In October 2007 further investment strategy opportunities became available to Irish-domiciled Undertakings for Collective Investment in Transferable Securities (Ucits) funds, when the Irish Financial Regulator issued a revised guidance note clarifying that Ucits will now be permitted to enter into physical short selling arrangements.
Before this policy change, Irish Ucits were only permitted to engage in synthetic short selling through the use of derivatives. The Financial Regulator’s revised policy provides a framework for the establishment of 130/30 funds as Ucits in Ireland.
Short selling, in broad terms, refers to the sale of a security the seller does not own. Investment funds may wish to use this strategy where the fund manager expects the price of the security in question to decline.
In summary, the fund will initially agree to sell a security. Before the date on which it has committed to deliver it, it will seek to purchase the security at a lower price than that at which it has agreed to sell it. The profit is made on the difference between the higher price at which it was agreed to sell and the lower price at which it subsequently purchased the security.
Physical short selling
Physical short selling involves the actual sale of the security, and it may be covered or uncovered. An uncovered short sale is where the fund, for example, has no right to the security at the time of agreeing to its sale. A covered sale is where the security is borrowed from another party and is then sold on in the belief that when the time comes to return the security it will be possible to purchase it more cheaply.
Synthetic short selling
In synthetic short selling, the security is not actually sold. A share position is created through financial derivative instruments that create an exposure to the price of the security, rather than the actual sale of the security.
130/30 funds are so called because on the one hand they replicate traditional long-only funds by compiling their portfolio as normal, allocating 100 per cent of net asset value to long positions, while also short selling securities to the value of 30 per cent of net asset value. The proceeds from the short sale will contribute towards the acquisition of further long positions, bringing the total exposure to 130 per cent long and 30 per cent short. The strategy is designed to give full exposure to any securities which the fund manager expects to increase in value, while allowing the fund manager to simultaneously short sell securities it believes are going to fall in value.130/30 funds have grown in popularity in the past five years, particularly in the US, with much of the demand coming from sophisticated investors and other institutions. However, a Ucits 130/30 allows the alternative fund manager to market to retail investors or institutional investors such as pension funds, which were previously averse to investing in hedge funds.
The name 130/30 may be misleading as these funds can be structured with a range of ratios for the long/short positions, therefore allowing such other combinations, but it is generally agreed that the 130/30 label is more of a generic term. The level of securities sold short can be as low as 5 per cent, creating a 105/5 fund, or as high as 50 per cent, creating a 150/50 fund.
The revised policy
The Irish Ucits regulations, in compliance with Article 42 of the Ucits Directive, prohibit Ucits from carrying out uncovered short sales. In applying this concept, prior to the policy change the Financial Regulator prohibited Ucits from engaging in physical short selling, confining exposure under a short selling strategy to synthetic short selling.
In applying this strategy, the Ucits was restricted by the requirements to limit its overall exposure to 100 per cent of its net assets. The question that the Financial Regulator then faced was whether borrowing a security in advance of a physical short sale would satisfy the requirement for short sales to be ‘covered’.
The essence of the new policy is that the Financial Regulator has accepted that a short position can be covered through a stock borrowing arrangement, clearing the way for Ucits to engage in physical short selling.
As a result, the Financial Regulator will now permit Ucits to engage in physical short selling strategies provided that:
• general leverage limits are not exceeded;
• leverage generated, as measured by global exposure, falls within permitted limits;
• the strategy is subject to the submission of a risk-management process in accordance with the requirements of guidance note 3/03, (Ucits – Financial Derivatives Instruments), in particular in relation to the calculation of global exposure;
• as part of this submission, the Ucits must demonstrate expertise and prior experience in relation to the use of short selling strategies; and
• the strategy is appropriately disclosed in the prospectus of the fund.
A Ucits intending to engage in physical short selling will be required to include the following disclosures in its prospectus:
• a clear description of the covered short sale strategy, including the stock borrowing arrangement;
• a statement, under risk factors, to the effect that shorting involves the risk or a theoretically unlimited increase in the market price of the short security positions and therefore the risk of unlimited loss;
• a statement to the effect that leverage is expected to be generated and an indication of the level of such leverage; and
• a statement that leverage will be measured in accordance with the requirements of the Financial Regulator and will be added to any exposure created through the use of financial derivative instruments.
There is currently a lot of interest from asset managers in this new opportunity afforded to Ucits funds. The combination of increased alpha and robust risk controls is particularly attractive to institutional investors and pension funds, with the possibility of offering such a product to retail investors also generating great interest.
The Financial Regulator’s willingness to work with the industry in Ireland to meet product demand must, once again, be commended. This, together with Ireland’s established reputation as a centre of excellence for servicing both long-only and hedge funds, forms a strong basis for the development of this product as an Irish-domiciled fund.
Fionán Breathnach is head of the investment funds unit at Mason Hayes & Curran