Trends shaping Ireland’s hedge funds market

Other factors, including scrutiny of fund fees and costs, and recent macroprudential developments, are also set to shape the future development of the market.

Sustainable investing

Over the past 12 months, hedge fund managers have responded to growing investor appetite for sustainable investments. Consequently, many managers have set up hedge funds to promote sustainable investments, or alternatively, managers have upgraded their funds to so-called Article 8 or Article 9 funds, for the purposes of the Sustainable Finance Disclosure Regulation (SFDR). The statistics published by Central Bank of Ireland (Central Bank) emphasise this trend, revealing that out of a total 265 funds it authorised for the 12-month period ending June 2023, 134, or 50.5%, of those funds were Article 8 or Article 9 funds.

Varying themes in relation to sustainable investments are generally offered by larger hedge fund managers, such as sustainable funds focusing on investing in companies that have low carbon intensity and are aligned to the Paris Agreement climate change goal, exchange-traded funds (ETFs) and index tracking funds that track sustainable indices, or more thematic investment strategies like sustainable water and waste strategies, sustainable technology funds, or sustainable infrastructure investments.

The growth of sustainable investing has required hedge fund managers to expend resources in developing an effective sustainable investment function, usually within the investment team, that is responsible for integrating sustainable investment strategies in the assessment and appraisal of investment portfolios. The integration of sustainable investment strategies in the investment appraisal process is challenging for hedge fund managers, with main obstacles relating to the quality and availability of ESG data and the subjectivity of sustainability assessments.

The area of sustainable investing will be a continuing focus for EU regulatory authorities.

In July 2023, the European Securities and Markets Authority (ESMA) launched a common supervisory action (CSA) on the integration of sustainability and risk disclosures. The purpose of the CSA is to examine how managers are complying with SFDR and the Taxonomy Regulation, gather information on greenwashing risks, and identify if further supervisory intervention is required to enhance compliance with SFDR or tackle risks of greenwashing.

In Ireland, the Central Bank has also informed the funds industry that it will review fund compliance with SFDR disclosure requirements, and to mitigate the risks of greenwashing, it will give specific attention to Article 8 funds promoting environmental or social characteristics that have a low proportion of their portfolio invested in sustainable investments.

Having developed a framework for transparency for managers and their funds regarding sustainable investing, it is apparent that over the next 18 months, EU regulators will focus their attention on supervising how managers integrate sustainable investing practices in their investment process and compliance with the disclosure requirements under SFDR.

Fund fees and costs

European regulatory authorities are currently focusing on the requirement for Undertakings for the Collective Investment in Transferable Securities (UCITS) managers to prevent funds being charged undue costs, which has required managers to assess costs and fees, and implement pricing policies to enable the transparent identification and quantification of all costs charged to funds.

The background to the current regulatory scrutiny is the launch of ESMA’s CSA on the supervision of costs and fees of UCITS, which has encouraged European regulators to review the costs and fees charged to UCITS. Pursuant to the CSA, regulators such as the Central Bank in Ireland and the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg have identified the actions UCITS managers should undertake to prevent funds being charged undue costs, and require UCITS managers to put in place action plans to ensure that appropriate governance structures are implemented.

In a letter to UCITS managers, the Central Bank advised managers to:

• implement documented pricing policies and processes to ensure that costs and fees are calculated in a fair and equitable manner, serving the best interests of investors;
• review fund fees and costs on an annual basis;
• adopt policies and procedures to ensure that all revenue, net of operational costs, in relation to securities lending and efficient portfolio management techniques is returned to the fund;
• if a manager operates a fixed operating expense (FOE) model, calibrate the FOE model to minimise the differential between the fund’s actual fixed operating expenses and expenses under the model, so that undue costs are not charged to investors.

The Central Bank expects that its comments, although directed to UCITS managers under the CSA, will also be considered and addressed by alternative investment fund managers (AIFMs).

Resulting from the regulatory scrutiny on costs and fees, managers should be able to determine whether the costs are proportionate when compared to market standards, establish if fees are consistent with the characteristics of the fund, ascertain if costs are sustainable considering expected returns, and ultimately justify the cost structure of the funds they manage. According to some commentators, the regulatory scrutiny on fees and costs may result in additional fee compression.

Macroprudential developments: leverage and liquidity In focus

International regulatory bodies such as the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO) are assessing the activities of investment funds and the systemic risk, if any, that they pose to the financial system. Factors driving macroprudential scrutiny of investment funds include the growth and significance of the sector, the interconnectedness of funds to the financial system, and the emerging awareness of possible risks posed by the funds sector. Work in this area is ongoing and may evolve as regulatory bodies gain a better understanding of how different types of funds generate systemic risk.

Recent financial market events such as the UK gilt crisis in September 2022, and the financial market distress at the onset of Covid-19 lockdown in spring 2020, have illustrated the risk of investment amplifying market shocks. With this background, the Central Bank issued a discussion paper in July, seeking industry views on a potential approach to the development and operationalisation of a macroprudential framework for the investment funds sector.

The Central Bank’s peper identifies the tools that may be used to reduce the risk that funds pose to the financial system, which are focused on the management of liquidity mismatches, the management of leverage, and tools to target the interconnectedness of funds with the financial system or real economy.

The Central Bank supports the adoption of the FSB’s policy recommendations to enhance the liquidity management of open-ended funds. It also considers such proposals would establish a baseline level of resilience in liquidity management. Regarding the management of leverage, the Central Bank believes that regulators could enhance the stress testing of leverage from a macroprudential perspective, both as a policy measure and as a risk assessment tool.

Following the Central Bank's implementation of macroprudential measures for Irish-domiciled property funds, including the introduction of a leverage limit of 60% debt to a fund’s total assets, fund managers can anticipate the development of broader set of macroprudential rules for the funds sector.

Outsourcing

The range of functions that managers are outsourcing, and the criticality of those functions, continues to increase. Recognising that outsourcing has the potential to impact the operational resilience of managers and the funds they manage, regulators have focused on the measures implemented by managers to effectively govern, manage and minimise outsourcing risks.

In this regard, the Central Bank was one of the first regulators to address the issue when it issued its cross-industry guidance on outsourcing. This guidance sets out a comprehensive framework detailing how managers should implement outsourcing policies and procedures. Although the guidance was issued over 18 months ago, managers have needed to maintain ongoing focus on the management of outsourcing, and in many cases, managers needed to enhance the oversight of outsourced service providers (OSPs), review contractual arrangements with OSPs, and dedicate additional resources to the management of operation risk.

One of the main areas where managers rely on OSPs is IT and cloud services. The EU’s new Digital Operational Resilience Framework (DORA) aims to mitigate technology and cyber risk by enhancing a firms’ technology and cyber risk management and resilience. DORA requires managers to ensure they can withstand, and recover from, ICT-related disruptions and threats, including cyber-attacks.

Looking ahead, DORA will apply from 17 January 2025. In the meantime, managers are recommended to start preparing for its application. This involves identifying any gaps in ICT governance frameworks, considering which of their OSPs are likely to be considered ‘critical’, and reviewing their testing and recovery protocols against the standards set out under DORA.

Operating in a dynamic environment, as ever, managers face opportunities and challenges. Adapting and proactively managing current trends and developments will be key to how managers prosper in the years ahead.

A version of this article was first published by IFC Review, November 2023.