Whereas the United States has had to delay implementation of some parts of Dodd Frank – despite producing thousands of pages, and millions of words, of new rules – UCITS at the EU level is running on schedule, possibly because in many areas the directives set out broad principles rather than providing prescriptive guidance. This leaves managers free to draw their own inferences, at least until and unless any clearer guidance, which may emanate from ESMA, eventuates. So, the first challenge is that room for manoeuvre could be constrained by future guidance, or of course by UCITS V, although that is another story. For now the field seems wide open. Yet behind the headlines lie some practical obstacles meaning that not all managers will be able – or indeed willing – to take full advantage of all aspects of the new framework.
Faster fund formation
Scope for swifter fund launches – via a 10-day turnaround – is no excuse for not doing the preparatory homework. Perhaps some big groups who already have the infrastructure in place can just turn the key and churn out another UCITS in a week or two. But for UCITS neophytes, even the old two-month timetable was not enough, say those who have been through the hoops before.
Establishing a UCITS under your own company name can involve capital requirements of the order of €6 million in Luxembourg and €600,000 in Ireland. This is one reason why platforms are so popular: the operator takes on this burden, for a small fee. Realistically smaller managers who cannot arrive at a mutually agreeable deal – and do not wish to set aside so much idle cash – might find that the barriers to entry are still too high. New domiciles Malta and Gibraltar may have lower capital requirements, and both seem keen to lure funds from other offshore places to redomicile; any EU UCITS looks like one way to sidestep AIFMD, although UCITS V may well end up closely aligned with AIFMD.
Babble of many taxes
A passport for distribution throughout the European Union, without the need for local management companies, will let some funds tap new sources of capital. But absent a pan-European tax treaty, feeders for certain countries still need to be tailored to local laws. For instance, German and Austrian tax law effectively requires feeder funds to downstream financial data from master funds with a high degree of granularity, disaggregating returns into several categories and even sometimes distinguishing between derivative and cash transactions. If managers have not previously carried out this exercise they will need expert advice or must partner with a local distributor just as they would have done pre-UCITS IV.
Notwithstanding tax differences, the implication of being able to sell and combine UCITS anywhere in the European Union, whether or not you have a local management company, will be a new web of dialogue between 20 or more national regulators, who need to approve mergers and distribution as well as alerting each other to breaches. This is a time commitment that the ambitiously Europhile manager may also need to make extra allowances for. It remains to be seen whether bodies such as Paris-based ESMA will be able to play a useful coordinating role, or whether Interpol in Lyons will be drafted in. Since not everyone speaks the international business language (English) or the language of diplomacy (French) it is also possible that regulators might ask to call upon the army of translators already employed by European agencies. A bull market in advertisements associated with the “Google translate” function seems a near certainty.
Feeding merger mania?
The ability to channel myriad feeders into one master seems somewhat overdue when offshore funds have been doing this for a generation. UCITS feeders will need to invest at least 85% of their assets into the master fund, which should in most cases leave enough leeway for setting aside margin on foreign currency hedges where feeders have different currencies. There may be rare cases where 15% is not sufficient to allow some types of feeder to participate in master performance, in which instance a separate vehicle would need to be set up.
Whilst this type of rationalisation can promote long-term savings from eliminating duplication of costs, service providers, governance and so on, in the near term there may be costs. Closing legal entities in some countries could incur tax liabilities if profits or gains are crystallised. In light of the parlous state of UK Government finances, it seems bold for HM Treasury in its consultation paper to aspire to consult with the industry to “ensure no adverse UK tax consequences for a foreign UCITS fund as a result of having a UK management company”; yet clearly with tax remaining a matter of national sovereignty, there could well be adverse consequences elsewhere in Europe. Ending employment and service provider contracts can be extortionately expensive in some countries, where redundancy costs remain the chief cause of corporate bankruptcy. More subtly brand names could be impaired by exiting key markets.
Execution efficiency
Some see UCITS IV as a ploy to extend the purview of other European rules, such as MiFID, and there is some overlap but the UCITS rules also go further. UCITS managers are now obliged to demonstrate best execution, although they are left with substantial latitude over how the concept is defined. The directive allows managers to consider price, cost, speed and likelihood of execution in pinning down what “best” means: so the pragmatic implication is that it might be acceptable to pay a premium for faster or deeper market access. Best execution principles should be reviewed every year, and also need to address the choice of brokers, execution venues, intermediaries and fees. Best execution policy statements should be posted on the internet for all and sundry to see.
Crystal clear prospectuses
This is far from the only thing that needs to be documented. Each and every trade should also be checked for compliance with the stated investment strategy of the vehicle. The latter has to be far more precisely defined than most hedge fund prospectuses have done in the past. For example, the phrase small cap would need to have its parameters outlined. If a fund says it focuses on a particular country, then the defining features of nationhood must be spelled out: is it country of listing, of domicile, of most revenues, and so on. Investable asset classes also need to be explained without ambiguity, as do liquidity criteria. And managers should forewarn investors in writing of what action is taken if any criteria are breached: before any breach occurs, not after.
KIDs cost money
The style as well as the substance of language is a focus of the new rules. Bureaucrats may be renowned for impenetrable legalese, but they are now legislating for plain English. Not just plain English in fact – the Key Information Document that supersedes the Simplified Prospectus will need to be translated into local languages wherever it is distributed, so that’s potentially plain Czech, French, Maltese and a host of other languages besides and not forgetting the language of the home of UCITS regulators – Luxembourgish. Although UCITS are widely sold in Asia, it is not clear whether the documents will need to also be in Hong Kong’s tongue of Cantonese and mainland China’s of Mandarin without mentioning local dialects such as Shanghainese. More challenging than translation is the requirement to keep the KID down to two pages (three for structured funds) – without sizing the text smaller than font size 8! The simplified prospectus was criticised for length and complexity, but realistically there is only so much detail that can be condensed into so little space. Yet the new mottos of UCITS are clearly “less is more” and “small is beautiful”. The words need to be concise as well as clear, and this has given rise to a whole new industry offering outsourced KID-writing services: an area where law firms are also happy to oblige. Unfortunately, the cost of producing KIDs may be another reason why the much vaunted savings from rationalisation might not materialise.
What is SRRI?
SRI is an abbreviation for Socially Responsible Investment, so it is potentially confusing for the regulator to have chosen a near identical acronym for a risk measure that has nothing to do with ethical investments. SRRI stands for Synthetic Risk and Return Indicator, whereby funds are categorised into seven risk rankings, based mainly on their historical volatility, or for newer funds, predominantly the historical volatility of their benchmark. The calculation method varies by fund category, but more funds will end up following statistical risk approaches.
The rise and rise of VaR
Whereas previously managers had discretion to choose whether they wanted risk limits based on exposure (for a simple UCITS) or statistical risk (for a sophisticated UCITS), now the choice will be dictated by their investment strategy. It seems likely that some managers using the exposure-based approach will need to move to statistical risk: one example is that any fund with non-negligible exposure to non-linear instruments will be asked to abide by the VaR limit of 20% over 20 days at the 99% level. Strategies that come under the “complex” umbrella, or those where their exposure “does not adequately capture the risks”, are two other nebulous categories that will be required to observe VaR caps. However, managers will still have some flexibility over deciding how to calculate the VaR statistics.
The three main ways to arrive at a VaR figure are parametric, historical, and simulated. The first gauges the current portfolio’s volatility. The second looks at the manager’s trading history, even if the portfolio has changed shape over time. The third applies random simulations to a distribution. If similar managers work out their VAR figures in different ways, it may be difficult for investors to make comparisons. Even if everyone goes for the Monte Carlo simulation approach, they may use different distributions over varying look-back periods. Investors might need to ask managers to crank out extra VaR metrics to compare apples with apples. Whichever VaR method is used, it needs to be back tested for predictive power. And daily updating is only the maximum periodicity: sometimes intraday may be deemed appropriate.
A chorus line of models
Risk measurement for UCITS might no longer be a two horse choice between commitment, and various VAR approaches. The third possibility heralded by UCITS IV is vaguely defined as “other advanced risk measurement methodologies”; however, whatever is dreamt up must be approved by the European Securities and Markets Authority. Watch out for new risk metrics in the UCITS space!
Already managers have a lot of choice over which models they use for stress tests – and which stress tests they feel are appropriate. This is yet another area where qualitative judgements come into play. Managers are free to build their own in-house models, or could use any number or combination of statistical or risk forecasting models from vendors. Some approaches are purely historical statistical, others only use history to infer factor sensitivities that then feed into factor-based forecasts.
Hedging bets with netting
Whilst some funds will transition to the VaR approach, plenty of plain vanilla hedge fund strategies will be able to continue with the seemingly simpler 200% limit on gross exposure. However, it is not as simple as it might seem at first sight. Total gross exposure could in fact be multiples of the headline 200% figure, if managers can navigate the new netting rules. Some managers might in fact be able to pursue some quite aggressive calendar spread trades, to the extent that the rules allow two positions in the same derivative to be offset even if maturity dates are different. Even for fixed income derivatives, the duration “buckets” have ranges as wide as from seven to 15 years. Similarly, two different derivatives based on the same underlying asset could be netted off. As far as index hedging is concerned, exposure to an index that is highly correlated to positions being hedged can be netted: but as usual, correlation is not defined in terms of a minimum coefficient. Nor is the period or periodicity of data used to calculate the correlation prescribed. Once again there will be potential for different managers to follow different methodologies.
Quantifying counterparty risks
Counterparty risks and concentrations need to be measured according to new rules on netting and other factors. Any risks associated with cash deposits need to be addressed. The types of collateral held and their locations at custodians and sub custodians should also be documented. If managers are trying to enhance returns by taking some credit risk with their collateral, this will not escape from the gross exposure calculation: collateral returning more than the risk-free rate must be included in the total. Along the lines of living wills for banks, the rules ask managers to map out in advance what would happen in the event of default: would assets be lost, safe and segregated, or frozen pending years of liquidation?. And it does not stop there: in this interconnected financial world, managers are expected to quantify the degree of correlation between their counterparties.
Segregation of duties
Risk, internal audit and compliance have to be independent of asset management. This need not necessarily require designated individuals within a firm for each function, since some can be outsourced. But farming out these activities does not absolve managers of responsibility for them. As regulators are scrutinising pay more intrusively, remuneration structures of risk and compliance staff may need to be more carefully designed to remove even the perception of possible conflicts of interest.
Extraterritorial omissions
As much as 40% of new sales of UCITS funds emanate from outside the European Union, in so called “third countries”. This rather vague label hints at a possible weakness: Asians and Australians have complained that they were not sufficiently consulted, or even not at all. This raises the spectre of other regions of the world devising their own, competing, regulated fund structures. It is not yet certain whether the benefits of UCITS IV will be enough to keep the aspirations for an Asian UCITS at bay, but it is likely that voices from Asia will be increasingly heard.
