Interview with Bryn Sandison, Aurum Research Limited

Bryn SandisonBryn Sandison currently heads Aurum Research Limited’s (“Aurum”) operational due diligence function, having joined the firm in 2007. Bryn began his career at PwC auditing investment fund vehicles, later moving to PwC USA to work on developing the firm’s approach to risk analytics. Aurum has been advising a range of fund of hedge funds for over 21 years and, more recently, has been focusing on the Alt UCITS space. You recently voiced concerns that investors trust the UCITS brand too much. What problems do you see when investors make their investment decisions?
Bryn Sandison: Aurum’s long history of analysing hedge fund solutions has meant that we‘ve learnt through experience to spot the pitfalls behind operational risk.  We demand high standards of underlying managers if they are to be the stewards of our investors’ capital. Aurum was an early adopter in creating a dedicated operational due diligence function, whereas many competitors were late to the game, setting up operational due diligence as a reaction the losses of Madoff and the Lehman bankruptcy, which highlighted the importance of operational due diligence. Since 2014 Aurum has been applying its sceptical lens to the Alt UCITS space. Whilst many great managers exist, we have unearthed several serious malpractices at individual fund level, and some elements of wider ‘grey‘ area industry malpractice. Malpractice by individual funds is a serious problem – but equally serious is the sheer lack of operational due diligence effort which many institutional investors apply to Alt UCITS.  Many investors presume that the protections and rules put in place to regulate UCITS provides an exemption from performing operational due diligence. Aurum believes such a casual approach to operational oversight represents a serious lacking of fiduciary responsibility by investors.  Yes, rules exist and have been put in place to protect investors – but this does not mean that some managers do not seek to subvert rules or their intent. Using an analogy, a zebra crossing gives pedestrians the right to cross the road and requires cars to give way to pedestrians – but do you step blindly into the road, placing faith in the ‘rules‘? No – you pause and look for any madmen careering toward the crossing.  Being right is small recompense if you are lying in a hospital bed. Regulators have put rules in place, but you simply cannot trust everyone to play by the rules. As institutional practitioners we have a duty to uphold the specifics and the intent of the UCITS directives and a responsibility for the future development of the space. What issues have you come across yourself doing due diligence in UCITS alternative funds?
Sandison: Where do I begin? Aurum has evidenced all cornerstone elements of the UCITS brand ‘protection’ being compromised within the Alt UCITS space, namely portfolio transparency, liquidity, fee transparency, custody, track record validity and risk management activity. Whilst Alt UCITS has attracted some great managers to set up funds, the operational complexity, compared to vanilla UCITS products, has dramatically increased. Many institutional investors have sleepwalked from a position of comfort with more vanilla UCITS offerings to incorrectly assuming that the same comforts and transparency exist in the Alt UCITS world. In particular, many Alt UCITS funds structure themselves under single total return swap (“TRS”) wrappers.  This adds levels of complexity which demand more detailed due diligence. The advantage of this is that these TRS structures have allowed many good managers to efficiently implement their strategy under a UCITS framework. The flipside of this, however, is that as fiduciaries we need to pay particular attention to underlying economics in order to identify and understand hidden fee structures and portfolio transparency, amongst other potential conflicts. So far – at least to our knowledge – none of the UCITS alternative funds ever has imposed gates. Although imposing gates under UCITS is limited do you expect funds in the near future having to impose such gates and what impact will it have on the UCITS brand?
Sandison: Whilst we will hopefully never have a situation like 2008 again where many in the hedge fund industry suspended/gated/side-pocketed large chunks of their portfolio, the presumption of liquidity within Alt UCITS, can come at a cost and this cost will be seen where pricing gaps down. Liquidity exits will be available, but at what cost? We have, on occasion, seen strategies shoehorned in to UCITS funds where liquidity assumptions and oversight are concerning, notably converts/high yield/long only EM/small caps strategies. With UCITS V to be implemented soon the safekeeping of assets will become a bigger topic. Will this make operational due diligence easier as investors will be protected more by law? 
Sandison: In theory UCITS V should mean safekeeping becomes less of a topic of interest to operational due diligence practitioners, with greater accountability over depositaries and safe custody rights conferred to investors. UCITS V will bring consistency across the disparate rules currently in place across the various EU member states. That said, beware the unintended consequences of the ‘greater protections’. Such ‘protections’ may well come at a cost, through additional fees and investment restrictions applied by custodians. Depending on the jurisdiction some local laws will still require sub-custody arrangements – albeit with the UCITS custodian remaining on the hook for losses from these delegated relationships. Somewhat nonsensically, this means that UCITS investors obtain better protections from custodians than direct investors who, in some jurisdictions, would also require sub-custody. Custodians will look to compensate themselves for absorbing these additional responsibilities, or seek to restrict investment managers’ ability to conduct their strategies; ultimately to the detriment of end returns. Thank you for the interview.