The development of UCITs funds
December 2013 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
The UCITs Directive provides a harmonised platform and an EU passport for those funds meeting the stringent investment and borrowing powers set out in the UCITs Directive, which are designed to ensure adequate diversification of investment and risk management, so that they are appropriate for investment by retail investors without advice.
When the UCITs Directive was first implemented, it was designed to cover simple funds which were appropriate for all retail investors. However, since UCITs III, the funds structures permitted under the UCITs brand have become increasingly flexible, leading to UCITs being permitted to use indices, including the use of total return swaps to gain exposure to asset classes which cannot be directly invested in, such as commodities. UCITs funds have also been set up for professional clients only, through the use of high minimum subscriptions.
The UCITs brand is strong throughout Europe, America and Asia. They are perceived as funds which are heavily regulated, safe and secure and this is the reason why they are so popular and sell well. It is this fact that is making stakeholders nervous about the increasing flexibility of UCITs funds, and it looks like the tide may currently be turning on the flexibility of UCITs funds, particularly with the advent of Alternative Investment Funds.
UCITs V has brought in, for example, transparency requirements for use of derivatives based on indices and use of total return swaps to gain exposure to non permissible asset classes. In addition, what constitutes permissible assets for UCITs funds will be analysed in UCITs VI. It is conceivable that UCITs VI will be used to simplify UCITs funds to pre UCITs III days, restricting them to simple structures that are suitable for all retail clients. There may be a look through so that UCITs funds cannot have exposure to non permissible asset classes such as commodities.
Alternatively, asset classes such as commodities may be included as permissible assets, which would widen the scope.
Interestingly, ‘complex funds’, such as complex UCITs, may not necessarily be suitable for all retail clients. There should be more transparency for investors, in particular around the composition of indices and absolute return swaps. The MIFID II proposal rightly suggests that an appropriateness test should be used for complex UCITs. This subject seems to be a rather emotive and divisive one. However, transparency is a central requirement across all financial services as a result of the credit crisis. It is not simply one raised in relation to UCITs and it is not going to go away. After Lehmans, the general view is that all investors should be able to understand the products they are investing in and relevant stakeholders should know who is purchasing the products and be able to monitor the purchase of the products.
In addition, the proposals do not seem to be dangerous for UCITs funds. There is room for complex funds in the UCITs structure. Even complex funds need to comply with the strict investment and borrowing powers in the UCITs directive and this provides diversification and security and makes them suitable to the wider market.
If the UCITs world is resistant to the idea that there are varying complexities within the UCITs structure and argues that there should not be greater transparency on complex funds, this may lead to stakeholders using this as a reason to use UCITs VI to simplify UCITs back to pre UCITs III funds. By accepting the need for greater transparency and the idea that there are complex funds which are not appropriate for all retail investors, without an appropriateness test, it is more likely that the flexibility of the UCITs structures will remain. The danger with going back to pre UCITs III structures is that they were not very popular until flexibility was permitted, and there is no guarantee that they will be popular in the future without flexibility.
It will be interesting to see what happens as Alternative Investment Funds take off. If the brand becomes strong, it is conceivable that managers of ‘complex UCITs funds’ will change them to AIFs, in particular those only directed at non professional clients. Under the AIFMD, an EU passport can be obtained by EU managers of EU funds but they have the advantage over UCITs in that the funds themselves are not regulated – they are not subject to the stringent investment and borrowing powers in the UCITs directive. This will only happen, however, if the AIF brand becomes popular. There is no doubt that the UCITs brand sells.
If the AIF brand becomes respected and the two brands are then in equal competition, AIFs are likely to prevail because there is more money to be made from them. UCITs may only be used for simple funds then, in any event.
Jacqui Hatfield is a partner at Reed Smith. She can be contacted on +44 (0)20 3116 2971 or by email: firstname.lastname@example.org.
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