Sunday, 29 November 2015
Last updated 1 day ago
Sep 1 2009 | 1:00am ET
By Grellan O'Kelly -- This article reviews the dominant regulated European retail fund, the UCITS, and its emergence as a leading global fund vehicle that combines robust investor protection with financial innovation opportunities, primarily accessed through the use of financial derivatives.
UCITS – An Introduction
The term UCITS refers to the title “Undertakings for Collective Investment in Transferable Securities”. UCITS are retail funds authorised by one of the member states of the European Union, and these funds have grown to become a hugely successful product, seen by investors and promoters as a “gold-standard” in terms of investor protection, regulation and disclosure. Latest figures from the Brussels-based European Fund and Asset Management Association (EFAMA) show that UCITS net assets under management as at end March 2009 amounted to almost $6 trillion. One of the key attractions of UCITS is their ability to “passport” throughout the EU. This means that a UCITS authorised in Ireland for example, can be sold in any of the other 27 EU member states without the requirement for further regulatory authorisation. In addition, UCITS are now also becoming hugely popular in many Asian and Latin America countries, with investors and regulators in those countries becoming more and more comfortable with UCITS’ built-in safeguards. And recent newspaper reports suggest that US fund managers are stepping up their interest in UCITS as their domestic market matures. But why would a highly regulated retail fund product be of interest to the alternative asset-management industry?
The Convergence Factor
In Europe there’s been a rapid convergence between the hedge fund and traditional asset-management worlds. Indeed, the number of UCITS using certain hedge fund strategies has increased greatly over the last 5 years. And interestingly, anecdotal evidence suggests that this trend is set to accelerate. The movement from long-only traditional plays to more complex asset-allocations such as statistical and convertible arbitrage, global macro and replication strategies have been facilitated by the fact that UCITS are allowed to use derivatives for investment purposes. Historically, UCITS could only use derivatives for risk-reduction purposes. However, in 2001, an updated UCITS Directive (known as “UCITS III”) allowed UCITS to generate a certain amount of leverage and use synthetic shorting, subject to clear risk measurement limits and the existence of a robust risk management framework. Certainly traditional asset managers used the new powers somewhat cautiously to begin with, however as the large investment banks saw the benefits of UCITS, they really pushed at the boundaries of what was allowed from around 2005. The ability to wrap a relatively complex strategy in a highly-regulated fund structure is an attractive proposition, with the result that UCITS are now more likely to be “alpha-hunters” rather than “beta-grazers”. While some large hedge fund players have already embraced the regulated UCITS model, the expectation is that that the cross-border and operational benefits expected to accrue from the updated 2009 UCITS Directive (known as “UCITS IV”) will attract increased interest from other alternative investment managers over the coming years. However, before reviewing some of the more interesting investment strategies and themes used by UCITS, an overview of the regulatory safeguards in place is necessary.
UCITS are at the sharp-end of the regulatory, product and operational evolutionary cycle. The regulatory model adopts a number of interdependent and independent controls that, for example, dictate the asset-classes UCITS may gain exposure to and specify the level of risk-spreading and diversification limits that must be respected. This has an overlay of operational requirements such as the need to use an independent custodian and the requirement to perform independent valuations of fund assets. While these certainly impose additional costs on UCITS funds, these costs are now ones that more asset-managers and investors are more willing to bear given recent experiences. The number of steps and hurdles involved in setting up a UCITS can appear daunting, but there are plenty of advisors that have vast experience in how these funds work and the type of strategies that can be implemented.
In addition to this, the regulatory bodies of the EU, the European Commission and the Committee of European Securities Regulators (“CESR”) are continually improving the product, both by clarifying and interpreting existing requirements, and introducing updated legislation to further streamline the passporting process mentioned above. Recent regulatory initiatives have led to public consultations on investor disclosure (using volatility-based measures), the quantitative aspects of derivative exposure and the principles behind strong risk management. This allows all interested parties and stakeholders a very real input into the regulatory process and indeed, using Ireland as an example, the Irish Financial Regulator holds meetings with promoters and their advisors on a regular basis in order to discuss complex or unusual fund proposals and to generally engage in useful two-way dialogue on market trends and issues.
Hedge Fund Opportunities
Most readers will have heard of the European Union’s new proposal to regulate alternative investment managers. Despite significant industry misgivings with the proposed Directive, one consequence from its inevitable implementation will be to make UCITS funds more attractive to offshore managers. While certain highly leveraged and illiquid hedge fund strategies are not permissible in UCITS, many common strategies can be successfully pursued as mentioned above. Current investor sentiment also appears to be skewed towards more structured products, sometimes with in-built capital guarantee features. And at the more sophisticated end of the product spectrum, dynamic, multi-asset, long-short strategies are becoming more common, through the use of, for example, financial indices or total-return swaps. One of the innovations of recent years worth emphasising has been the construction and use of financial indices that are specifically designed to extract alpha and provide liquidity to previously inaccessible and opaque markets. The growth of swap-based exchange-traded funds (“ETFs”) has also given investors access to asset classes, via index form, that would not have been possible a few years ago. Naturally there are robust UCITS requirements around the construction of indices and the independence of the index provider, but this development is a good example of how UCITS allow product innovation while insisting that strict regulatory standards are followed.
It is worth mentioning that one of the primary reasons that such strategies can be used in UCITS is that European regulators are, subject to the imposition of clear parameters, satisfied that risk-based measures such as Value at Risk (VaR) can be used to monitor market risk. Obviously asset managers only pursuing relatively simple asset allocations with limited leverage can avail of more simple and conservative measures of market risk and leverage, but it is possible to use sophisticated risk-based measures instead. Certainly from the Irish regulatory experience, the use of VaR has greatly increased over the last number of years as more and more sophisticated asset managers feel comfortable using UCITS as part of their product offering.
The markets are continually flexing and evolving despite current upheavals, and European regulatory authorities are continually monitoring market developments and assessing their impact on the UCITS product. It is a constant challenge for regulators to assess new product proposals given that recent history has certainly taught us that much of what passed as financial innovation actually concealed risks and leverage. Macro financial developments will normally impact UCITS in one way or another and the UCITS model has been adept at coping with these. It is clear that UCITS offer a unique proposition that allows a controlled level of product and strategy innovation with robust regulatory oversight. As such the product is an excellent example of how both commercial and regulatory requirements can successfully work and, as such, will continue to attract the growing interest of both traditional and alternative asset managers.
Grellan O’Kelly, FCA, works in the Policy Section of the Financial Institutions and Funds Authorisation Department of the Irish Financial Regulator specialising in regulatory policy on derivatives, risk management and structured products. Any views expressed in this article are made in a personal capacity and are not intended to represent the views of the Financial Regulator.
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