Retail funds

Available vehicles

What are the main legal vehicles used to set up a retail fund? How are they formed?

A retail fund will probably be established in the UK as an open-ended UCITS fund. A UK exchange-traded retail fund (a retail ETF) will typically be a UCITS fund listed on a stock exchange. Alternatively, a manager may establish a closed-ended vehicle, typically to invest in assets (such as real estate) in which a UCITS fund is not permitted to invest, and adopt the investment trust model (see below). An investment trust will typically be listed on a stock exchange to allow investors to realise their shares on the stock market and to enable a public offering of the shares (if desired).

Open-ended retail funds

Open-ended retail funds established in the UK are either UCITS funds or (more rarely) non-UCITS retail schemes (NURS). A NURS is a type of non-UCITS fund authorised by the FCA for distribution to retail investors in the UK, with wider investment and borrowing powers than a UCITS - in particular, a NURS can invest in real estate (land) and gold. In either case, the fund will be legally constituted in the UK as an open-ended investment company (OEIC), an authorised unit trust (AUT) or an authorised contractual scheme (ACS).

The term ‘investment company with variable capital’ is synonymous with OEIC. An OEIC is formed with an instrument of incorporation, at least one director and shareholders (investors). An OEIC must have an authorised corporate director (ACD), which must be an FCA-authorised person, who is responsible for managing the fund. Typically, the ACD is the OEIC’s sole director. An AUT is a trust and, as such, has no separate legal personality under UK law. It is constituted by a trust deed made between the trustee and the fund manager. The trustee holds the assets (investments) on trust for the beneficiaries (investors), who are known as ‘unitholders’, since their beneficial interests are represented by ‘units’ under the trust. Unlike an OEIC or AUT, an ACS is a tax-transparent vehicle constituted either as a co-ownership scheme or limited partnership. A co-ownership scheme is constituted by an agreement between the fund manager and the depositary (custodian), under which the investors’ rights to the assets are similar to those of AUT unitholders.

Any of these vehicles, except an ACS constituted as a limited partnership, can be an umbrella fund, with underlying sub-funds. The property of a sub-fund may be used only to discharge the liabilities of that sub-fund. Each sub-fund of an umbrella is therefore individually ring-fenced.

Closed-ended retail funds

Closed-ended retail funds established in the UK are typically companies listed on the London Stock Exchange’s (LSE) Main Market (traditionally called investment trusts, although nowadays in corporate form). The Main Market is the most liquid market in the UK (offering the widest investor base). It is also a ‘regulated market’ under EU law. Funds listed on the Main Market can accordingly be marketed to retail investors and also qualify for inclusion in institutional investors’ mandates limited to investments listed on a regulated market. Investment trusts must comply with requirements relating to, for instance, investment diversification, in order to qualify for favourable tax treatment (see question 18).

Some investment companies are traded on the LSE’s Alternative Investment Market (AIM) or its Specialist Fund Segment. AIM is an exchange-regulated market, not a regulated market under EU law. As such, it is generally easier and quicker for a fund to make an initial offering of its shares on AIM rather than on the Main Market (and also follow-on offerings), provided the offering is limited to institutional investors, because compliance with the EU Prospectus Directive 2003 is not then required. The Specialist Fund Segment is designed for specialist investment funds targeting only professional, professionally advised, institutional or knowledgeable investors. Compliance with the Prospectus Directive is required. There are also special LSE regimes for closed-ended funds investing in venture capital (venture capital trusts) and real estate (real estate investment trusts).

Most investment companies listed or traded on the LSE are classified as AIFs, with the exception of some real estate investment trusts, because they have a commercial, not an investment, purpose.

Laws and regulations

What are the key laws and other sets of rules that govern retail funds?

The establishment and operation of open-ended retail funds in the UK are governed by the FSMA, various statutory instruments made under the FSMA and the FCA’s rules (in particular, the FCA’s collective investment scheme (COLL) rules). In addition, from 31 December 2019, the EU Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation may apply to all UK open-ended retail funds. Currently, all EEA UCITS funds are exempted until 1 January 2022, but it is unclear whether the exemption will continue from that date. This Regulation requires a standardised pre-contractual key information document for each fund. If the Regulation applies, this would replace the equivalent key investor information document currently required by virtue of the UCITS Directive. Closed-ended retail funds constituted as companies are not collective investment schemes in UK terms, and are therefore subject only to FSMA and FCA financial promotion rules and, if listed on the LSE’s Main Market, the FCA’s Listing Rules or, if traded on AIM or the LSE’s Specialist Fund Segment, the rules of those markets. Specialised rules apply to UK UCITS funds that are money market funds (MMFs) under the EU Money Markets Fund Regulation 2017 (MMFR), including liquidity management procedures and a prohibition on external financial support (such as a guarantee).

Authorisation

Must retail funds be authorised or licensed to be established or marketed in your jurisdiction?

Open-ended retail funds

To be marketed in the UK, open-ended retail funds must either be authorised by the FCA (if established in the UK) or recognised by the FCA (if established outside the UK). Any entity established as an open-ended retail fund in the UK must be authorised by the FCA. Most non-UK funds recognised by the FCA are UCITS funds established in other EEA jurisdictions. The authorisation process is outlined in question 20.

Closed-ended retail funds

Closed-ended retail funds listed on the LSE’s Main Market or traded on its Specialist Fund Segment are not authorised as funds by the FCA, although the actual listing on the Main Market will require approval by the FCA in its capacity as the UK ‘listing authority’, and Main and Specialist Fund Segment prospectuses will require its approval under EU ‘approved prospectus’ law. Closed-ended funds traded on AIM are also not FCA authorised, but will still be subject to the AIM rules. In addition, an AIM prospectus will require approval by the FCA if the shares are to be offered to retail investors. Any fund traded on AIM must appoint an independent adviser to act as a nominated adviser (NOMAD), whose function will be to confirm to the LSE the fund’s compliance with the AIM rules.

Marketing

Who can market retail funds? To whom can they be marketed?

Open-ended retail funds authorised or recognised by the FCA, and closed-ended retail funds listed on the LSE’s Main Market or traded on its Specialist Fund Segment, can be marketed to any type of investor in the UK (although, in practice, a fund traded on the Specialist Fund Segment will not make a retail offering, because the LSE will admit to that market only funds targeted at professional, professionally advised, institutional or knowledgeable investors). A fund traded on AIM is also, in practice, rarely offered to retail investors in the UK (any retail offering would require compliance with the Prospectus Directive, and AIM-traded funds typically seek to avoid this expense). However, UK retail investors can and do acquire shares in AIM-traded funds on the secondary (as distinct from primary) market.

An entity marketing a retail fund in the UK must be FCA-authorised if:

  • it carries on a regulated activity in the course of marketing the fund, such as giving investment advice or arranging deals in investments; and
  • it carries on that activity in the UK, subject to the overseas person exclusion described in question 4.

In practice, a professional UK fund distributor, such as an IFA, is normally FCA-authorised either because it gives investment advice to clients or because its distribution activities, such as taking clients’ investment orders and transmitting their investment subscription monies, constitute the regulated activity of ‘arranging deals’ in investments.

Managers and operators

Are there any special requirements that apply to managers or operators of retail funds?

The manager of a UK UCITS fund, or a UK NURS, established as an AUT must be independent from the AUT trustee and a body corporate established in the UK or another EEA state. The manager of a UK UCITS fund established as an OEIC will usually be the ACD of the OEIC (see question 12).

The manager of a UK UCITS fund must be authorised by the FCA to carry on the regulated activity of ‘managing a UCITS’ or may be a firm established in another EEA state operating under the EU UCITS management passport. The manager of a NURS (see question 12) must be authorised to carry on the regulated activity of managing an AIF. The manager of a closed-ended retail fund must be authorised by the FCA, typically to carry on the regulated activity of managing an AIF. Alternatively, the fund itself can be authorised as a self-managed AIF, if it has no external AIFM.

Under product governance rules introduced in 2018 by MiFID II, a firm ‘manufacturing’ a new fund (ie, creating, developing, issuing or designing a new fund) must identify the fund’s ‘target market’ of ‘end (ultimate) clients’, ensure its distribution strategy is compatible with that market and take reasonable steps to ensure the fund is in fact distributed to that market. Typically, it will be the manager or operator of a fund that will manufacture it for these purposes, although this will not necessarily preclude a primary distributor from also being a manufacturer. Although the rules apply to non-retail funds as well as retail funds, they will, in practice, have a greater impact on retail funds, simply because the end clients and distributors will be more numerous and identifying the target market and monitoring distributors will therefore be more difficult.

Investment and borrowing restrictions

What are the investment and borrowing restrictions on retail funds?

The investment and borrowing powers for UK UCITS funds (except MMFs) are set out in the FCA’s COLL rules, implementing the UCITS Directive. A UK UCITS fund (except an MMF) can invest its portfolio in the following assets:

  • transferable securities and money market instruments traded on an EEA regulated market or on an ‘eligible market’ (a non-UK market listed in the UCITS fund’s prospectus satisfying specified criteria). Transferable securities consist of shares, debt securities and other traded securities, such as depositary receipts;
  • certain other money market instruments issued by a regulated body;
  • other transferable securities and money market instruments (unlisted securities) (subject to the investment spread limit below);
  • cash and near cash (including bank deposits and Treasury bills);
  • units in other UCITS funds and regulated collective investment schemes, subject to conditions; and
  • derivatives and forward transactions.

A UK UCITS fund (except an MMF) is subject to investment spread and concentration requirements, including:

  • up to 5 per cent of its assets can be invested in transferable securities or money market instruments issued by a single body (unless the fund tracks an index, when a higher limit may apply - see below) . The 5 per cent limit can be raised to 10 per cent for 40 per cent of the portfolio;
  • up to 10 per cent of its assets can be invested in unlisted securities;
  • up to 20 per cent of its assets can be invested in cash deposits with a single body;
  • exposure to a single OTC derivatives counterparty cannot exceed 5 per cent of its assets, except where the counterparty is an approved bank, where the exposure can be up to 10 per cent;
  • up to 20 per cent of its assets can be invested in transferable securities and money market instruments issued by the same group (or, exceptionally, up to 35 per cent in transferable shares or debt securities issued by a single body, if the fund tracks an index);
  • up to 20 per cent of its assets can be invested in units of (broadly) any one regulated collective investment scheme (eg, another UCITS fund) and up to 30 per cent in (broadly) all other regulated collective investment schemes;
  • up to 35 per cent of its assets can be invested in government or public securities issued by a single body - or 100 per cent, subject to conditions, including:
    • no more than 30 per cent can be invested in a single issue; and
    • the securities must comprise at least six different issues;
  • the fund cannot hold more than 10 per cent of the debt securities issued by a single body ;
  • the fund cannot hold more than 25 per cent of the units or shares issued by a single regulated collective investment scheme; and
  • the fund cannot hold more than 10 per cent of the money market instruments issued by a single body.

A UK UCITS fund (except an MMF) fund can borrow up to 10 per cent of its assets on a temporary basis. It follows that, in practice, a UK UCITS fund cannot borrow for investment purposes, and so can do so only to cover redemptions of units or shares by selling investors - or, if it is an MMF, not at all.

A UK UCITS fund that is an MMF must comply instead with the MMFR’s specialised investment eligibility, spread, concentration and portfolio rules. The applicable investment portfolio rules will depend on the type of MMF and whether it is ‘short-term’ or ‘standard’.

A UK NURS is subject to less restrictive investment spread limits than a UK UCITS fund, so that (for example) it can invest :

  • up to 100 per cent of its assets in real property (land);
  • up to 10 per cent of its assets in transferable securities issued by a single body ;
  • up to 10 per cent of its assets in gold;
  • up to 20 per cent of its assets in unlisted transferable securities; and
  • up to 35 per cent of its assets in other collective investment schemes (including non-UK non-UCITS funds whose investment and borrowing powers are equivalent to, or more restricted than, NURSs, and other non-UCITS funds, provided that the combined value of unlisted transferable securities and those other non-UCITS funds does not exceed 20 per cent of its assets).

In addition, a UK NURS authorised as a ‘fund of alternative investment funds’ can invest in a range of AIFs.

A UK NURS can borrow up to 10 per cent of its assets on a permanent basis and, if it tracks an index , can invest up to 20 per cent of its assets in transferable shares or debt securities issued by a single body (or, exceptionally, up to 35 per cent).

Closed-ended retail funds

Closed-ended retail funds listed on the LSE’s Main Market are not subject to restrictions on investment or borrowing, although, as a condition of listing, they must have a published investment policy covering asset allocation, risk diversification, gearing and maximum exposures. In practice, a fund will have to draw up its own set of investment restrictions and require shareholder approval to amend them.

A UK closed-ended retail fund listed on the LSE’s Main Market must satisfy certain investment conditions in order to qualify for favourable tax treatment. For example, the business of the company must consist of investing its funds in shares, land or other assets with the aim of spreading investment risk and giving members of the company the benefit of the results of the management of its funds.

Tax treatment

What is the tax treatment of retail funds? Are exemptions available?

Open-ended retail funds

Subject to special rules applying to tax-elected funds, property authorised investment funds, (PAIFs) and Funds invested in Non-Reporting Offshore Funds (FINROFs), AUTs and OEICs are generally exempt from UK tax on gains on the disposal of investments (capital gains), but subject to corporation tax at a special rate of 20 per cent on income, although dividend income (primarily from shares) is exempt, subject to conditions, and deductions are available, subject to conditions, for amounts distributed by funds primarily invested in debt securities including MMFs (bond funds) as interest distributions.

UK-resident individual fund investors will be subject to tax on dividend distributions made, or (if the fund accumulates or reinvests its income) deemed to be made, subject to a £2,000 annual dividend allowance, with no withholding. These dividend distributions are generally tax exempt for UK corporation taxpayers, such as companies.

UK-resident individual investors in bond funds will have their interest distributions generally treated as interest for tax purposes, subject to an annual personal savings allowance under certain circumstances, with no withholding. UK corporation taxpayers will be subject to corporation tax on interest distributions, again with no withholding.

UK-resident individual fund investors are generally subject to capital gains tax on gains realised on the disposal of units or shares in an AUT or an OEIC (excluding a FINROF). UK non-resident individual fund investors are generally not directly subject to UK tax withholding tax (excluding investors in PAIFs receiving property income dividends) nor subject to UK capital gains tax unless the fund (including a PAIF or FINROF) has a significant direct or indirect investment (broadly 75 per cent by gross asset value) in UK land (real estate).

For tax purposes, individual ACS investors will be treated broadly as if they had invested directly in the underlying assets if the ACS is structured as a partnership. However, an ACS structured as a co-ownership scheme is transparent for income tax purposes but generally opaque for capital gains. These capital gains are therefore taxed at ACS-level unless the fund in which the ACS has a significant direct or indirect investment (broadly 75 per cent by gross asset value) is invested in UK land (real estate).

Closed-ended retail funds

UK investment trusts are exempt from tax on capital gains, but otherwise generally subject to UK corporation tax at 19 per cent (from 1 April 2020, 17 per cent). Individual investment trust investors are taxed in the same way as individual shareholders in other UK companies, except that investment trusts primarily invested in debt securities can elect to be treated in broadly the same way as AUT and OEIC bond funds (including payment of dividends as interest distributions) to the extent they receive interest income.

Asset protection

Must the portfolio of assets of a retail fund be held by a separate local custodian? What regulations are in place to protect the fund’s assets?

Open-ended UK retail funds must appoint an independent entity (a custodian) to hold their assets. This must be a trustee, for an AUT, or a depositary, for an OEIC. A trustee must be independent from the manager and established in the UK, or, if established in another EEA state, have a place of business in the UK. A depositary must likewise be established in the UK, or, if established in another EEA state, have a place of business in the UK. Trustees and depositaries must be authorised by the FCA, since these are regulated activities. They will be subject to the FCA’s client asset (CASS) rules on custody of assets, which are intended to ensure that custodians observe professional standards of care and diligence, including in the appointment of sub-custodians. Depositaries of UCITS funds, and trustees, in the case of AUTs, are subject to strict liability for the loss of assets held in custody, similar to AIF depositaries (see question 30).

Most closed-ended retail funds marketed in the UK are AIFs. Under the AIFMD, an AIF must appoint a depositary if the AIF is established and managed in the EEA (see question 30). Closed-ended retail funds not required under the AIFMD to appoint a depositary, because the fund or the AIFM is established outside the EEA (or the fund is managed by a sub-threshold AIFM - see question 25), will, in practice, appoint a custodian, where they hold assets, such as listed securities, requiring a custodian for trade settlement purposes.

Governance

What are the main governance requirements for a retail fund formed in your jurisdiction?

The registration and organisational governance requirements for UK UCITS funds established as AUTs, OEICs or ACSs are largely the same. All must be authorised by the FCA. Application is accordingly made to the FCA with:

  • a draft prospectus;
  • a draft instrument of incorporation, in the case of an OEIC;
  • a trust deed, in the case of an AUT, or limited partnership agreement or co-ownership deed, in the case of an ACS;
  • a model portfolio;
  • an application form; and
  • a solicitor’s certificate confirming that the constitutional documents comply with the applicable regulations.

The FCA has two months in which to consider a UCITS application.

UCITS funds established elsewhere in the EEA can be recognised by the FCA for sale in the UK under the EU passporting process. Under this process, the UCITS manager provides a notification letter and the fund documentation to its EEA home state regulator, which then approves the application and sends the documents on to the FCA.

Certain schemes considered comparable to UK-authorisable schemes can also be recognised by the FCA for sale in the UK. In practice, though, such funds are seldom recognised, unless established in Guernsey, the Isle of Man or Jersey.

As previously noted, most UK closed-ended retail funds, as distinct from their managers, are outside FCA regulation, although their manager, or the fund itself if (unusually) self-managed, will be subject to FCA regulation (see question 16). A listed or exchange-traded closed-ended retail fund is subject to the governance requirements of the rules of the exchange on which it is listed or traded. In particular, the FCA’s Listing Rules, applying to the LSE’s Main Market, require that the majority of the fund’s board of directors are independent of the investment manager.

Reporting

What are the periodic reporting requirements for retail funds?

For UK open-ended retail funds, reports must be made available on request to investors and to the public generally, free of charge, annually and half-yearly. The reports must include certain prescribed information, including the accounts and, in the annual report, a report from the auditor and the trustee or depositary.

Closed-ended retail funds listed on the LSE’s Main Market, or traded on its Specialist Fund Segment or AIM, must also publish a report twice a year, with a long report annually. A closed-ended retail fund listed on the Main Market must also report to the UK tax authority (HMRC) annually in order to secure approval for favourable tax treatment (see questions 17 and 18) and make ongoing notifications to HMRC to maintain the approval.

Issue, transfer and redemption of interests

Can the manager or operator place any restrictions on the issue, transfer and redemption of interests in retail funds?

UK open-ended retail funds must offer to issue and redeem (buy back) shares or units to or from investors on every dealing day. There must be at least two dealing days in each month, at least a fortnight apart. Retail funds can limit the number of shares or units in issue, provided this complies with the fund prospectus. Retail funds with a daily dealing day may defer redemptions to the next dealing day, if redemption requests for a particular day exceed 10 per cent of the fund’s value, or some other reasonable proportion stated in the prospectus, subject to certain conditions. Dealing in open-ended retail funds may also be temporarily suspended under exceptional circumstances and where justified in the interests of unit or shareholders. This must be immediately notified to the FCA. In addition, specialised rules apply to the suspension of redemptions by UK UCITS funds that are MMFs under the MMFR’s liquidity management procedures. A UK NURS can impose limited redemption arrangements (to limit redemptions for up to every six months) if it is a property fund, has an investment objective providing for a specified level of return (capital protection) or is a fund of alternative investment funds.

Shares in UK-listed or exchange-traded closed-ended retail funds are dealt in on-exchange. It will usually be a condition of listing or admission to trading, and of admission of the shares to a trade settlement system, that there are no restrictions on share transfer, although limited restrictions (such as on transfers to US persons) can be permitted. A UK closed-ended retail fund can repurchase its shares out of distributable profits, a method sometimes used to reduce a discount of the trading price to the fund’s net asset (net investment) value.