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Facing a complex/non-complex situation

October 18, 2011

Complex formula on blackboardIf a fund uses derivatives heavily, does it become too complex for the average retail investor? That’s the question facing the European fund industry right now. Regulators in the European Union have proposed that UCITS funds* using derivatives extensively should be designated as “complex” — and subject to more stringent rules on sales and marketing.

The prospect of a divided UCITS brand was a hot topic of discussion at the ALFI Global Distribution Conference held in Luxembourg in late September in association with NICSA and the Hong Kong Investment Funds Association. Here’s an overview of the conversation.

UCITS have grown more complex. . .

When UCITS funds were first introduced in 1984, they were “plain vanilla” investment vehicles: long-only with limited ability to use derivatives.  This simplicity helped UCITS funds to become accepted not just in Europe, but throughout the world. Investors looking for more sophisticated approaches had to look elsewhere – generally to unregistered hedge funds.

At least that was the case until the middle of the last decade, when the list of permissible investments for UCITS funds was expanded to include credit default swaps, index futures and asset-backed securities, among other instruments. UCITS were also permitted to use these derivatives to create leverage up to twice the value of the underlying assets.

Funds using the new capabilities – known as “sophisticated UCITS” or, more familiarly, as “NewCITS” — quickly became popular with investors looking for more aggressive approaches. According FINalternatives, there are now over 1,000 of these funds registered in Europe.

. . . prompting regulatory scrutiny in Europe. . .

But while the new UCITS funds were popular with certain investors, they raised red flags with regulators, who worried that these funds were being sold to individuals who didn’t fully appreciate their risks.

To stave off futures problems, the European Securities and Markets Authority or ESMA – the European equivalent of the SEC – made a radical proposal this summer. They suggested dividing UCITS funds into two categories: complex and non-complex. While non-complex funds could continue to be widely distributed, complex funds would be subject to suitability requirements.

European fund managers have generally responded to the proposal with less than enthusiasm. They’re concerned that it will be difficult to define complex versus non-complex precisely. Will categorization be determined by notional value of derivatives contracts, by value at risk or some other measure? And they’re worried that splitting the UCITS brand into two subcategories will lessen its appeal around the world.

That’s not a universal opinion, however. At least one major fund manager – Fidelity Investments – has argued that dividing the brand will actually strengthen UCITS’ position of UCITS in Asia.

Simple formula on blackboard. . . and in Asia. . .

In its comment letter on the proposed rule, Fidelity explains that Asia is critical for investment managers. Over 5,000 UCITS funds are already being sold in Asia – and prospects for growth in assets under management are among the best in the world. Countries in the region are experiencing steady economic gains – meaning that they have more money to invest. At the same time, many of these countries have established mandatory savings programs – like Hong Kong’s Central Provident Fund – that automatically direct some of that new wealth into long-term investments, which are often UCITS funds.

Asian regulators worry that there’s the potential for a mismatch – sophisticated UCITS fund with unsophisticated investor in a mandatory savings program. (For a U.S. equivalent, think leveraged ETF in a 401(k) plan.) They’re often not willing to wait for ESMA to act: Hong Kong and Singapore have already imposed controls on offerings of more complex funds – effectively requiring a visa in addition to a UCITS passport before funds can be sold locally.

. . . while U.S. regulators pursue a similar line of inquiry.

In a parallel universe, similar issues are being discussed here in the United States — just substitute the leveraged ETFs for complex UCITS. Instead of an ESMA consultation, we have an SEC concept release: “Use of Derivatives by Investment Companies under the Investment Company Act of 1940.” Do you see other similarities?


*UCITS funds in brief: The UCITS directives approved by the European Council and Parliament establish rules for the registration and sales of mutual funds within the European Union. A fund registered in one EU country that complies with all the UCITS regulations can be sold in all other EU countries merely by filing a notice with regulators in those countries under a “passport” system. This passport has also been accepted by many countries outside the European Union as well. In fact, UCITS funds account for a significant proportion of fund investments in Chile, Hong Kong, Singapore and Taiwan. UCITS stands for “Undertaking for Collective Investment in Transferable Securities.”

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