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FT.com: New Products Make Use of UCITS Powers

Steve Johnson, Financial Times, 12 March 2007

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Asset managers have so far failed to utilise the full range of power afforded to them under the European Union's Ucits III regime. But there are indications that this could be about to change.

Asset managers have so far failed to utilise the full range of power afforded to them under the European Union's Ucits III regime. But there are indications that this could be about to change. Ucits III, introduced in 2004, afforded fund managers the power to use derivatives in a bid to add value to their portfolios. Previously, derivatives such as put and call options could only be used as risk reduction tools. So far, the impact of Ucits III has been more evolutionary than revolutionary. A number of long-only equity managers have made limited use of their new powers by employing index options in an attempt to improve their risk/return trade-offs. A swathe of investment houses have taken this a step further by rolling out 130/30-type funds, which allow fund managers to build modest short positions in individual stocks. However, in a more radical departure, a number of new, entirely derivatives-based products are starting to come out of the woodwork. ABN Amro launched its first pure derivatives, Ucits III-compliant, UK-domiciled open-ended investment company a week ago. Several more are in the pipeline. Courtiers Investment Services, a Henley-based boutique fund manager, also chose last week to launch a suite of derivatives-based funds aimed at high net worth retail investors and small to medium-sized institutions. Crédit Agricole has pioneered the trend in France, while Dresdner Kleinwort, aided by Germany's long-standing love of structured products, has dipped its toes into the UK market with a Ucits III-compliant volatility arbitrage fund, as well as a range of capital protected offerings. "I think there will be other products like this that come along," says Gary Reynolds, chief investment officer of Courtiers. "The Financial Services Authority was very comfortable with these products, they were very helpful." The developments promise to narrow further the divide between the once long-only world of unit trusts and Oeics and the racier hedge fund universe. "There will be a convergence between long-only funds and hedge funds as they move towards each other," says Bella Ferreira, senior market analyst at Feri Fund Market Information, which monitors new fund launches. ABN's first offering is its Defined Alpha 20 fund, which aims to exploit the historic divergence between implied and realised volatility on New York's S&P 500 index. It mirrors Merrill Lynch's recently unveiled Equity Volatility Arbitrage Index, the first low-cost-single-strategy hedge fund replication index developed by the US bank. While the timing of ABN's launch was unfortunate - the recent sell-off in global equity markets means realised volatility is likely to exceed implied volatility this month, meaning a loss for the fund - its creators are optimistic for the longer term. Mike Egerton, director of private investor products at ABN, who has tested the investment thesis over the past 15 years, says: "The strategy has been down in only 24 of the past 180 months, although this will be the 25th. While this month has been the toughest since January 1990 the fund should really perform in the following period.It really is a case of what doesn't kill you can only make you stronger." The Defined Alpha fund is a structured product, with month-on-month losses limited to 20 per cent. While this may seem surprising given that a recent study by ABN and the London Business School concluded that structuring products through derivatives tends to worsen the risk/return trade-off, the Dutch bank says this at least proves it has effective Chinese walls between divisions. ABN's own data point to average returns of 20.7 per cent since 1992, with a highly impressive Sharpe ratio, a measure of the risk/return trade-off, of 3.2. The fund is initially aimed at institutional investors, such as private banks, wealth managers and private client stockbrokers, and has a minimum contribution of £500,000 ($964,000, €735,000). A retail version is planned for later in the year as ABN seeks to exploit further the Ucits III regime to launch new derivatives. A capital-protected, rules-based call-overwriting fund, which sacrifices some potential capital gains for generating additional income, may be next, and ABN is also looking at catastrophe bonds. Courtiers' response to the new-found freedoms embodied in Ucits III is perhaps even more dramatic. Launched in 1984, Courtiers had largely been operating a multi-manager platform for its roster of private clients, small pension funds and charities, making decisions on asset allocation and then parcelling out cash between long-only funds. Now, instead of allocating this discretionary money between actively managed funds, it will simply generate exposure to underlying assets through the use of derivatives. "We have got approval to put all of our portfolio in derivatives," says Courtiers' Mr Reynolds. "This is efficient in terms of cost, tax and liquidity. We think it will take about 100 basis points off the costs." For example, Mr Reynolds estimates it will cost about £150 to get exposure to £6m worth of UK equities via options, with the bid/offer spread accounting for a further £250. In contrast, a fund buying the shares outright would have to pay tax of £30,000 alone. For full article click here.

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