The Alternative Investment Management Association has issued a new guide concerning the development and management of liquid alternative funds.
Such funds are a growing part of the alternatives world. According to K&L Gates, in 2014 the total assets under management of alternative UCITs’ alone were €260 billion, which implies a 37% increase over the AUM of one year before.
The AIMA guide deals with a number of issues centered on two specific formats: a UCITs fund in Europe and a mutual fund registered under the Investment Company Act of 1940 in the U.S. These issues include practical management considerations, regulatory and tax developments, and the peculiarities of some of the common domiciles, especially famous fund hubs Luxembourg and Ireland.
Inglis’ View
“Investment managers that are used to the regulatory environment of private funds should expect to face new operational and regulatory challenges in a liquid alternative fund,” said Jack Inglis, AIMA’s chief executive, in a statement issued with the guide. But, Inglis added, the challenges come with “significant new growth opportunities at a time when many individual investors, pension funds and other institutional investors are looking for ways to increase the liquidity and risk-adjusted performance of their portfolios.”
The guide, sponsored by JP Morgan and KPMG LLP, is the product of a working group of AIMA member firms on the Sound Practices Committee of AIMA.
Its executive summary begins with these two percentages: 26 and 15.
That is: according to a recent survey of fund managers, 26% of respondents expect to develop at least one alternative UCITS within the next five years. Fifteen percent expect to develop an alternative mutual fund within that period. That adds up to a strong impetus for the continued expansion of the industry.
One of the most often mentioned drawback of hedge funds as classically conceived is precisely their illiquidity. As Bob Swarup explained at this site almost four years ago, investors “increasingly want the ability to recover their money at short notice, particularly if there are any unexpected downturns.”
Most AMFs, and most UITS as well, offer their investors daily liquidity. Further, the pertinent laws limit exit hurdles such as suspensions or gates.
Greater Restrictions over Time
The only way a system can guarantee a fund’s investors liquidity in this way is by ensuring liquidity in the same fund’s underlying assets as well. This is a big part of the reason why these Liquid Alts are as highly regulated as they are: authorities limit the kind of assets in which they can invest, the amount of leverage they are allowed, and their derivative use.
In fact, regulators are getting more restrictive on these fronts over time. On September 22, 2015, the U.S. SEC proposed rules that would require mutual funds to “enhance effective liquidity risk management” and disclosures on liquidity and redemption policy. Part of this involved the codification of a [til now informal] 15% limit on illiquid assets, and the creation of a three-day liquid asset minimum.
If a hedge fund manager accustomed to a less regulated system (and its illiquidity at both ends) has on the blackboard a liquid product, it needs to “evaluate whether [its] strategy is suitable for a UCITS or an AMF format, and whether it can maintain an investment portfolio with sufficient liquid assets to meet the stringent liquidity requirements that exist” under those regimes, the new guide cautions.
Aside from that, there is the market reality that a manager in that position, running hedge funds and considering liquid products, also has to worry about whether it is going to cannibalize itself, or whether there are going to be conflicts of interest “in critical areas such as valuation and the allocation and timing of trades.”
Nonetheless, AIMA says confidently that most alternative strategies can be implemented under a UCITS or an AMF regime.
As a related point, the manager has to understand that a liquid alt fund “will require an enhancement of the fund’s compliance and operational superstructure.” Fortunately, it won’t have to work from scratch here, they’ll simply have to beef up what they have in place to work with the SEC, CFTC, and/or AIFMD regulations with which they must already in a particular instance cope.