The Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD) has caused much upheaval in the European alternative fund industry and beyond. In anticipation of AIFMD, some managers launched UCITS replicating alternative strategies. Core to doing so was the ability to use derivatives. But the regulators’ attention has not stopped with alternatives. In parallel, the European Commission and the European Securities and Markets Authority (ESMA) have been looking at the well-known UCITS fund structure.This article considers these initiatives and how they may impact the use of derivatives by UCITS.
The original Directive for Undertakings for Collective Investment in Transferable Securities Directive 85/611/EC (UCITS I) allowed investment by UCITS in transferable securities (equities and bonds). Derivatives could be used for limited ends only. First, for efficient portfolio management (EPM) purposes to enable the UCITS to reduce risk or cost. Secondly, to produce extra capital or income for the UCITS, but only if doing so was consistent with the risk profile of the UCITS and the risk diversification rules in UCITS I.
From UCITS to Newcits
Nearly 30 years ago, this restrictive use of derivatives – for EPM and income generation within a strict risk framework – was thought to be suitable for UCITS products. By 2001, the outlook had changed. Then the view was that derivatives could be used for investment purposes in UCITS, subject to careful oversight under risk management processes. UCITS I was amended to this effect, notably by Directive 2001/108/EC, known as the Product Directive and part of the package of amendments comprising UCITS III.
UCITS III liberalised the range of investment instruments a UCITS fund could use. That meant UCITS funds, designed with the retail investor in mind, could employ or mirror, using derivatives, alternative investment strategies, more usually associated with hedge funds aimed at professional investors. The media soon named this new breed of UCITS “Newcits”. This was something of a misnomer as Newcits were not a new type of fund. Nor do “Newcits” have a precise definition. Instead, the Newcits concept is as broad as the range of strategies that could be included or reproduced within the UCITS.
Despite new investment content, the defining features of a UCITS fund also apply to a Newcits. These include:
- Liquidity. UCITS must be able to meet redemption requests daily. No gates or tie-ins.
- Risk diversification rules. The current directive, UCITS IV, still contains risk diversification rules.
- Authorisation and supervision. UCITS managers are subject to strict prudential and conduct rules.
- Disclosure. UCITS must disclose investment information in a prescribed form.
The purpose of these criteria was to provide effective and uniform protection for investors.
The success of UCITS rapidly gave them a reputation as a gold standard for collective retail investment vehicles, that investors outside Europe as well as within it considered “safe”. Investor interest in UCITS was also bolstered by investor risk aversion following the financial crisis. Product scandals, such as Madoff, also drove demand for investments investors considered to be “safe”, such as UCITS. From a manager perspective, UCITS were a known, well regarded vehicle, already benefiting from a European passport and retail recognition. The (current) ability to sell UCITS on an execution-only basis – due to UCITS being non-complex for the purposes of the Markets in Financial Instruments Directive (2004/39/EC) (MiFID) – is an added bonus.
But was UCITS III a shift too far? Would Newcits undermine the success of UCITS? New guidelines published by ESMA, as well as the European Commission’s July 26, 2012 consultation document on UCITS (commonly referred to as UCITS VI) suggest the regulator has adopted these views. At the least, the use of derivatives by UCITS is under scrutiny.
The ESMA guidelines on ETFs and other UCITS issues (ESMA/2012/832 EN) dated December 28, 2012 (the ESMA guidelines) impose new requirements on UCITS managers. They must be read with ESMA’s related questions and answers (most recently dated November 27, 2013) (ESMA/2013/1547) (Q&A). In addition, the UCITS VI covers the issues the Commission believes require closer scrutiny. The issues include the scope of assets and exposures considered eligible for a UCITS fund, and EPM.
UCITS IV risk diversification and product rules
Before turning to the ESMA guidelines and UCITS VI consultation, a brief reprise of the existing rules is necessary.
Although the directives that comprised UCITS III have now been repealed, the amendments they made to UCITS I remain. The UCITS IV Directive (2009/65 /EC) recast the amended UCITS I. So investment in derivatives was, under UCITS III, and still is subject to precise conditions under UCITS IV. These conditions include limits on the percentage of the UCITS total assets the manager invests in derivatives.
First, UCITS may not invest in commodity derivatives directly. They can invest in financial derivative instruments (including equivalent cash settled instruments) if the derivatives satisfy one or more of the following conditions. They must be:
- admitted to, or dealt in, on a regulated market as defined in MiFID; or
- dealt in on another regulated market of a Member State; or
- admitted to official listing on a stock exchange in a third country or dealt in on another regulated market in a third country as set out in UCITS IV; or
- subject to a further set of conditions, an OTC financial derivative instrument.
The further conditions that apply to OTC instruments are:
- the underlying consists of financial indices, interest rates, foreign exchange rates or currencies in which the UCITS may invest according to its investment objectives in its fund rules or instruments of incorporation;
- the counterparties to OTC derivative transactions are institutions subject to prudential supervision and belonging to the categories approved by the competent authorities of the UCITS’ home Member State; and
- the OTC derivatives are subject to reliable, verifiable, daily valuation and can be sold, liquidated, or closed by an offsetting transaction at their fair value at the UCITS manager’s initiative.
Part VII of UCITS IV (Obligations Concerning the Investment Policies of UCITS) lists the types of investments the manager may employ (including financial derivative instruments). Article 52 critically provides that a UCITS invests no more than:
- 5% of its assets in transferable securities or money market instruments (as defined) issued by the same body; or
- 20% of its assets in deposits made with the same body.
In addition, the risk exposure to a counterparty of the UCITS in an OTC derivative transaction cannot exceed either:
- 10% of its assets when the counterparty is a credit institution; or
- 5% of its assets in other cases (including where the counterparty is a member of a group including a credit institution).
It is also important to be aware of the total limit rule in article 52(2). So, in addition to the individual limits above, a UCITS must be careful not to have a global exposure of more than 20% of its assets in a single body. So it must not combine investments in transferable securities or money market instruments issued by a body, deposits made with that body, or exposures arising from OTC derivative transactions undertaken with that body, where to do so would breach the 20% rule.
To prevent liability for breach, a UCITS management company must have clear procedures (or contractual limits) to adhere to the relevant thresholds. For example, it will need procedures or contractual limits imposed, to ensure it stays within the net 5% threshold for financial derivatives with non-bank counterparties, being mindful also of the global threshold. Alternatively, it should confine itself to trading on exchange (on regulated markets) – for which there is no counterparty exposure limit pursuant to UCITS Directive article 50(g).
These categories and restrictions now seem antiquated, given the reforms brought in by Regulation (EU) No 648/2012 of the European Parliament and of the Council of July 4, 2012 on OTC derivatives, central counterparties and trade repositories (EMIR). It is not clear why futures should not be subject to counterparty limits, but cleared OTC derivatives should, especially given that the EMIR rules in article 39 on segregation and portability apply to all cleared derivatives, whether traded bilaterally, on a multilateral trading facility (MTF) or a regulated market.