New rules trigger explosion of funds

The advent of 130/30 funds boosts managers’ quest for alpha as shorting techniques enable them to express negative views with more conviction – and the range of products is set to widen in 2008.

This year saw an explosion of new products, partly prompted by Ucits III. As fund management companies have mastered the new powers that the directive allows, their product development teams have flexed their imaginations. And of course, as investors saw the sophistication and flexibility of funds increase, their expectations have been adjusted upwards.

So, many of the exciting new products brought to the market in the past year were distinctively Ucits III in flavour. Derivative usage for investment purposes was a theme, as was limited leveraging – the directive allows gross exposure up to 200% – and performance fees. In short, retail investors have for the first time been able to avail themselves of some of the characteristics associated with hedge funds.

Following an initial burst of activity in 2005 and 2006, the number of absolute return bond funds on offer continued to grow in 2007. But perhaps the biggest event of the year was the arrival, in some volume, of 130/30 funds. These products provide an elegant illustration of the appliance of Ucits III. They use some hedge fund techniques – namely shorting and leveraging. However, they are not absolute return vehicles; 130/30 portfolios are benchmarked against indices and aim to outperform them throughout the cycle. If they succeed, many will take a performance fee. So they are a premium product aiming for premium performance relative to traditional funds.

The key advantage of a 130/30 fund over its long-only stable-mate is that it incorporates short selling. This feature greatly expands the opportunity set available to the fund manager. To take the American market as an example, there are only 40 companies whose weighting in the benchmark S&P 500 index is more than 0.5%. This means that, for 460 stocks, the highest conviction a traditional fund manager can show in an unloved stock is to underweight it by a maximum of 0.5%. By introducing shorting, fund managers can express their negative views with more conviction, unlocking an additional source of alpha for investors.

Like many generic product names, “130/30” masks a range of approaches. As well as geographical diversity, quantitative and fundamental approaches are available. At the moment, there are more of the former than the latter but several of this year’s higher profile launches have been fundamental offerings, seeking to take a team of proven stockpickers and provide them with more flexibility to express their views. The number of managers developing and launching these strategies has led some commentators to call them a fad. However, the level of interest and debate merely reflects the newness of the product class – in 12 months’ time, 130/30 will be incorporated into fund ranges, investors will understand how to use the product and the noise will die down.

There has been more to 2007 than just 130/30 funds. Much lower profile but just as innovative and important was the arrival of “new balanced” funds. These have mainly targeted the institutional market so far, but there is nothing stopping them being marketed to retail investors. So, what is a new balanced fund? The premise is to take a traditional (or “old”) balanced fund of cash, equities and bonds and to augment it with other, relatively uncorrelated assets such as hedge funds, property and commodities.

Most new balanced funds operate as funds of funds outside Ucits III – they are so-called non-Ucits retail schemes (Nurs). In parallel with Ucits, the regulations governing these schemes were updated in 2007 such that they can employ derivatives for investment purposes and incorporate alternatives in their portfolios.

The arrival of new balanced funds was timely as it coincided with increased investor awareness of, and concern about, correlations between their investments. In this regard, the new balanced fund is an illustration of new regulations allowing fund providers to meet the shifting needs of demanding investors.

Other innovations were driven by the more basic mechanism of investor interest in far-flung markets. China was this year’s hottest market and many companies have sought to take advantage of the gradual opening of the market, together with its undoubted saleability, to launch funds.

But for all the mind-boggling statistics about China, there are more opportunities in other markets. Emerging market bond funds have long been available as niche offerings from a handful of companies, but the increased flexibility of Ucits III, together with positive change at the market fundamental level, has opened new avenues.

For example, the increasing credit worthiness of emerging market issuers (in many cases a by-product of the long bull market in commodities and the prudent usage of the resulting cash) means that many countries are no longer limited to dollars when issuing bonds. Incorporating local currency bonds into portfolios, and using derivatives to express further views on emerging currencies, creates additional sources of performance for the fund manager.

The result would be a product that should deliver the long-term total returns normally associated with emerging market debt, with an additional return from currency and improved flexibility to manage risk. There are some specialist skills involved in running such a product that would be beyond many providers. However, far-sighted houses have built the infrastructure to take advantage of the opportunities and new funds are in the pipeline.

So 2007 has been a vintage year for product development, but what are the signs for 2008? Investors are becoming more sophisticated and demanding, and this is leading the market to develop into separate strands providing lower-cost beta and higher-cost alpha. At the same time, regulations have been developed that allow fund managers greater flexibility, and many providers have stepped up to meet the challenge of using the Ucits III toolbox to match products with client needs.

As these trends continue to develop, the range of products available will become wider. Advisers and investors are likely to have plenty to get to grips with in 2008.

Celeste Dias – Head of product development at Threadneedle