The regulator has put forward proposals to introduce a number of new product classes following the adoption of the EC Product Directive, which extends the range of possible investments in Ucits schemes
The FSA is proposing to broaden the range of investments permitted in UK authorised collective investment schemes such as unit trusts and investment companies with variable capital (formerly known as Oeics).
The proposals also allow for the introduction of limited issue and guaranteed funds to enable authorised funds to offer new products that provide some protection against unit price falls. As a result of these changes, fund operators should be able to offer a range of new products, thereby improving consumer choice.
The changes are a direct result of the need to implement the recently adopted European Undertakings for Collective Investment in Transferable Securities (Ucits) Amending Directive relating to investment powers (the Product Directive). This directive, one of two, has been passed following many years of discussion in Brussels and extends the range of investments for Ucits schemes from the usual stocks and shares to assets including cash deposits, derivatives and other collective investment schemes.
While these asset classes have been available onshore since 1991, they can now be sold under the Ucits passport and the FSA is proposing bringing these changes into force in the UK more quickly than the February 2004 deadline set by the Product Directive.
The other directive, the Management Directive, has the same implementation deadlines and provides a passport to the Ucits management company, similar to the Investment Services Directive for asset managers, proposals for a simplified prospectus and new capital requirements on scheme operators. Because the Management Directive requires changes to a number of rulebooks, the FSA will consult on it later in the year.
To implement the Product Directive, the FSA is proposing the removal of many of the existing categories of fund, paving the way for a mixed fund. The rationale for this is that the directive does not require strict categorisation and therefore keeping such specialised funds in the rules would hamper product innovation. Whether this will lead to a major shake-up in the industry remains to be seen. Many providers may stick to offering a range of distinctive funds such as funds of funds, cash and bond funds either as individual portfolios or as sub-funds in an umbrella scheme structure, while others may wish to mix asset classes within a fund or sub-fund. The change is shown in diagram form above.
Derivative funds have been available in the UK since 1991 in the form of futures and options schemes and geared futures and options schemes. Most of the proposed changes in this area will not have a significant practical effect, except that the use of options may be relaxed so a fund can invest just in such instruments. This is different from the current futures and options rules, although 100% investment in warrants is already allowed in a Ucits qualifying warrant scheme. These new rules come with the requirement for a risk management process to be used by the fund operator. The FSA needs to be informed of such a process and the directive requires this information to be available to investors on request.
The proposals say very little else on how the risk management process should look and the FSA is leaving it up to the scheme operator to decide the appropriateness of the system. This is a step forward from the existing rules, which require all operators to comply with strict rules on how derivative exposure must be managed.
The proposals also extend the types of derivatives a scheme may purchase. Currently, UK schemes cannot use swaps, something that is permitted in other European countries. The FSA is proposing to relax these rules in light of the extended Ucits investment powers.
Whatever the final outcome following the FSA's consultation, it seems likely promotional literature will need to be clear about what the scheme will be able to invest in. In particular, the directive requires clear disclosure if the fund invests in derivatives or uses them for hedging purposes only.
There is also a specific disclosure rule on high volatility. While no changes to marketing rules are proposed, the FSA is intending to amend the definition of higher volatility fund to capture those product providers that might want to offer more risky funds. The effect will be that such funds will need to give clear risk warnings and they may not be cold called. At the moment, this requirement is only relevant to geared futures and warrants schemes.
The directive also requires disclosure for funds replicating an index. Here, the FSA has proposed adopting the directive's relaxation of the current spread requirements for Ucits schemes to allow index-replicating funds to track indices that have a higher proportion of the index in a single stock.
The relaxation is from 10% per issuer to 20% and possibly 35% in extreme market conditions. This will not lead to a free-for-all in the index fund market as the indices need to be approved by the FSA before the relaxation can apply.
Some issues are still to be sorted out with regard to cross-border marketing. The European Commission (EC) suggested recently that early implementation of the directives does not necessarily mean there is early freedom to sell the new products across different European states and the FSA agrees with this. However, usual EC treaty rights exist so some cross-border marketing may occur before the February 2004 deadline.
Complementing the proposals on investment powers, the FSA's consultation paper includes proposals that allow product providers to limit entry into a scheme and so shut off new business. The advantages are that a specialised scheme can stop subscription where it invests in a market in which it is difficult to invest directly. New cash can often have a negative impact on performance and may result in the scheme's investment objectives being hard to meet.
By far the bigger use may be to enable product providers to more easily offer a guarantee or other form of downside protection to investors. That is not easy to do at present, where a fund is entirely open-ended.
The proposals do not go as far as limiting redemption of units. The FSA believes greater legal hurdles exist to such structures in open-ended collective investment scheme vehicles and Ucits funds must provide redemption at the request of investors.
The FSA is still keeping a firm grasp on when a fund is to be allowed to call itself guaranteed. The rules propose a fund can only be called guaranteed where the capital value is unconditionally guaranteed by a third party.
While that third party might be able to be in the same group as the scheme operator, it will have to be a regulated body, although the scheme's trustee or depository will not be able to provide this facility. If these conditions are not met, the FSA proposes that such funds may call themselves capital protected, provided the fund adopts an investment policy that provides a degree of downside protection.
Clear disclosure of the guaranteed arrangements is required. The FSA is seeking responses to its proposals by 31 July 2002. The full consultation paper 135, New Collective Investment Scheme Products, is available from the FSA website at www.fsa.gov.uk.
Proposals allow introduction of limited issue and guaranteed funds.
Changes are a direct result of EC directives.
FSA will seek consultation on the Management Directive later in the year.
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