Alternative Investment Management Association
UCITS developments in 2012 will have lasting impact for those hedge fund managers able to offer their strategies in UCITS funds. There will also be ramifications for those with alternative investment funds (AIFs) under the incoming AIFMD1.
Regulations for AIFs and UCITS are moving in harness with each other, with many recent UCITS developments arising from implementation of the AIFMD, which itself borrows heavily from the UCITS provisions. When we see regulators focus on a particular area in the UCITS sphere this may be taken as an indication of what may be coming for AIFs and vice versa. Below are some key UCITS developments on investment restrictions which all managers should note.
Not so long after member state implementation on 1 July 2011 of UCITS IV2, the European Commission adopted on 3 July 2012 a legislative proposal for UCITS V3. No sooner had it done so, on 26 July 2012 it published a consultation document (referred to as "UCITS VI") seeking views on the UCITS regime and whether further measures are needed to address its concerns on specific aspects4.
Of particular interest within the UCITS VI consultation (the "Consultation") is the Commission's review of UCITS eligible assets and use of financial derivative instruments (FDI). This could go either way, with current restrictions being tightened or relaxed and, in consequence, the distinction between UCITS and AIFS hardening or blurring. This will have a knock-on impact for the hedge fund industry and the choices which managers and investors make between UCITS and AIFs.
Currently UCITS funds are required to invest in eligible assets, which comprise transferable securities, money market instruments, units of collective investment schemes, bank deposits and FDI. Commodities and FDI on commodities are excluded. UCITS funds are also permitted to gain exposure to non-eligible assets in a number of ways, notably FDI based on financial indices which comply with a defined set of criteria, closed-ended funds, or structured transferable securities. Much innovation in the use of hedge fund strategies in UCITS form has been through the use of FDI and financial indices.
The Commission finds that the emergence of UCITS adopting hedge fund strategies has raised several questions regarding the appropriateness of these strategies and risk profiles in a UCITS context. It asks whether the scope of assets and exposures deemed eligible for a UCITS fund should be reviewed, querying whether all investment strategies current observed in the marketplace are in line with what investors expect of a product regulated by UCITS.
Significantly, the Commission is looking at preventing exposure to certain non-eligible assets (for example by adopting a "look through" approach for transferable securities, investments in financial indices, or closed-ended funds).
The Commission also asks if there may be merit in distinguishing or limiting the scope of eligible FDI. In its response to the Consultation, AIMA argues that the ability to use derivatives is an indispensable portfolio management tool and that eligible FDI should not be decreased. Certainly, if some or all FDI were disallowed this would severely constrain the UCITS sector.
The Consultation has at least provided a formal opportunity for debate. Some stakeholders have used this to point out that not only has the current eligible assets regime generally worked well but also that in certain respects it would make sense for the range to be expanded. Thus AIMA argues that, with proper risk measurement and disclosure, the eligible assets in which a UCITS can invest directly should include FDI on single commodities. Indeed, the current prohibition of commodity derivatives appears to be outdated and in contradiction with the investor protection concerns and the interest of investors in general. Arguably, it would be more transparent for underlying investors if UCITS could invest in commodity derivatives directly as opposed to through financial indices.
Meanwhile, in its response to the Consultation, the Loan Market Association requests that the list of eligible assets be expanded to include certain types of loan, arguing that loans are a safe, liquid, remunerative and transparent asset class. The Investment Management Association also warns against restricting UCITS investment strategies but argues for a new type of EU passport for non-UCITS retail funds that invest in alternative assets such as real estate, venture capital and commodities or that are closed-ended or have limited redemption.
Meanwhile, on 25 July 2012 ESMA issued a Report and Consultation Paper containing Guidelines on Exchange Traded Funds (ETFs) and other UCITS issues (the "Guidelines")5. Echoing the Commission's rationale for its Consultation, the Guidelines are the culmination of concerns about the possible impact on investor protection and market integrity arising from hedge fund strategies in UCITS form as well as the increasing use of synthetic and more complex strategies by ETFs.
The Guidelines are aimed at investor protection and disclosure but also contain specific rules to be applied by UCITS when entering into over-the-counter (OTC) derivative transactions and efficient portfolio management (EPM) techniques. Finally, the Guidelines set out detailed criteria for financial indices in which UCITS invest6.
Given the prohibition on UCITS investing in commodities and FDI on commodities, financial indices represent the principal method by which UCITS can gain exposure to commodities. However, the Guidelines provide that UCITS must not invest in commodity indices unless they consist of different commodities. For diversification purposes sub-categories of the same commodity should be considered as being the same commodity. For example, WTI Crude, Gasoline or Heating Oil contracts would all be categorised as oil.
The Guidelines also impose a significant potential restriction on customised indices, stating that "an index shall not be considered as being an adequate benchmark of a market if it has been created and calculated at the request of one, or a very limited number of market participants and according to the specifications of those market participants". Thus UCITS may be asked by regulators to confirm or demonstrate that the index has not been created on the basis set out above, something which may well require index provider confirmation.
Notably, the Guidelines state that a UCITS should not invest in a financial index unless sufficient information in respect of its calculation methodology is freely and easily accessible by investors to enable them to replicate the financial index. Some providers already make a point of offering transparency but a number will have intellectual property protection concerns. Nor, in a requirement apparently aimed at highly active hedge fund strategies, should the rebalancing frequency of the financial index prevent investors from being able to replicate it.
ESMA also imposes requirements prohibiting the use of financial indices whose index provider accepts payments from potential index components for inclusion in the index; or whose methodology permits respective changes to previously published index values ("backfilling"), as well as requirements relating to due diligence and independent valuation.
UCITS affected by the Guidelines will need to be aware of the transitional provisions and monitor closely the changes suggested by the Guidelines.
As stated above, the UCITS VI consultation at least provides a formal opportunity for debate and it is hoped that due note is taken of responses. A more considered approach than that often seen since the financial crisis to the investment fund industry's development is in the interests of regulators, managers and investors.
 The Alternative Investment Fund Managers Directive (2011/61/EU).
 UCITS IV introduced a number of improvements such as a management company passport, master-feeder structures, mergers and improved investor disclosure.
 The draft UCITS V covers eligibility to act as a depositary, criteria for delegating custody, liability for the loss of financial instruments held in custody, the remuneration of UCITS managers, and sanctions for breaches.
 European Commission consultation entitled: Undertakings for Collective Investment in Transferable Securities (UCITS): Product Rules, Liquidity Management, Depositary, Money Market Funds, Long-term Investments. The consultation closed on 18 October 2012.
 ESMA/2012/474, 25 July 2012. The document also includes ESMA's consultation on the recallability of repurchase and reverse repurchase arrangements. Feedback on this consultation, which closed 25 September 2012, will be used by ESMA to finalise its position, which will be incorporated into the rest of the Guidelines.
 See client briefing for details on the Guidelines' requirements http://www.gide.com/front/files/GLN_nwsl_London_FinancialRegulation_ESMAsGuidelines_ETFs_UCITS_EN_aug2012.pdf