Roland Meerdter on the challenge posed by Ucits III
This article was written by Angus Foote and published in Citywire Selector on September 1, 2006.
It will be the driving topic for the next couple of years, according to Roland Meerdter. The arrival of a whole new generation of funds is set to reshape the way in which fund selectors operate.
Meerdter believes the birth of this new generation will force serious changes in the way fund selectors evaluate and compare products. As Deutsche Bank’s head of global manager research, responsible for selecting the managers whose funds will be sold through all the arms of the Deutsche Bank network, he is well placed to assess the impact of these changes.
The dividing line between the sections of the investment industry labeled ‘traditional’ and ‘alternative’ is becoming increasingly blurred, Meerdter believes. A number of factors lie behind this but the most important is the changing regulatory environment – and Ucits III in particular.
‘The regulatory changes are forcing a dynamic expansion in the way funds are managed, sold and allocated in overall portfolios,’ Meerdter explains.
‘Innovative new fund products presenting opportunities for manufacturers, distributors and investors alike are being launched. The adoption of Ucits III is giving rise to the emergence of what I broadly label “next generation” funds.’
The latest version of the Ucits rules divides into two main parts: the management directive, which focuses mainly on the practicalities of cross-border marketing, and the product directive, which deals with the actual framework of the investment fund.
It is this second part that defines what type of instruments a fund is allowed to invest in. The aim is to provide a consistent, Europe-wide definition of what is acceptable within a retail fund. As with so many directives, there is still considerable variation in the way it is interpreted in different member states. While debate will continue about specific elements, as the legally binding version of the directive is incorporated into local legislation, the general direction of the changes is already clear.
‘With these changes, investment management companies are launching a full range of next generation funds with a variety of risk/return targets, investing in an array of newly available instruments and strategies,’ Meerdter says.
‘The full extent to which investment managers will utilize the greater range of flexibility and more robust toolbox is yet to be seen but already, in the past 12-18 months, the first wave of next generation funds have made their way to market. If these newly launched funds are an indication, Ucits III is making possible the separation of alpha and beta – and therefore “portable alpha” strategies, value-at-risk constructions and absolute-return strategies of a broad variety,’ he says.
Meerdter is seeing funds increasingly making use of currency strategies, leverage, indirect short selling (through the use of derivatives) and tactical asset allocation programmes. And there are strong indications that what has been launched so far is only the beginning of a long pipeline of innovative, next-generation funds.
‘Clearly, there will be a broad range of strategy types of funds launched under Ucits III,’ says Meerdter. ‘This will make the process of identifying, analysing and monitoring of next generation funds both increasingly important and resource demanding.’
In addition to funds taking full advantage of Ucits III, he points out, some investment managers are using portions of the expanded toolbox to modify an existing fund – sometimes only slightly, sometimes significantly.
‘One example is long-only equity funds using futures to increase or decrease net market exposure but otherwise running “traditional” strategies,’ he says. ‘So what I mean by next generation is not an all-or-nothing proposition. As this trend develops, there will be a full range of products across the alternative-traditional product spectrum – from those utilising the full range of the expanded toolbox to those using a narrower range to add incremental alpha or, conversely, to hedge specific risk in a more limited fashion.
‘New innovations, once popularized and accepted as useful, inevitably enter the mainstream. Just as the automobile was once an oddity among horses, what was once considered an alternative investment is increasingly becoming part of investors’ overall portfolios and accepted as mainstream.’
Ucits III, Meerdter says, provides some of the framework to begin bridging the divide. So what does this mean for the fund industry – and for fund selectors in particular?
Meerdter’s view is that the introduction of the more flexible regulations contained in Ucits III goes hand in hand with other developments across the investment management industry, including the launching of hedge funds by historically long-only mutual fund groups and the buyout of hedge-fund shops by those same long-only groups.
At the same time, we are seeing the launch of long-only products from hedge-fund providers. All this is allied to an increasing demand from investors for alternatives to mainstream investment opportunities, Meerdter says.
‘Alternative investments as a whole have been a central focus of investors in recent years – and rightfully so, as they present a unique set of opportunities including low correlation to other more traditional investments, diversification benefits, and additional opportunities to bolster performance and control risk,’ he says.
Increasingly sophisticated mutual funds created to take advantage of Ucits III will give investors access to instruments and portfolio management techniques that provide the benefits of low correlation with other assets.
Overall, investors will also gain access to a broader palette of investment opportunities, Meerdter believes, including a range of attractive risk/reward profiles including absolute-return strategies, as well as to the flexibility to make money in multi-directional market situations. Of course, there are also benefits for the providers.
Mutual funds, Meerdter points out, are increasingly using management plus performance-based fees. In particular, he says, it is foreseeable that in cases where limited capacity strategies are adding significant alpha the managers will have the power to charge significantly higher fees.
‘Going forward, it is my view that investment managers, either individual or team, with the benefit of changes under Ucits III, will increasingly manage multiple products across the range of the traditional-alternative spectrum,’ he says.
‘Effectively, investment management shops will seek to exploit a single research, portfolio management and trading platform to broaden their product ranges and fee potential.’
Broadening the product range does not just mean mutual funds or hedge funds but can also include insurance wrappers, structured products, segregated accounts, sources for alpha transport strategies and so on.
‘Clearly the limitations of the vehicle will limit the range of the strategies implemented, ’Meerdter says. ‘This is not a leap as we already see many examples of this “multi-wrapping” of strategies by investment managers. These strategies are implemented within the constraints of the vehicle and client mandate.’
As a consequence of these developments, promoters and distributors will need to look at the investment management industry in a much broader context. ‘From a research perspective, the key focus will need to be foremost on the investment manager and secondly on the strategies available and lastly the vehicle through which it is implemented,’ Meerdter stresses.
‘The liberalisation of opportunities for mutual funds under Ucits III will have implications for the relative relationship of the two seemingly distant cousins with the same last name: hedge and mutual funds.
‘While the two types of vehicles are arguably quite different in terms of target audience, degrees of flexibility and approach, it is an increasingly common view that these cousins will meet more often at family get-togethers.’
It is fair to ask whether the managers of these products will be able to effectively implement the new flexibility to produce results. There is a view in some quarters that the skills, techniques and knowledge used to manage so-called traditional and alternative strategies are irreconcilably different and non-transferable.
Meerdter acknowledges that some of the experience and expertise developed by hedge-fund organisations is unique. In recent years the picture has been further complicated as higher fee structures and greater investment freedom have attracted many talented long-only managers into the hedge-fund sector.
But Meerdter is already looking at the bigger picture and provides a succinct summary of what he sees: ‘What differentiates managers of hedge funds from other investment managers is not that they are fundamentally smarter or more talented.
‘The key distinction is that they are better able to implement their specific market views given the unconstrained vehicle and environment in which they manage money. Ucits III removes some of the constraints investment managers previously observed in managing mutual funds. Their ultimate role and level of success is yet to be seen. But, it is clear that these next generation funds are beginning to reshape the potential of the mutual fund vehicle and bridge the divide between traditional and alternative strategies.’