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14 September 2015

VoxEU: Regulation and fund performance - New evidence from UCITS hedge funds

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In the aftermath of the Global Crisis, there have been many regulatory initiatives targeting financial institutions, especially investment funds. This column sheds light on the costs and benefits of increased financial regulation.

One type of initiative relates to the regulation of investment funds, in particular, the push towards more tightly regulated and liquid alternative funds and away from lightly regulated offshore alternative investment funds. However, relatively little research has been carried out quantifying the effect of regulatory constraints, such as liquidity requirements, on fund performance. This is surprising since tightly regulated onshore funds are the main access route for savers – be it as retail investors or through their pension funds – to alternative investment strategies which, according to their proponents, offer diversification benefits and superior risk-adjusted returns. In an era of historically low bond yields and widespread underfunded pension plans, it is important for savers and policymakers to understand whether such liquid alternative funds potentially offer solutions to the problems faced by savers or whether onerous regulation erodes away any return advantage that such investments may, in principle, have over traditional assets.

Although in 2009 there were calls by the G20 (an international finance minister and central bank governor forum) for coordinated international financial regulation, regulation continues to vary widely by country. With regard to alternative investment funds, regulatory responses – for example, the US Dodd–Frank Act and the European Union’s AIFMD – also display significant geographic differences with regard to liquidity requirements, risk limits, and remuneration rules. In Europe, access to alternative funds is possible via the so-called UCITS fund format, while the American version of the European ‘hedge-fund lite’ UCITS funds are liquid alternative funds registered under the Investment Company Act of 1940.

Authors study sheds light on the debate over the costs and benefits of increased financial regulation. Given that such regulation is intended to protect investors, one of authors’main contributions to this debate is quantifying the cost of regulation and liquidity requirements. Estimates based on their data show that the indirect cost of UCITS regulation is around 2% per annum in terms of risk-adjusted returns.

Because there is evidence of a substantial liquidity premium in alternative investment funds, policymakers should carefully consider the effect of higher liquidity requirements on the returns that alternative investment funds can be expected to generate.

And since institutional investors (e.g., pension funds) are one of the largest groups of hedge fund investors, such requirements ultimately affect the growth of pension assets in Europe and other countries where ARU funds can be marketed. Similarly, the lack of performance persistence among ARUs should caution retail and institutional hedge fund investors against ‘returns chasing’.

Full article on Vox EU


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