The current rush of hedge fund managers to use the Ucits III structure will ultimately disrupt fund returns, argues Robin Bowie, chairman of London-based fund-of-hedge-fund group Dexion Capital.

The flow of hedge-fund investors into the highly regulated Ucits III fund structure is set to become a flood. In March, French business school Edhec surveyed 437 members of the global asset-management community, including investors, managers and distributors, with combined assets under management of over €13 trillion.

Of these, 92% reported "a trend towards packaging HF strategies as Ucits". Half of insurance companies surveyed said it was very likely that they would ask promoters and managers to restructure. Among hedge funds, 65% reported that they planned to restructure their funds as Ucits; only 25% said they did not.

Investors are not only concentrated in Europe, where Ucits was introduced to provide a template for retail fund distribution across the European Union. Asian investors have for many years been attracted by the Ucits structure as an EU kite mark. Like their European - and even some North American - peers, they are attracted by the four pillars of operational security, transparency, diversified investment strategies and guaranteed liquidity.

The problem is that returns are being limited by precisely those factors that protect investors - namely, limiting the concentration of assets, imposing tough operational standards around custody and reporting to shut out fraudulent practices, and requiring minimum levels of asset liquidity to protect client redemptions.

"When you provide liquidity on a daily basis (the Ucits minimum requirement is redemptions every two weeks), you don't align the interests of the managers with those of the investors," says Bowie. "While there is more capacity in the equity long/short and commodity trading adviser space, where the strategies are not suited to this level of liquidity, imposing it results in poor returns."

Less liquid strategies, such as convertible bond arbitrage funds, or those that use highly concentrated asset allocation or high degrees of leverage, such as event-driven, have their hands tied by the requirements of a Ucits III wrapper. The respondents to the Edhec survey echo Bowie's concerns; 69% reported that "the liquidity premium of hedge-fund strategies will disappear and that performance will fall" under the trend to Ucits III.

"The overpricing of liquidity is one of the things that has led to the disappointing returns in the first half of the year in hedge funds, as in other asset classes," says Bowie.

Hedge-fund investors are still smarting from the liquidity crunch they were caught in last year as managers unable to sell assets without sustaining huge losses via imposed gates on redemptions. Funds of funds were hit especially hard, as they were forced to sell well-performing assets to meet investor redemptions.

Dexion Capital tries to provide high returns without sacrificing liquidity by offering closed-end fund structures. Underlying funds invest in illiquid assets and fund units are traded as shares. Funds of closed-end funds can suffer from a discount of share value to net asset value of the fund, but the manager can compensate partially through share buybacks. Dexion's closed-end strategy has accounted for 40% of total buybacks of underlying shares since January 2009.

Bowie reports that demand is increasing for structures that combine exposure to illiquid investment opportunities with regular daily dealing. As market-maker, Dexion Capital has just completed a sizeable, but still undisclosed, new launch for SeaCrest Investment Management, a New York-based manager specialising in sovereign and emerging-market debt.