WHITE
PAPER
UCITS Come to the Fore:
Opportunities and Challenges
for the Funds Industry
TABLE OF CONTENTS
[03]
Introduction
[05]
Meeting Investor and Manager Demands
Traditional Investment Managers
Hedge Funds
Limitations
[06]
UCITS IV Evolution
[07]
Anticipated Benefits
[08]
Headwinds Ahead
[08]
Investment Manager Benefits
and Challenges
Cross-border competition
Scale and efficiency
Operational complexity
[10]
Operational Keys to Success
Liquidity
Risk Management
[12]
Conclusion
[12]
About Advent
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03
Introduction
UCITS IV, due to be implemented by European Union member states
by July 2011, marks the latest iteration of what has turned into a
hugely successful fund wrapper brand.
The UCITS III amendments, which took effect in 2001, have added a
welcome dimension to the industry. By significantly broadening the
range of eligible assets in which UCITS can invest, they have opened
the way for traditional managers to launch absolute return funds
and allowed hedge funds to enter the fray with so-called “Newcits”
products.
For its part, UCITS IV will introduce an efficiency package of measures
aimed at tying up many of the loose ends left over from previous versions of the directive. As such, it has been roundly applauded by the
industry in Europe, and is the subject of growing interest in the US.
In this paper we will assess the opportunities and challenges brought
by UCITS III and IV, and examine the technology frameworks fund firms
need if they are to prosper in this changing environment.
This communication is provided by Advent
Software, Inc. for informational purposes only
and should not be construed as, and does
not constitute, legal advice on any matter
whatsoever discussed herein.
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UCITS Freedoms and Requirements
UCITS must invest in liquid financial assets.
Some assets are excluded, such as unregulated hedge funds, illiquid commodities or property.
However, investing in indices of non-eligible assets such as commodities and hedge funds, as
well as in non-leveraged collateralized debt obligations, is allowed.
Units must be valued at least twice monthly.
Redemption requests must be honored within 14 days.
Investments must ensure at least 20% of assets can be redeemed.
A maximum of 10% may be invested in illiquid securities, subject to having accurate valuation
and risk management capabilities.
A maximum of 5% of NAV may be invested with a general issuer, 25% with credit institutions and
100% for government bonds, so long as there are a minimum of six securities and none exceeds
30% of the NAV.
Counterparty risk with any credit institution is capped at 10%.
UCITS can invest a 20% maximum in another supervised fund. Total investments in non-UCITS
funds limited to 30%.
Naked short sales are not allowed.
Short sales can be carried out synthetically, through the use of total return swaps, options,
futures, etc.
Cash or securities borrowings must not exceed 10% of NAV.
Leverage
Leverage through derivatives is restricted to two times assets (100% of NAV).
Risk
Management
To gauge leverage, sophisticated UCITS can use either an Absolute or Relative Value-at-Risk (VaR)
approach. They must also engage in stress testing.
Transparency
NAVs must be available twice monthly.
Funds must publish audited annual reports and financial reports, detailing their transactions and
holdings.
The key information document (KID) given to investors must describe the fund’s strategy and
risk profile.
Eligible Assets
Liquidity
Concentration
Limits
Short Sales
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05
Meeting Investor and
Manager Demands
UCITS III Fund Attractions
The freedoms instituted by UCITS III in 2001 paved the way for vehicles employing an expanded range of investment strategies to be
launched under the UCITS umbrella. As a result, there are now more
than a thousand alternative and absolute return UCITS funds in
Europe, which together total approximately $200 billion in assets.
While this still represents a relatively small portion of the overall UCITS
universe, a convergence of investor and manager interest is expected
to drive growth in these types of funds going forward.
Absolute return strategies offer
more consistent risk-adjusted performance.
Strategies and asset classes with low
correlations help manage volatility.
Vehicles provide transparency, liquidity, and safekeeping assurances.
Investors
Traditional Investment Managers
Tools to address shifting investor
demands.
Foster product differentiation.
Diversify product offerings.
Generate higher fees.
Traditional Investment Managers
The traditional investment management industry is faced with an
ongoing squeeze on profit margins due to the growth of passive
investment strategies, greater scrutiny on fee structures given recent
poor investment performance, and a crowded market for traditional
equity and bond products that makes fund differentiation difficult.
By offering absolute return products under the UCITS banner, traditional fund managers can leverage a broader array of tools to address
shifting investor demands for regulated products that offer an attractive risk-adjusted performance profile. In addition, alternative products
can generate higher fees to counter the margin squeeze being felt in
other parts of the industry.
Hedge Funds
According to research by PricewaterhouseCoopers, documented in a
March 2010 report,1 there are now more than 200 hedge fund-run
UCITS. And as the report noted, research by Hedge Fund Intelligence,
released in November 2009, found more than half of European hedge
fund managers have either launched or plan to launch Newcits.
For alternative investment managers, the main attraction of launching
a UCITS fund is the access it offers to an expanded investor audience.
Since many hedge funds hemorrhaged assets and investors during the
financial crisis, this opportunity to rebuild and grow their asset and
client base is appealing.
The European Union’s Alternative Investment Fund Managers Directive
(AIFMD) may also create further incentives for firms to launch Newcits.
Under the AIFMD, the ability of non-EU managers to market offshore
funds within the bloc will be restricted. Therefore Newcits may offer an
attractive alternative gateway into the EU market.
1 Future Newcits regulation?, PricewaterhouseCoopers
Hedge Funds
Access a larger investor universe.
Satisfy client demands for greater
transparency, disclosure, and liquidity.
Skirt the EU’s AIFMD restrictions.
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As the EDHEC Risk Institute noted in a recent research report,2 “60% of
alternative investment funds (AIFs) very much agree that the AIFM
directive leads to uncertainty about the distribution of funds; 65% of
AIFs plan (either “somewhat” or “very much”) to restructure their
funds as UCITS, whereas 25% do not.”
Limitations
The downside, as the EDHEC paper pointed out, is that shoe-horning
hedge funds into a UCITS structure—with the liquidity, portfolio concentration, asset eligibility, short-selling, and leverage limitations that
brings—may distort the strategies and produce diminished returns.
Similarly, there are fears that launching a parallel, watered-down UCITS
version of a firm’s regular hedge funds may erode the returns those
vehicles can achieve.
Another concern is that, despite initially meeting the qualifying
criteria, some funds may discover that in reality they do not have the
liquidity needed to weather periods of exceptional market stress.
Being unable to fulfill this key requirement of the UCITS framework
could damage the brand’s reputation.
Furthermore, not all hedge fund strategies will fit into a UCITS structure. According to the EDHEC paper, equity long/short strategies are
seen as the easiest to adapt to the UCITS framework. Event-driven and
relative-value strategies though are the hardest.
And for the time being at least, the growth in the absolute return
UCITS sector has been disappointing. Thus far, only 3% of alternative
and absolute return UCITS funds have managed to top $1 billion in
assets, with nearly 75% still short of $100 million, according to a recent
paper produced by the SEI Knowledge Partnership and Strategic
Insight.3 The paper went on to note the average absolute return fund
produced investment returns of 9% in 2009, compared to nearly
30% for the average equity fund. In addition, approximately 15% of
absolute return UCITS funds posted negative returns during 2009,
while only 2% of global equity funds did so.
UCITS IV Evolution
Alternative and absolute return UCITS may constitute a relatively small
part of the overall UCITS industry at present, but the sector remains in
the early phases of development. More important than the actual
asset numbers though is that by expanding the types of instruments
and investment techniques available, UCITS III has adapted the frame-
2 Are Hedge-Fund UCITS the Cure-All?, March 2010, EDHEC Risk Institute
3 Exotic to Mainstream: Growth of Alternative Mutual Funds in the U.S. and Europe,
the SEI Knowledge Partnership and Strategic Insight
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work to meet industry participants’ needs and goals, thereby ensuring
it remains relevant in today’s marketplace.
Yet despite the advances it brought, industry participants always
complained of the gaps UCITS III left when it came to creating a fully
functioning single market in Europe. Most notable was the absence of
a workable management passport process. As a result, a subsequent
iteration of the directive always seemed likely.
The upshot is UCITS IV, which is scheduled to come into force in July
2011. At its core is an “Efficiency Package,” comprising six headline
measures that have attracted widespread industry endorsement.
Anticipated Benefits
The big gain UCITS IV holds out is that it will make it easier for fund
firms to generate economies of scale, and thus help rationalize costs,
noted Tom Burroughes, Group Editor at WealthBriefing, during Advent
Software EMEA’s 2010 User Conference.
The financial crisis has forced firms to review their cost-income ratios
and rethink product production policies, with a view to streamlining
fund ranges. Nevertheless, with over 36,000 UCITS now in existence
viability issues remain, with many funds duplicated across various
jurisdictions and/or of sub-optimal size.
The result, it has long been contended, is high costs and inefficiency.
For instance, a Lipper study found that total expense ratios (TERs),
when weighted by fund assets, across all actively managed equity
funds were 0.91% in the US, 1.44% in Germany, 1.63% in the United
Kingdom and 1.89% among cross-border funds.4 The simple average
TER for bond funds was 0.83% in the US, 0.88% in Germany, 1.20% in
the UK and 1.24% for cross-border funds.
Under UCITS IV, however, firms will be able to:
Leverage the MCP to reduce the number of management companies they operate across Europe, thereby cutting their cost structures and capital requirements.
Make use of the fund merger and master-feeder capabilities to
integrate small, duplicated funds into larger structures with better
economies of scale.
Use master-feeder structures located in tax favorable jurisdictions
to lower the tax drag for investors.
4 Fund Expenses: A Transatlantic Study, by Ed Moisson and Jonathan Kreider,
September 2009, http://www.lipperweb.com/docs/Research/Fiduciary/Fund_
Expenses_A_Transatlantic_Study.pdf
07
UCITS IV
Efficiency Package
i)
A full Management Company Passport (MCP) that enables companies
authorized in one member state to
manage UCITS funds domiciled in
other jurisdictions.
ii)
Introduction of new rules allowing
fund mergers.
iii) A new framework for the creation of
master-feeder structures, allowing
firms to collapse down management
structures.
iv) A revamped regulator-to-regulator
notification procedure to speed up
cross-border distribution of funds.
v)
Better supervisory cooperation
mechanisms.
vi) Introduction of a streamlined Key
Investor Document (KID).
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Foster product innovation by using the master-feeder and merger
structures to bring new ideas to market that might not otherwise
generate sufficient scale in individual jurisdictions.
Launch funds cross-border more rapidly.
The hope, therefore, is the European funds industry will be able to
reduce average TERs and bring them closer to the levels seen in the
United States, said Mr. Burroughes.
And if UCITS IV helps drive consolidation in the number of funds available in the market, that may reduce some of the product proliferation
and complexity that investors and wealth managers face at present,
and help rebuild investor trust.
Language barriers
Accurately translating the precise
descriptions of what a fund does from,
say, Spanish to Czech is a tough job.
Culture
In France, for example, there is a strong
bias toward buying enhanced cash products, which don’t sell well in the UK.
Currency
A firm running a Polish zloty bond fund
is unlikely to register it for sale in Italy.
Tax
Leveraging the Management Company
Passport, cross-border merger and
master-feeder structures may result in
multiple tax implications. For instance,
cross-border mergers may produce capital gains tax and stamp duty charges,
while the location of a master fund
brings withholding tax considerations.
Therefore, European tax harmonization
is needed if UCITS IV is to achieve its full
potential, a move that is highly unlikely.
In the meantime, the market will remain
full of tax-optimized funds designed for
specific countries, for which there is no
incentive to passport abroad.
Headwinds Ahead
UCITS IV, in tying up some of the loose ends left over from UCITS I and
UCITS III, is a welcome initiative that has the potential to bring significant benefits to managers and investors alike. Nevertheless, fund
management groups tend to act in response to investors’ demands.
And given that their needs are already being addressed for the most
part by the existing UCITS regime, it will take some time before fund
managers feel a compelling urge to revamp their businesses in the way
UCITS IV allows.
Furthermore, as Kate Hollis, Global Head, Fixed Income / Alternatives,
Standard & Poor’s, pointed out during her presentation at the Advent
conference, there are headwinds that will hamper the speed and
extent to which firms will want or be able to merge and passport their
fund ranges across Europe. Among the most important are language,
culture, currency and tax.
Investment Manager Benefits
and Challenges
Despite these headwinds, the positive changes held out by UCITS IV
will eventually permeate the industry, as those introduced with UCITS
III are gradually doing. But alongside the benefits, the existing and
upcoming UCITS regulations bring an array of challenges for industry
participants.
Cross-border competition
With cross-border access becoming easier, firms will find it more difficult to hide in their national markets, argued David Hammond, Director with Dublin-based advisory firm Bridge Consulting at the Advent
EMEA 2010 User Conference. As a result, they will be challenged to
make their products more saleable to a broader audience.
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In this environment, organizations will have to combine international
competitiveness with the flexibility to cope with country nuances. This
means being able to:
Handle differences between tax systems.
Handle different product and service expectations between
national markets.
Offer product ranges that can appeal across borders and be available in different flavors e.g. to meet the UCITS and AIFMD rules.
Scale and efficiency
With competition for market share getting more intense, players will
need to be more niche-focused and/or able to achieve critical mass.
So as well as having the flexibility to support national market exigencies, firms will need to maximize scale and efficiency in their infrastructures wherever possible.
Operational complexity
As noted above, the freedoms introduced by UCITS III come with a
swathe of compliance requirements—for example, to provide liquidity
at least twice a month, ensure the fund remains within strict investment parameters, and adopt sophisticated risk management
approaches.
And in addition to the overarching UCITS rules, funds operating crossborder must ensure that they comply with the national idiosyncrasies
of multiple jurisdictions.
Furthermore, although UCITS III has enhanced the investment flexibility available to funds by expanding the list of eligible assets, firms
need the cross-asset class capabilities in place that allow them to
support a broader range of instruments.
Dan Waters, Director, Conduct Risk, and Asset Management Sector
Leader with the UK Financial Services Authority, underlined the operational challenges in a speech to the McKinsey Asset Management
Conference in January: “We would remind new UCITS managers that
compliance with the UCITS framework will take considerable investment in systems and controls, and while asset managers may delegate
various functions, they retain ultimate responsibility for compliance
with the quite detailed requirements of UCITS III and, even more,
under UCITS IV.”5
5 Asset management regulatory trends and priorities in the post-crisis environment:
an update from the FSA, Speech by Dan Waters, Director, Conduct Risk, and
Asset Management Sector Leader, the FSA at the McKinsey Asset Management
Conference, London, 25 January 2010, http://www.fsa.gov.uk/pages/Library/
Communication/Speeches/2010/0125_dw.shtml
09
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Operational Keys to Success
To thrive in the UCITS arena firms need a host of elements in place,
including the investing expertise to manage a range of asset classes
and alternative strategies, and an effective distribution network.
In addition, a robust, sophisticated and cost-efficient IT infrastructure
is crucial if firms are to meet the challenges highlighted.
1. Automation. As market competition intensifies in a post-UCITS IV
world, firms will need to become more efficient in order to contain
costs and provide exceptional client service.
2. Compliance. The liquidity, diversification, leverage, and reporting
stipulations laid down by the UCITS framework mean firms need
sophisticated pre- and post-trade compliance capabilities to ensure
that they remain within the strict parameters set out by the regulations, as well as those established internally. An automated infrastructure will also provide an audit trail that records each stage in
the transaction chain.
3. Risk Management. The financial crisis has propelled risk management to the forefront of investors, regulators, and fund managers’
minds. But risk in all its guises—from market and credit to counterparty, country, and operational risk—can be better monitored and
managed with an effective IT framework. Capabilities it should
comprise include:
Multi-asset class coverage—an order and portfolio management platform that supports the array of financial instruments
eligible under UCITS III, with cross-asset class risk tracking
and reporting that provides a quick and accurate view of the
manager’s firm-wide risk positions.
Monitoring fund/portfolio manager thresholds—accurate monitoring of portfolio manager thresholds and fund concentration
limits to guard against exposures that exceed the limits laid
down by UCITS III.
Intra-day VaR capability—to abide by the UCITS rules in this
area managers need the ability to measure VaR during the trading day, and support stress, correlation, and back testing for the
VaR measures.
Real-time reporting—providing management with accurate and
up-to-date information on their assets so as to monitor exposures and optimize performance.
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4. Client Service. This year’s Financial News Asset Management CEO
Snapshot survey 6 found over three-quarters of respondents plan to
increase spending on sales and marketing over the next 12 months,
as they strive to improve client servicing and rebuild their asset
bases. But alongside well-trained client-facing staff, firms can
strengthen the relationships with their investors through the deployment of effective technology. This includes having:
Performance attribution tools that conduct detailed analysis to
provide distributors and investors with transparent insights into
the performance of the firm’s funds, to foster understanding of
the products and garner trust.
A market data source providing good constituent data from the
different benchmarks being used as the points of performance
comparison.
Sophisticated reporting capabilities to provide clients with accurate and useful reports on a timely basis, helping to keep them
informed and in control of their investments.
Liquidity
If there is to be a UCITS V, one area it may address is liquidity. With
memories of the redemption restrictions that occurred during the
financial crisis still fresh in investors’ minds, the majority of asset
inflows are heading for the most liquid options available. However,
although UCITS III funds are promising daily liquidity, there is concern
whether the instruments in which they invest allow them to be as liquid
as they claim.
With this in mind, the next tweak to the directive may aim to ensure
that if funds promise daily liquidity they are able to deliver it. Any
suggestion they cannot would cause a serious credibility problem for
the UCITS framework as a whole.
Risk Management
During 2009 a CESR working group launched a consultation to examine various risk management issues, in particular the use of leverage
through the commitment and VaR approaches. For while leverage is
limited to two times NAV under the regime’s rules, the VaR method
allows exposures to be above this.
The working group’s findings are due to be added to the final version
of the UCITS IV Directive. However, if the changes it proposes on the
risks that managers are able to take fail to provide adequate investor
protection, the rules may need further tightening. Should this transpire,
there will be even more focus on firms’ risk management infrastructures.
6 Asset management CEO Snapshot survey, Financial News, http://www.
efinancialnews.com/story/2010-06-21/funds-invest-in-sales-and-marketing
?ref=email_31128
11
Future Evolution: UCITS V?
The shortcomings identified in UCITS III
meant that before the directive even
came into force there was much discussion about the need for a further iteration to plug the holes it left. But with
UCITS IV now coming down the line are
there additional areas that will need
tackling with a subsequent directive?
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Conclusion
In the quarter-century since the regime’s launch, UCITS has grown into
a globally recognized brand that has attracted trillions of dollars of
investor assets. And with the combination of the investment flexibilities introduced by UCITS III and the lessons of the financial crisis, the
framework is broadening its scope to incorporate a new breed of
“hedge fund-lite” vehicles. The upcoming UCITS IV iteration, meanwhile, is broadly welcomed by industry participants as a further step
toward the goal of creating an efficient, harmonized, single European
marketplace, and by US firms as a way to expand their investor base.
But in this brave new world fund firms face intense pressures to minimize their costs and maximize the returns they can offer to clients.
More than ever they require robust and sophisticated technology
capabilities that can take the work burden off staff where possible, and
provide employees with the requisite tools in those areas where humans
are most effective: guiding investment decisions and serving clients.
Increasingly, only those firms that have invested in appropriate IT infrastructures will have the strength, speed, and flexibility to profit from
the opportunities that lie ahead.
About Advent
Advent Software, Inc., a global firm, has provided trusted solutions
to the world’s financial professionals since 1983. Firms in more than
50 countries rely on Advent technology to run their mission-critical
operations. Advent’s quality software, data, services and tools enable
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clients, allowing them to grow their business while controlling costs.
Advent is the only financial services software company to be awarded
the Service Capability and Performance certification for being a worldclass support and services organization. For more information on
Advent products visit http://www.advent.com/about/resources/
demos/pr.
Find out more:
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