Regulation of Collective Funds: Threat or Opportunity?

Over the last 10 years, Europe has witnessed a radical overhaul of financial regulation. The Lisbon strategy, launched in March 2000, aimed to make Europe the most dynamic and competitive knowledge-based economy in the world. Why? Because Europe was lagging the United States and the position was worsening: in 1995, European output per hour was 94% of the U.S. level and by 2003 it had declined to 85%. In 2002, euro area per capita GDP was a full 30% lower that of the United States. The European Commission (EC) thus began a series of legislative measures designed to improve European capital markets and contribute to the achievement of Lisbon’s lofty goals. Nearly 10 years on, we are emerging from a financial crisis worse than most of us have ever seen. The incoming Swedish presidency of the EU stated in June that it wanted “a new, more focused and more efficient Lisbon strategy for growth and jobs.” While the ink is barely dry on many of the financial reform measures, the financial crisis is prompting global regulatory changes. Much has been achieved, but that could be at risk if change is ill-conceived. One of the biggest European success stories is UCITS1, a major and lasting testament to the vision of the single European market. The UCITS2 framework has evolved since 1985, now recognized far beyond

“We must preserve...the integrity of the UCITS ‘Kitemark’, ensuring at all times that investor protection is not compromised,” said EU Internal Markets Commissioner Charlie McCreevy in March 2008.

The UCITS framework was last amended under the auspices of what is known as UCITS III, which widened the range of eligible assets to include, for example, derivatives and money market instruments. Widening its scope has proved to be a boost to the asset management industry, enabling more sophisticated investment strategies and encouraging new entrants, such as hedge funds.

Now, UCITS IV sets out to promote efficiency3, and address some of the structural shortcomings of the market. UCITS IV should complete a cycle of adjustment and change that readies European regulated mutual funds to become the global standard4 for collective investment. It will go into effect in July 2011.

The Directive itself, known as Level 1, has been passed by the European Parliament. Level 2 implementing measures will fill in more of the detail, but it’s fair to say most in the asset management community welcome this set of changes, perceiving them as an opportunity and a good example of ‘enabling’ regulation.

Overview of UCITS IV
UCITS IV will provide:

• A framework for fund mergers on a cross-border basis
• Master feeder arrangements from 85% to 100% investment
• Electronic regulator-to-regulator notification
• Simplified prospectus replaced by Key Investor Information
• Improved co-operation between national supervisors
• Management Company Passport

Fund Mergers
The framework for fund mergers recognises both cross-border and domestic mergers. However, the complex issue of taxation is not addressed, and this is likely to be a stumbling block. However, it should encourage fund groups to rationalise their ranges and potentially eliminate duplication.

Master Feeder
This may be the most effective of all the Directive’s provisions in the short term, although it may lead to a resurgence of the fund proliferation5 phenomenon. A minimum of 85% of a feeder must be invested in the master and the other 15% may be invested in derivatives for hedging purposes only.6 This structure calls for agreements on information sharing between depositaries and auditors of the participating entities.

Management Company Passport (MCP)
This proposal was the subject of much political wrangling. Under the original UCITS directive, a fund, its depositary and its management company had to be located in the same member state. The MCP should permit a management company in a member state to manage the asset of a UCITS in another member state. The management company must comply with the requirements of the member state of the UCITS itself.

The Road Ahead
Much remains to be done to reinforce UCITS success. A recent Think Tank Report7 made a series of recommendations, including—crucially—a call for mutual funds to be the cornerstone of future pan-European retirement savings products. This could take European mutual funds into a new phase of significant growth, mirroring the impact of 401(k) on the U.S. mutual fund industry. The aging population in Europe is one of the biggest challenges Europe faces, and urgent action is called for. The very simplicity and transparency of mutual funds should make them a natural contender for leadership in addressing this challenge.

However, UCITS IV is on its way against a difficult backdrop, given the fallout from the financial crisis.

One recent piece of draft legislation is the draft Directive on Alternative Investment Fund Managers. This set of proposals has caused an outcry from a wide spectrum of the industry. The draft catches managers of all non-UCITS collective investment undertakings, including hedge and private equity funds. While few would doubt there are good intentions embedded in the draft (e.g., investor protection and improved transparency), there are legitimate concerns that many alternative managers may be driven out of Europe altogether—they are, after all, mobile and play on the world stage—but that would be a heavy price to pay. In addition, it is not clear that non-EU hedge funds would continue to be available to European institutional investors such as pension funds and insurers—again an undesirable outcome.

In addition, although the Directive is aimed at the regulation of alternative managers, provisions concerning depositaries have implications for UCITS and the Commission is consulting on plans to align the requirements. Many trade associations are concerned that changes to depositary rules could have serious negative consequences—in particular, significantly increased costs and reduced investor returns, as well as a potential reduction in the choice of markets available to institutional and retail investors. Lobbying at the national and EU levels is seeking to make the Directive a more workable one that does not threaten the industry and indirectly harm investors. Serious thought needs to be given to how these changes will impact the diverse product models across Europe and their investors.

It is vital that all the advances that have been made in European financial market reform over the past few years not be lost: a measured approach is called for, and one that carries the industry and the interests of investors at its heart.

1. UCITS: Undertakings for Collective Investment in Transferable Securities.
2. Council Directive 86/611/EC.
3. Around two thirds of Europe’s mutual funds have assets of less than 50 million.
4. UCITS are five times smaller than U.S. mutual funds and twice as expensive to manage.
5. Europe has over 30,000 mutual funds; the United States has 8,900.
6. The feeder can calculate its total derivatives exposure by combining its own exposure either on a look-through basis with the actual exposure of the master, or with an assumed maximum exposure based on the fund rules of the master.
7. Building Long-Term Savings in Europe—The Case for Europe