What are the long-term prospects for alternative UCITS?
This article was first published in HFMWeek in September 2012.
Since the financial crisis began, UCITS have increasingly attracted institutional investors seeking to access alternative investment funds with greater regulatory protection. As a result, an already successful retail investment fund product has achieved phenomenal growth levels in turbulent market conditions. In an Irish context, assets in Irish UCITS have grown 64% since the end of 2008. Current asset levels in European UCITS exceed €5.8 trn. However, in the long term UCITS will need to adapt in order to sustain the hold on the market. So will the success story continue or could market factors, changing investor demands and much future regulation threaten to derail the investment funds’ poster child?
UCITS of today
Firstly, it might be helpful to take stock and assess where UCITS sits at the moment, particularly as a vehicle for alternative investments.
The opportunities for alternative UCITS gradually began opening up following the introduction of the UCITS III Directive in 2001 and further with the Eligible Assets Directive in 2007. UCITS today can invest in a diverse range of financial instruments including derivatives. Most alternative investment strategies (but not all) can be replicated, at least to a certain extent, within a UCITS. However, it should be said that there are elements of the UCITS regime that can restrain this replication process and add an administrative burden. These include: asset eligibility rules; asset diversification rules; liquidity requirements; risk and counterparty exposure limits; and operational, compliance and governance rules.
UCITS have been increasingly utilised by fund sponsors pursuing alternative investment strategies. Ireland, with its renowned expertise in the alternative investment space as an asset servicing jurisdiction, has benefitted significantly from this increased activity and is now the second largest and fastest growing jurisdiction to locate cross-border UCITS.
Recent estimates put the level of assets in alternative investment UCITS (EU wide) at approximately €123bn. A small portion of overall UCITS assets, but a significant figure nonetheless.
UCITS of tomorrow?
Of course, UCITS are not immune to the challenges the financial markets and the financial industry continue to face. Investors appreciate the landscape has shifted dramatically and the purpose served by alternative investment funds has changed as a result. Investor aspirations are now about more modest growth (or absolute returns) and reduced risk. On the regulated side, UCITS can expect to achieve further growth as long as this trend continues.
However, UCITS are typically subject to relatively higher operating costs and significant investment constraint. These are factors that affect bottom-line returns. To the extent that UCITS were a regulated shelter from the storm in turbulent times, investors may begin to drift back to funds with lower operating costs and less investment constraint - once markets return to some form of stability and the returns of UCITS and less-constrained funds start to diverge.
Future regulatory landscape
UCITS V and UCITS VI represent two pending initiatives on the continuing path towards increased EU harmonisation of UCITS and improvement to the regime. The challenge is to ensure that these are implemented in a form that does not result in a disproportionate regulatory burden or bring additional undue costs without enhancing investor protection.
UCITS V was outlined by the European Commission (the Commission) in draft form on 3 July 2012 and is due to be considered at EU level over the first half of 2013. In current form, it focuses on three key elements, namely: depositary role; manager remuneration; and regulatory sanctions.
Manager remuneration is sure to present issues for fund managers operating UCITS. Increased powers for regulators will also be viewed with caution. However, the most contentious piece relates to depositaries. UCITS V proposes rules relating to the scope of depositories’ duties, imposing stricter rules on liability for the loss of assets held in custody and standards expected on delegation of custodial functions. Depositary liability is already causing much consternation in the context of the Alternative Investment Fund Managers Directive (AIFMD). It was inevitable that the higher standard from AIFMD would be carried across and applied consistently in UCITS.
The proposed UCITS V measures set an ominous tone for depositaries and there is a distinct possibility that it could result in higher costs to provide the depositary services.
On 26 July 2012 (just over three weeks after UCITS V’s publication), the Commission published a consultation paper marking the start of a process that will form UCITS VI. This could take up to two years (or longer) to come into effect.
It is not all retrenchment and negative measures. A number of the questions posed in the consultation paper relate to potential product enhancements, for example, extraordinary liquidity measures; a depositary passport; and improvements to measures introduced in UCITS IV.
Undoubtedly the headline item is the enquiry in relation to the scope of eligible assets. The Commission expresses a concern that the emerging practice of a UCITS adopting highly sophisticated investment strategies that provide access to highly complex risk profiles "may not be appropriate for a retail fund". The Commission then questions whether there is a need to review the scope of assets and exposures deemed eligible for a UCITS and whether all investment strategies currently pursued within UCITS are in line with what investors expect of a regulated UCITS product.
Many commentators see this as the first clear indicator that the Commission will look to unwind the UCITS III scope and confine UCITS in future to a much more restrictive range of assets and strategies. While this could certainly present challenges for some of the more esoteric alternative strategies in UCITS, it would be remiss of the Commission to determine that, in today’s economy, long only equity and bonds are the only suitable strategies for retail investors.
In fact, the impact may not necessarily be entirely negative. It is worth noting that the initial Commission proposal from 1976, upon which the 1985 UCITS Directive was largely based, proposed a vehicle that could invest not just in transferable securities but also other liquid financial instruments. (Incidentally, the initial proposal also supported a 5% facility for investment in non-liquid assets.) Recognising that the financial markets have developed since 1985 (and even since UCITS III in 2001), it is arguable that the range of liquid financial instruments should be re-evaluated on first principles. This could theoretically lead to additional asset classes (such as real property and commodities) being added to the list of UCITS eligible investments.
Well before UCITS VI comes into effect, AIFMD will have made its long awaited arrival. While this is of course still a very contentious area, we can assume that ultimately it will pave the way for a pan-EU alternative investment fund product of some kind. Implemented successfully, investors may be presented with another compelling option. Take a scenario where an EU-based institutional investor required that its alternative investment allocation was made to a UCITS. If, in theory, a new pan-EU offering comes online with many of the key investor protections but in a product that does not carry the level of investment constraints, it is not unrealistic to venture that the investor may be open to an allocation to this vehicle rather than a UCITS.
So where might that leave UCITS? UCITS could find itself sharing the EU-domiciled fund shelf-space with AIFMD funds. We actually have this already, with Irish qualifying investor funds (QIFs) and similar products. But a pan-EU branded solution on both fronts would be a new proposition. UCITS for retail investors and less complex alternative investment strategies; AIFMD funds for institutional investors and more complex alternative investment strategies. This is speculative at this stage, but we could see two complementary product ranges that can naturally fit along side each other, with unregulated funds continuing to complement these options further.
With everything that is in play, it is likely that the investment fund landscape in five to ten years time will have shifted significantly. And while UCITS will certainly still have an important role to play, its continued success will be very dependent on market factors, investor demand and sensible regulatory measures.