational setup, technology and capital introduction.
"UBS Group as a broader organisation is one of the few banks that can support a hedge fund... at fund level, management company level or individual hedge fund principals," says Richard Heyes, co-head of global financing services.
The week on Risk.net, December 2–8, 2017Receive this by email