FSA opens the way for funds that can include equities, funds,derivatives, bonds and cash within a single portfolio
The retail fund industry is undergoing radical change with the passing of the European product directive into UK regulations, making it the first member state to adopt the rules.
The Financial Services Authority (FSA) has now approved limited issue funds, guaranteed funds and has widened the individual stock holding limitations for trackers to exceed 10%. In addition, all portfolios have now been given greater flexibility on allocation between varied asset classes.
As reported in the 4 November issue of Investment Week, all securities and funds of funds launched from now on will fall under the classification of mixed funds. The classification allows managers to mix various asset classes within one portfolio in whatever proportion the manager decides, including bonds, equities, cash, derivatives and other collective investment schemes.
The acceptance of the European directive into UK regulations means groups offering Ucits-compliant products have up to five years to switch their existing funds over to this classification.
In the meantime, however, they can continue to launch funds or manage existing funds under the old Ucits rules.
With immediate effect, however, the rule extends the ability of managers to hold other funds in their portfolios from 5% to 10%.
The introduction of mixed funds creates a problem for fund of fund managers in that it may limit the number of portfolios open to them. If a portfolio exceeds 10% in other collectives, they will become ineligible for fund of funds investments. This is to avoid a stacking effect within the underlying portfolios.
However, on the whole the added flexibility enables managers greater scope in defining their portfolios.
The extension of other collectives at whatever proportion could lead to a fund 50% invested in collectives and 50% in direct equities or bonds, widening fund choice and increasing product innovation.
The ability of funds of unit trusts to hold investment trusts as well also adds to the product development available to the industry.
Rules on individual stock holdings within unit trusts or Oeics do not change from the current 10%, except for tracker funds, which under the new rules can hold between 20% and 35%. This is to ensure UK rules are in line with the rest of Europe and allows for tracking products to be developed for more concentrated indices, something that was impossible for UK fund groups to offer. Up until now when companies such as BP, which makes up more than 10% of the FTSE 100, exceed 10% of an index, managers have had to make up the difference with the use of derivatives.
The allowance of greater use of derivatives also increases opportunities for investment houses to create more innovative products. However, some of the existing rules on the use of derivatives will still apply. This means that even though the derivatives can be used to short stocks, retail fund managers will not be able to use them in this manner.
The addition of limited issue funds, which the FSA has approved alongside the European product directive but which is not included in the directive, will lead to a completely different set of products. Limited issue, which will enable groups to limit the number of units in issue for onshore portfolios, will not be Ucits compliant. The funds will be used to cap the amount of assets in a fund if the group decides that the individual manager can only efficiently manage a specified amount. Fund management companies can either limit the number of units in issue or have a time period for the sale of units.
At the moment, groups have considered increasing the annual management fees in a portfolio run by a manager who is uncomfortable running large amounts. This has been the case with Patrick Evershed's portfolio at New Star and with Schroders' US Smaller Companies fund, run by Ira Unschuld.
The FSA did look at whether existing funds could be converted to limited issue, rather than groups being required to launch new funds. Most respondents to the FSA's consultation thought there would be some demand for the conversion of existing funds and sub-funds into limited issue and that there should be the necessary mechanisms to enable that.
Industry members also wanted the ability to convert without unitholder consent on the basis that existing investors would not have bought units with rights or expectations to purchase further units.
While initially against the idea, the FSA concluded there was minimal risk of causing investor detriment by not gaining unit holder approval for a conversion.
The regulator conceded any limitation on the issue of units would be unlikely to have adverse effects on existing investors. As a result the introduction of limited issue units or shares can take place without unitholder consent but investors would have to be notified in the next report and accounts.
The ability to invest in a variety of assets, including derivatives, and to operate limited issue funds will provide fund managers with increased opportunities to offer guaranteed or protected funds to investors. To facilitate this, the FSA is allowing collective investment schemes to include the unqualified expression 'guaranteed' in their name provided a number of criteria are met.
Previously the FSA has not permitted funds to use such terms.
Funds will be able to label themselves as 'guaranteed' if there is a separate full-money-back guarantee, according to the FSA. Other terms implying a degree of capital security will be permitted in controlled circumstances.
Effective disclosure to investors of how funds will take advantage of these wider powers is a key part of the new rules. Consumer-facing material must include details of investment policies and any guarantees or limits on issue.
The transitional provisions means most existing schemes, both Ucits and non-Ucits, will be able to continue to operate under the existing rules until 13 February 2007. The directive has the effect that for a limited period, up until 13 February 2004, it is possible for new funds to continue to be authorised under the existing rules.
However, such funds do not attract the extended transitional period and need to comply with the new rules by 13 February 2004.
As the UK is the first to adopt the product directive it will limit the ability of groups, trying to change over immediately, to sell into Europe.
As other countries have yet to adopt the rules, any fund, which incorporates the new rules, held within an umbrella cannot be sold into other European countries.
However, the FSA has said there are a few EU members who are willing to be a bit more relaxed about accepting funds using the new directive prior to their own adoption.
In addition to these changes the FSA is undertaking a major revision of rules concerning collective investment schemes. As part of this the regulator will examine further the possibility of offering limited redemption funds, widening the scope of property funds, bringing in a separate type of institutional portfolio and introducing performance fees and unit classes.
On top of this are the expected rule changes with regards to disclosure, which as part of the EU manager directive examine the future look of key features documents and the use of past performance.
Regulations and consultation papers on these subjects are expected to be out by the end of the year and in the later part of the first quarter of 2003.
bACKGROUND TO THE DIRECTIVES
Negotiations between member states on two amending EU directives were completed at the end of 2001 and the two directives were formally adopted on 21 January 2002.
The main purpose of the product directive is:
• to extend the investment powers of Ucits schemes to allow investment in derivatives; a wider range of money market assets (including deposits) and investment, to a greater extent, in other CIS; and
• to introduce a regime for schemes that aim to replicate an index.
The Management Directive, also adopted on 21 January 2002:
• introduces a passport, similar to the Investment Services Directive, for the management company to operate throughout the EEA;
• imposes new prudential rules;
• introduces new rules on delegation; and
• provides for a simplified prospectus to be used as a marketing document throughout the EEA.
The product directive has passed into UK regulations, making it the first of the member states to implement the new directive.
The Management Directive is being implemented through two separate consultations. The simplified prospectus contents are being included in the forthcoming disclosure review consultation.
The FSA aims to consult on the remainder of the Management Directive in a paper by the end of 2002,which may also include draft statutory instruments amending the Financial Services and Markets Act 2000.
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