Development of UCITS to date
The origins of UCITS (“Undertakings for Collective Investment in Transferable Securities”) go back to 1985 when what became known as the UCITS Directive (85/611/EEC) was passed. The UCITS Directive looked to harmonise the sale and marketing of collective investment schemes that were open-ended, liquid and well diversified to retail investors, to create a single market in the sale of such schemes and to impose a common set of investment parameters, restrictions and supervision. The concept of the single market is that UCITS constituted in one European Economic Area (EEA) member state could be marketed in one or more other member states. All that was required for the “passport” was registration with the local regulator, which could not refuse registration provided the UCITS was authorised in another member state and complied with the local marketing rules. However, the UCITS Directive failed to achieve this outcome due to varying marketing rules and restrictions in the different member states, which made registration time-consuming and costly. In addition, the range of permitted investments (transferable securities only) was too limited to cover the increasing types of investments used in the market.
From 1985, amendments to the UCITS Directive were suggested (known as UCITS II), to deal with these problems. However these amendments were never made as the content could not be agreed by the European Council.
UCITS III
In 2002 however, the “Product Directive” and the “Management Directive” were adopted (collectively, UCITS III). The Product Directive, as expanded by the Eligible Assets Directive and CESR (Committee of European Securities Regulators) guidelines, extended the nature and scope of investments that UCITS could invest in (eligible assets), allowing investment into transferable securities (essentially quoted securities), money market instruments, other regulated collective investment schemes, financial derivatives and index tracker funds. The Management Directive gave UCITS management companies a passport to operate throughout Europe, though it is generally accepted that the Management Directive has not been a complete remedy to the problems associated with the passport. It also introduced a requirement for a simplified prospectus, intended to provide more accessible, concise and clear information for investors.
UCITS IV
The next development in the UCITS regime is UCITS IV, the text of which was adopted in July 2009 and is due to be implemented in all EEA member States by 31 July 2011. UCITS IV will codify changes to the UCITS Directive since 1985 and also looks to improve on the failings of the UCITS regime, in particular aiming to remove administrative barriers to the cross border marketing and distribution of UCITS funds in the EEA, to replace the simplified prospectus with a “key information document” (aimed, after the failure of the simplified prospectus to do so, at making it easier for consumers to understand and including a risk rating from 1 to 7), to facilitate mergers between UCITS and to allow for master-feeder UCITS structures. It should also create a genuine management passport by allowing a UCITS management company located in one member state to manage UCITS constituted in other member states. Finally, there are measures strengthening supervision, mainly by means of enhanced co-operation between national regulators.
UCITS V
The European Commission has indicated in its work programme for 2011 that it plans to introduce a UCITS V Directive to revise (and increase) the responsibilities of depositaries in light of the Madoff affair, which saw a number of UCITS funds (particularly in Luxembourg) suffering heavy losses.
Statistics
Whilst there remain some technical issues with UCITS structures that it is hoped will be overcome through UCITS IV, the brand has been phenomenally successful. Assets under management in UCITS currently stand at €5,610 billion as at the end of March 2010 (down on a peak of €6,160 billion in 2007) with net sales in April 2010 of €20 billion (€71.6 billion since the beginning of 2010). Currently UCITS funds represent approximately 76% of the assets managed by the investment fund industry in Europe (for these purposes, the EEA, (excluding Cyprus, Estonia, Iceland, Latvia, Lithuania and Malta) and Switzerland). Outside Europe generally, the UCITS brand is seen as a well regulated, innovative and flexible product, which, coupled with the lack of any competing products worldwide, has resulted in growing investor interest throughout Asia, South America and the Middle East, providing European fund managers with significant opportunities in these regions. The strength of the brand is shown by the ease with which UCITS can be registered for retail distribution in Hong Kong and Singapore.
Issues for alternatives managers
Whilst the UCITS Directive originally contemplated retail funds aimed at retail investors, there has increasingly been a move towards greater specialism within UCITS, with some UCITS employing strategies that exclusively target institutional investors.
One might ask whether there is any advantage for a hedge fund or other alternative investment manager in using a UCITS platform for their fund given the additional costs involved in UCITS compliance, and certainly at the time of writing it can be argued that unless the fund manager is looking to access those institutional investors that require the additional transparency and regulation of a UCITS product, or looking to access the more “institutional” end of the retail market, then the costs outweigh the gains. However, this must be viewed in the context of the AIFMD, itself working its way through the European legislative process and expected to be finalised in late 2010 and implemented throughout the EU two years later.
Historically many alternative investment managers have been able to establish investment funds as “unregulated collective investment schemes”, typically in an offshore location such as the Cayman Islands and subject to very limited regulation, so even if the manager or adviser was itself regulated in the provision of investment services the funds themselves were not. The AIFMD is one of the European responses to the global economic downturn and its aim is further to regulate alternative investment managers in order to increase transparency and investor protection. Whilst (unlike the UCITS Directive) it will not “directly” regulate investment funds, the degree of additional regulation that will be imposed on alternative investment fund managers is comparable to that imposed on fund managers under the UCITS Directives.
The definition of ‘alternative investment fund’ in the AIFMD is very wide and catches most types of funds, including plain vanilla investment trusts that invest in quoted equities as well as non-UCITS retail schemes. UCITS however are specifically exempted.
There are still two different drafts of the AIFMD being considered and it is difficult to predict the detail of the final text, but whichever version is agreed it appears that alternative investment managers will be subject to considerable additional compliance, including new requirements that:
• managers be authorised and regulated, and subject to strict new conduct of business rules, including capital adequacy, separation of portfolio management and risk management functions and detailed restrictions on executive remuneration;
• fund documentation be approved by the relevant competent authorities in the relevant member state in advance of marketing, with any subsequent changes to the documentation also to be approved by the relevant competent authority;
• managers be subject to detailed new disclosure requirements including an annual report for each fund managed and detailed portfolio company disclosures (largely relevant for private equity funds);
• managers be subject to detailed fund valuation requirements including independent valuation and a requirement for periodic valuation;
• managers be required to appoint a depositary to safeguard each fund’s investments and to monitor various functions of the manager.
The upside of all this is that managers will have a passport for their funds, which they can market to professional investors throughout the EEA, but it may not provide much compensation for the additional compliance burden.
Whilst the AIFMD will apply to EEA managers of alternative investment funds constituted in an EEA member state, not, perhaps, catching the offshore structures employed by many hedge funds, in order to be able to market a non-EEA fund to EEA professional investors the manager will effectively have to “opt in” to the AIFMD (or, possibly, establish a parallel fund “onshore” in the EEA), thus bringing the fund and the manager into the scope of EEA regulation. In this context if certainly no longer looks as if UCITS compliance would impose significant additional burdens on alternative investment managers operating in the EEA.
UCITS has a strong brand recognition worldwide, and UCITS products are expected to attract significant investor demand in the future months and years. We are aware that many alternative investment managers with investors in Europe are now exploring whether their investment strategies can be made to work in a UCITS in order to avoid AIFMD – better the devil you know in UCITS, than the devil you don’t in AIFMD.
Newcits and hedge fund managers
“Newcits” is the rather unattractive term that has been coined to describe the more sophisticated UCITS developed by hedge fund managers. It took some time before managers of alternative assets began to see the possibilities thrown open by UCITS III for creating a UCITS that applied alternative investment strategies. Traditionally, it had been thought that innovation in UCITS was impossible because of the 5/10/40 Rule which applies to transferable securities. This risk spreading rule provides that no more than 5% of an UCITS’ assets may be invested in quoted transferable securities or money market investments (MMIs) of a single issuer, but that 5% limit is increased to 10% in respect of up to 40% of the UCITS’ total assets. In addition, the rules provide for a “trash” bucket with up to 10% of the assets being able to be held in unlisted securities and MMIs.
UCITS III increased the range of eligible assets to include structured notes and other financial instruments that are not subject to the 5/10/40 Rule. In addition, assets that are in themselves ineligible may be accessed by the use of financial derivatives instruments, for example futures on commodities or real estate or structured notes linked to or backed by such assets, both being asset classes in which direct investment by UCITS is prohibited. UCITS can also invest in certificates on ineligible assets if there are no embedded derivatives and in Credit Default Swaps on loans provided there is no physical delivery. They can also use structured swaps to obtain an indirect exposure to a portfolio of offshore hedge funds, which, as unregulated collective investment schemes, would be ineligible assets for direct investment. Using derivatives, a UCITS can employ the 130/30 long/short strategy. Whilst direct borrowing for investment purposes is not permitted, synthetic leverage can be undertaken by using repos or total return swaps.
All this does not mean that hedge fund managers do not need to make any changes to their working methods. At least twice-monthly dealing is required at fortnightly intervals as opposed to the more usual monthly or quarterly periods for offshore hedge funds. The UCITS Directive must be read in conjunction with various EC Recommendations including on the use of financial derivatives, the Eligible Assets Directive and CESR guidance in particular on risk management principles.
The European Commission recommended a differentiated approach on risk management for the respective categories of “non-sophisticated UCITS” which have “overall less and simple derivative positions by using e.g. a few plain vanilla options” and “sophisticated UCITS”. Non-sophisticated UCITS were to use the commitment approach whereby the derivative positions of the UCITS are converted into the equivalent position in the underlying assets to be assessed and sophisticated UCITS were to use the daily value-at-risk (VaR) bi-monthly stress test approach. The EC Recommendation was followed by CESR Guidance 09-178 on risk management policy generally and in particular on the risk management function, risk measurement and reporting to senior management.
As a Directive, it is up to each EEA member state to ‘transpose’ or implement the original UCITS Directive and the various Directives that amend it into national legislation. In principle, the rules that apply on the creation of the UCITS in one member state should be the same throughout the EEA.
However, in practice, there is some scope for regulatory arbitrage. The vast majority of UCITS are incorporated in Luxembourg followed by Ireland although there are also a substantial number of UCITS incorporated in France and in the UK, in each of the latter cases primarily for distribution within the domestic market. In the UK, investment in other collective investment schemes that are not UCITS or schemes with equivalent regulation is absolutely prohibited; in Ireland and Luxembourg, such funds can be included within the 10% trash basket. Perhaps it is not surprising that those hedge fund managers that have established UCITS vehicles have tended to go to Ireland or Luxembourg.
Nobody should think that setting up an UCITS involves light touch regulation. Dan Waters, Director, Conduct Risk and Asset Management Sector leader at the FSA, who has spoken of some hedge fund managers “getting on what is beginning to look like a UCITS III bandwagon”, referred to the likely need for investment in systems and controls to meet the specific requirements of these “highly regulated structures” and has given a quiet reminder that asset managers retain ultimate responsibility for compliance with the quite detailed requirements of UCITS III and, even more, UCITS IV.
Conclusion
So, we have seen from the above that UCITS have developed from the “pure” retail product originally envisaged to something much more interesting, a strong brand with a broad range of applications, capable of housing a long-only fund or something much more akin to a hedge fund. Given the way in which regulation is moving in Europe, and the strong brand that UCITS have established over the years, it seems logical that any alternative manager seeking to remain active in Europe should consider whether theirs is an investment strategy that can work within the confines of a UCITS fund. Not to do so spells only more regulation under AIFMD, whereas working within the UCITS structure may bring with it access to a wide range of additional investors - both within the EU and elsewhere - who value the “gold standard” that UCITS has become in this difficult and turbulent time.
This article first appeared in the Butterworths Journal of International Banking and Financial Law, September 2010
