The Use of Derivatives by UCITS:

The Importance of Valuation and Risk Management

WHITE PAPER
The Use of Derivatives by UCITS
TABLE OF CONTENTS
Introduction: Rise of Sophisticated UCITS Funds ................................
1
Valuations: Making the Cut .....................................................................
2
Valuations and Risk Management Requirements ................................
2
Conclusions: Positioning For the Future .............................................
3
The Use of Derivatives by UCITS
INTRODUCTION
RISE OF SOPHISTICATED UCITS FUNDS
Financial derivative instruments, (including OTC derivatives) have been eligible
for use in Undertakings for Collective Investments in Transferable Securities
(UCITS) funds for investment purposes since the introduction of the UCITS
III product directive in 2001. This expanded investment power has given
rise to a growing interest in a new breed of funds. Called by many names,
Sophisticated funds, New-cits, or Hedge fund-lites, UCITS III paved the
way for the convergence between hedge fund strategies and UCITS.
If these funds have been around for nearly a decade why the interest now?
The widespread loss of investor condence arising from the liquidity crisis,
credit crisis, and revelations of Ponzi schemes has created a renewed demand
for investor assurances from investment vehicles. UCITS is a branding of
assurance via compliance measures.
For hedge funds, the post-crisis anticipation of higher regulation combined
with newly understood advantages for acquiring new investors are driving
the popularity of the UCITS vehicle. Sophisticated UCITS can use both
regulated and over-the-counter (OTC) derivatives, including exposures to
commodities, nancial indices, credit default swaps (CDS), total return swaps
and even hedge fund indices. Add to this the wide regulatory acceptance in
many jurisdictions (EU, Asia and Latin America) UCITS provide an attractive
vehicle indeed for accumulating funds under management to earn Alpha and
management fees.
What does all this mean for traditional asset managers the original players
in this domain? Competition is set to increase and innovation will be critical to
remain competitive.
For traditional asset managers and hedge funds, meeting the strictures of
a UCITS structure will be key to reaching a broader investor base, both
institutional and retail.
There is a learning curve involved in taking these products forward to take full
advantage of allowable derivatives under UCITS III. Hedge funds must adhere
to new transparency practices while traditional asset managers will need to
step out of their comfort zones and learn to innovate with derivatives. Critical
to this learning curve is the application of the independent valuation and risk
management compliance guidelines in UCITS III as well as the ability to quickly
adapt to changes in the investment climate.
1
UCITS III paved the way for the
convergence between hedge fund
strategies and UCITS.
Meeting the strictures of a UCITS
structure will be key to reaching a
broader investor base.
The Use of Derivatives by UCITS
VALUATIONS:
MAkINg THE CUT
On an operational basis, the most prominent requirement of achieving and
maintaining compliance as a UCITS fund is the frequent valuation of assets. In
sophisticated funds, where there is more frequent and complex use of deriva-
tives in portfolios, this adds an extra layer of complexity.

UCITS are compelled to be more transparent than hedge funds. They must
observe strictly reliable valuations of all their derivatives not only for invest-
ment management reasons, but also for disclosure to maintain UCITS status.
This means their valuation tools must not only cover the derivatives landscape
broadly but also be transparent enough to withstand scrutiny by regulatory
bodies and auditors.

The introduction of third-party valuation tools or services can contribute to the
independence and therefore credibility of valuations. While accuracy is impor-
tant, independence and transparency are more germane to UCITS compliance.
Independent valuations are less biased than self-generated valuation. Transpar-
ently produced valuations are more easily veried than valuations produced by
opaque or proprietary means.
VALUATIONS AND RISk MANAgEMENT REqUIREMENTS
The valuations produced by the UCITS risk management practice must remain
as independent as possible from the investment managers valuations. This is
especially relevant with over-the-counter (OTC) derivatives which require the
use of models combined with observable data.
Sophisticated UCITS measure their global exposure using approved
methodologies such as Value at Risk (VaR), combined with stress-testing and
back-testing. Both of these exercises require a reliable valuation process
and supporting tools. Conditions such as keeping derivatives counterparty
concentrations to less than 10% require active monitoring of derivative
positions. Again, the tools that support these risk calculations must be widely
accepted and transparent.
Indeed, expanding the investor base for a UCITS to those who seek explicit
assurances of protection means proactively making risk measures available for
examination. Transparency is a core part of the product being offered, not an
optional feature. Risk management must abide by this philosophy.
Where counterparty credit risks must be taken into account, there can be
disagreement between an independent valuation by a risk manager and the
valuation preferred by an investment manager. The valuations produced by risk
management must prevail through independence and superior transparency,
supported by tools and methods that will withstand regulatory and audit
scrutiny. As valuations and published risk measures converge to certain best
2
Valuation tools must not only
cover the derivatives landscape
broadly but also be transparent
enough to withstand scrutiny.
Transparency is a core part of
the product being offered, not an
optional feature.
The Use of Derivatives by UCITS
practices, these tools may eventually become recognizable to investors,
perhaps even by brand name.
The risk management framework for a sophisticated UCITS must remain
strongly independent, consistent, and documented. Furthermore the fund must
be able to provide fund risk measures to the board of directors, investors and
regulatory agencies on demand. Investor protection and the continuing
benets of UCITS status depend on it. Proven valuation tools from a known
provider are required to do this. In addition, risk management must be able to
explain risk mitigations, which may include sensitivity and scenario analysis.
CONCLUSIONS:
POSITIONINg FOR THE FUTURE
There is already a wide variety of nancial derivatives in use within UCITS. As
investment climates change, investment managers must adapt. Adaptation
may require using derivatives not used before. Therefore, the selected valuation
and risk measurement tools must be subject to a criterion of extensibility,
meaning they must already cover or expand to cover the derivative classes
the fund could potentially use in the future. A limited toolset can put both the
strategic investment and the operational valuation capabilities of a UCITS fund
at risk, and therefore the overall transparency of the fund at risk.
Speculatively, UCITS IV (targeted for July 2011) will introduce cross-border
distribution advantages and centralized product delivery conditions that
will encourage larger investment pools. This will in turn, up to the ante for
ready and robust daily derivative valuations risk management solutions for
sophisticated UCITS. Those ahead of the learning curve will be poised for
success and will surely gain the rst movers advantage.
3
Risk management must be able
to explain risk mitigations, which
may include sensitivity and
scenario analysis.
A limited toolset can put both
the strategic investment and the
operational valuation capabilities
of a UCITS fund at risk.
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