A&L Goodbody LLP
  October 31, 2006 - Ireland

New Ucits III Rules have Re-energised the Investment Funds Market in Europe.
  by Mr. Barry McGrath

As expected, the latest set of EU regulations regarding collective investment schemes - the undertakings for collective investments in transferable securities (Ucits III) - has opened up an exciting new spectrum of product possibilities for the investment funds industry in Europe. Since December 2004 there has been a new range of creative product offerings being authorised by the Irish financial regulator under the Ucits III banner. These innovations reveal some significant shifts in the market place. Traditionally Ucits funds were established in the main by investment managers and, to a much lesser extent, investment management arms of investment banks. When first introduced, Ucits were only permitted to utilise financial derivative instruments (FDIs) for efficient portfolio management. For this reason investment banks traditionally used securitisation issues and structured products such as debt programmes, certificates, collateralised loan obligations or collateralised debt obligations to structure their deals. These structures were not available as funds and, typically, public retail distribution was difficult. Ucits III has re-energised the market place by enabling Ucits III funds to invest in a range of FDIs for investment purposes. The regulator issued its final guidance note for Ucits III on the use of FDIs at the end of May. The note must be read in the light of the guidance provided by the Committee of European Securities Regulators (CESR) in the context of what eligible assets for Ucits are, the working papers issued by the EU Commission, and the draft commission directive on this evolving topic. As a result of all of this activity, the most active clients for establishing new Ucits III funds during the past two years have been investment banks, such as the UK-headquartered arms of Barclays, Citibank, Deutsche Bank, Nomura and UBS, who are now choosing to structure some of their traditional structured-product deals as funds. Investment banks are keen to utilise the competitive advantage provided to them by the ability of Ucits III funds to invest in FDIs. They have gained significant levels of derivative skill through their structured-product experience and this provides them with added control and creative scope. They also have a familiarity and high comfort level in producing and implementing appropriate risk-management processes to satisfy both the Ucits III fund itself and the regulator. In turn, this enables them to utilise dynamic leverage structures where appropriate. From the client's perspective, this positions the investment banks to facilitate those existing clients who, whether for diversification, regulatory or tax reasons, or simply because of historical familiarity, prefer to invest in funds, but who nevertheless require the same level of return as they could achieve by investing in securitisations and structured products. In addition, the changes provide a key advantage of opening up the structured product range to a new set of clients and distribution channels that encompass the retail sector as well as pension and insurance funds that have been unable to invest in structured products until this time. Moreover, Ucits III funds can passport across Europe. Investment banks, in particular, are using Ucits III funds to enter into FDIs to secure returns on a basket of securities. Alternatively, the FDIs may be linked to an existing proprietary index, a well-known index, or to an index established for the particular Ucits III fund where, in each scenario, the constituents of the index themselves may not satisfy the requirements of the Ucits regulations. As a further alternative, a fund may offer a constant portfolio protection insurance (CPPI) through an FDI on a CPPI index that provides capital protection by virtue of allocation between two assets - a market asset, which is typically an equity or other index, and what is called a reserve asset. The return may, under the terms of the CPPI index, be switched to the reserve asset if the securities underlying the index are not performing well. In these scenarios the investment banks enter into the FDIs as counter-party to the Ucits III fund and provide returns on that basis. Without any doubt, a great deal of progress has been made in the Ucits III process and that progress has been hard won in many cases. Ucits III has broadened the horizons of the investment funds world in Europe and is now recognised as an important marketing brand in its own right. It has inspired a new investor confidence in Europe in the financial markets. Nevertheless, it is crucially important that our European legislators and regulators continue to grow the European funds industry to support innovation, to secure appropriate and strong regulation while facilitating new products, and to adjust to the growing market environment efficiently and speedily. There are still hurdles to overcome. For example, the issue of marketing Ucits in other member states efficiently and speedily continues to cause difficulties to investment bank clients. While the CESR guidance on product-passporting represents a great deal of work and real progress, the guidelines now urgently need consistent and coherent interpretation and implementation in all member states. Regrettably, it appears that this will take some time to achieve for a variety of reasons, as, in some instances, domestic legislation will be required. Likewise, the European funds industry needs clear guidance on the ability of Ucits III funds to link their returns to indices representing a basket of hedge funds, the approach of regulators to such products and the conditions the regulators will be imposing. Again, these issues have been causing difficulties for a significant period of time and while progress has been made, it has been slow. It now appears that this issue will be dealt with by level-three implementing measures in tandem with the draft directive on eligible assets, which may mean further delay. Although progress has been made, one must question whether it is practical to expect the current CESR and European Commission structures to deal effectively with the rate of change of the financial markets globally. Some may agree with the comments by the Centre for European Policy Studies (CEPS) on the limitations of the Ucits directive in its current form (published in the Financial Times, 17 September 2006). In particular, it is refreshing to see an analysis of the "outdated product approach" by which the Ucits regulations identify specific products as eligible for investment of Ucits. As Jean-Pierre Casey of CEPS opines, it is time to do away with the Ucits directive's restrictions on asset choice and investment policies. This is because of the impossibility of regulators keeping pace with the increasing proliferation and innovation of asset types and because the product approach fails to take account of modern portfolio theory (MPT). MPT focuses less on the riskiness of an individual asset and more on how an asset contributes to overall portfolio construction. So an asset that is more exotic and therefore riskier may, in fact, lower overall portfolio risk. Casey concludes that it is possible that a portfolio including an exotic, non-Ucitseligible asset may outperform a Ucits portfolio not only in terms of absolute return (higher yield), but in terms of absolute risk (lower return volatility) and efficiency (higher return for a given level of risk). Product providers such as investment banks can continue to provide new, innovative and diversified products through funds to investors in Europe, but can and will only do so if the regulatory regime continues to protect investors' interests in a manner that does not frustrate the investment banks' culture of innovation.