Are Alternative Investment Strategies within the Spirit of UCITS?
This article was first published in The Hedge Fund Law Report in June 2012.
In the last four years in particular, UCITS have been increasingly utilised by fund sponsors pursuing alternative investment strategies. This can be attributed to a desire on the part of those fund sponsors to source new lines of capital at a time that many investors were seeking shelter in regulated structures with built-in investor protection measures. Whether those factors are here for the long term may not be clear, but with approximately €123 billion estimated to be invested in alternative investment UCITS, it is fair to say that a market for these funds has successfully been forged.
However, there is a small yet growing wave of sentiment in favour of narrowing the investment scope of UCITS. But is this really the time to consider tightening the reigns on UCITS?
The UCITS legacy
The 1985 UCITS Directive created a pan-EU framework for funds investing in transferable securities (essentially publicly traded shares and bonds). The objective was to support a common regime for investment funds to be offered to the public across the EU, that is, for investment funds suitable for retail investors.
In 2001, the European Commission recognised the developments in financial markets in the intervening period and also noted that one of the stated aims of the initial UCITS project was to later broaden its scope to cover other types of collective investment schemes. It was therefore considered desirable to extend the objectives of UCITS to permit them to invest beyond transferable securities and capture in other types of liquid financial instruments. The UCITS III Directive adapted the 1985 UCITS Directive to facilitate this.
It is worth noting that the initial European 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.)
The Eligible Assets Directive followed in 2007. Its aim was to give clarity on the eligibility of certain assets for UCITS investment. The directive’s recitals expressly referred to providing this clarity “in a manner consistent with the principles underlying the [1985 UCITS Directive]”. The following were cited as examples of these principles: (i) risk diversification and exposure limits; and (ii) the ability to calculate issue and redemption prices and redeem units at the request of investors – essentially risk management and liquidity.
Beyond the spirit of UCITS?
The question now is whether the extended scope of UCITS, brought about under the UCITS III Directive and clarified by the Eligible Assets Directive, has provided for a framework that does ensure that the key principles of UCITS are adhered to, or whether the regime now gives fund sponsors the scope to go further and enter into territory where investor protection is less than assured.
There are two sides to this argument. On one side there is the view that the UCITS rules and regulations are comprehensive and any product that can operate within those rules can rightly operate as a UCITS. The alternative view is that, even with all the rules, it is possible to design a fund within the UCITS regime that is simply not suitable for retail investors and these funds need to be dealt with in a different manner.
(a) What spirit of UCITS?
To take the first case, the view would be that there is no “spirit of UCITS” over and above the UCITS rules and regulations to be considered. The rules governing UCITS are detailed and prescriptive and capture all aspects of a fund’s operation. These rules all support a product suitable for retail investors. Without considering in great detail here, key measures include the following:
- UCITS asset eligibility rules – restricting investment to a prescriptive range of liquid instruments
- UCITS asset diversification rules – ensuring that single asset exposure will not have a potentially disproportionate impact on a fund’s returns
- Liquidity requirements – requiring redemptions are facilitated at least every two weeks, necessitating a portfolio that can be liquidated rapidly
- Risk exposure and counterparty exposure limits – prescribing limits on global exposure and leverage and the level of exposure to a counterparty – and also counterparty eligibility criteria, addressing counterparty credit risk issues
- Operational, compliance and governance rules – detailed operating rules covering, for example, valuations, board oversight and monitoring
- Independent custody, administration and audit – oversight from regulated third party entities, reducing the risk of fraud
- Key investor information document (“KIID”)– simplified product disclosure, objective risk measurement classification system (synthetic risk reward indicator)
These measures together make for a product specifically tailored to meet the investor protection requirements that apply to retail investment products. Corresponding investment products outside of UCITS (sold to retail investors) operate without many of these investor protection measures, although it is noted that this is another focus of EU regulation as part of the forthcoming packaged retail investments products (“PRIPS”) initiative.
(b) Is it suitable for retail investors?
To consider the second case, the view is that these rules are not adequate to prevent a fund sponsor putting an unsuitable fund product into a retail fund regime. One of the key points in this regard is the level of global exposure and leverage, particularly for funds using derivatives and measuring global exposure using the Value-at-Risk (“VAR”) methodology. UCITS can operate within the VAR limits yet produce reasonably high levels of leverage – if measured by other means, such as gross notional leverage. The point being that funds operating with such high leverage levels may not be suitable for retail investors.
The contrary position is that a gross notional leverage calculation is arbitrary and not a relevant indicator and that is why VAR is advocated by the regulators as an appropriate means of measuring global exposure and leverage. Notional gross leverage does not, for example, reflect derivatives which reduce actual net risk.
So while it may be that some UCITS are considered not suitable for retail investors, it seems less clear as to what objective parameters take it outside the spirit of UCITS. This is further complicated by the fact that a long only equity fund, with no leverage, may receive a maximum seven point score on the synthetic risk reward indicator in the KIID of a UCITS (due to the inherent volatility in the equity markets). So, no matter how tightly the product is designed, it cannot fully protect against market risk.
Is action necessary?
If it is the case that fund sponsors should operate with some kind of moral compass as an additional measure of investor protection, it is worth considering the recent historical context.
It has been twelve years since the advent of UCITS III and five years since the Eligible Assets Directive and we are four years into a financial crisis of unprecedented proportions in modern terms. And yet, despite being given plenty of time to develop (let’s call them) “racy” UCITS and plenty of opportunities (given market turbulence and uncertainty) for such “racy” UCITS to hit the wall, horror stories are few and far between. In fact, with the exception of collateral damage from Madoff (which was not a case of a “racy” UCITS anyway), UCITS have generally avoided fund collapses. One suspects that if there were cases of UCITS causing investors significant losses from the pursuit of inappropriate strategies, it would be difficult to keep this from going public. So, if we can assume there has not been a blow up yet, perhaps the concern can begin to subside.
If it is considered that, despite all the UCITS rules and regulations, it is still possible to design a product within the UCITS regime that is clearly not suitable for retail investors, is there an obligation on industry participants (fund sponsors, their service providers and their legal and professional advisers) to apply their own additional prudential rules? And if so, how should this work? A few possible options are considered below:
- Provide for additional risk warnings / better disclosure and explanation of strategy in offering materials. It is recognised that there are challenges for investors to get a full understanding of the investment strategy of a prospective investment. Policy language can often be vague. This could be improved. The KIID may way go some way towards addressing this issue – for both alternative and traditional style UCITS.
- Impose high minimum subscriptions and/or restrict investment in certain UCITS to sophisticated and institutional investors – on a voluntary basis or via additional guidance from the European Securities and Markets Authority (“ESMA”) or rules from the European Commission.
- Regulate how UCITS are sold – as already being considered under the proposed amendments to the Markets in Financial Instruments Directive (“MiFID II”) if certain UCITS are to be categorised as complex products. Objective criteria about what is considered non-complex or easily understood by the average retail investor may drive fund sponsors to simplify strategies to ensure the broadest offering base.
- Introduce rules to restrict UCITS to a more conservative range of assets and/or limit gross notional leverage. (This would need to be legislated for at EU level and has not been included for consideration in the context of the forthcoming UCITS V Directive.)
The final point above, were it to come about in the longer term, could be a significant trigger for many alternative investment UCITS to move into the forthcoming regime under the Alternative Investment Fund Managers Directive (“AIFMD”). There is a sense that this may be no bad thing. If the alternative fund sponsors are not targeting retail investors, they are probably utilising UCITS at present because it is what institutional investors prefer – a cross-border regulated fund product with robust investor protection measures and a product investors know about and understand – a brand. If that is the case, they will likely be able to live with the €100,000 minimum subscription and professional investor criteria under AIFMD. And the product parameters will be radically more flexible. If investors take to AIFMD as they did UCITS, this could be the way forward.
Calls to tighten the scope of their investment powers in UCITS could be perceived to be a symptom of the wider market mood in light of the financial crisis. While additional steps to ensure prudential investment are welcome, there is a danger that we restrict a successful product and positive investment tool and limit investor choice at a time when it can provide the greatest benefit to investors and the economy generally. With more than €5.6 trillion invested in UCITS across the EU, and given the consequences of a mis-step here, it is critical we tread carefully in further regulating UCITS.
But that is to assume AIFMD will work. There are a lot of challenges to overcome before that can come about. It may be too early to call, but it is feasible to see AIFMD replicating the UCITS brand success and for alternative investment fund sponsors moving in that direction to raise cross-border capital from institutional and sophisticated investors within the EU.