Following the changes in Ucits regulations, Brett Greatrex of Insight Investment, explores the opportunities for product development in the EU
A now retired colleague of mine would often say to me "if you aim for the moon and miss, you may as well miss by a mile". I assume he meant that there are some things you just have to get right with no room for error. To an extent this is how I feel about the implementation of the Ucits Product Directive. After all, what is the point of liberalising the types of assets eligible to be held in a Ucits fund if we have no standardised interpretation and are consequently unable to successfully promote the emerging new product ideas to potential consumers across Europe?
What value will the Ucits brand have if, in the face of this uncertainty, investment managers increasingly look to other legal structures in jurisdictions with a liberal regulatory approach to establishing alternative products?
For the citizens of Europe the need for new investment solutions has never been greater. Following the recent enlargement of the EU from 15 to 25 member countries, the population of the EU now stands at an estimated 456.863 million people. Within this population a demographic time bomb is ticking away as the baby boom generation starts to retire. Inevitably, this will put pressure on governments throughout the EU who have the burden of funding first pillar pension schemes that predominate throughout Europe.
Inevitably the younger generation of Europeans will need fresh new solutions to help them ensure they are financially equipped to deal with the consequences of increased longevity, preserving higher standards of living and the desire to pass on wealth to future generations. So, while there are still numerous cultural differences between member states, the citizens all share a common need: to make greater provision for their financial well being.
The Ucits brand, underpinned with the high level of investor protection inherent in the Ucits scheme, is ideally placed to help provide the solution. However, there is a real concern that a range of non-Ucits funds based in offshore jurisdictions will steal a march in providing more effective and flexible vehicles.
Ucits (Undertaking for Collective Investment in Transferable Securities) first waltzed on to the European stage in 1985, its purpose to harmonise the characteristics of retail collective investment schemes and smooth the way to cross-border activity. More recently a new updated Ucits directive has been issued to create a true single market in European collective investment schemes - a market which is second only in size to the US.
The Ucits product directive has liberalised the Ucits regime to include funds of funds, money market instruments and derivatives. Potentially, this paves the way to build a new generation of investment solutions for the citizens of Europe.
According to the latest EFAMA (quarterly statistical release (Q1, 2005) Ucits assets account for E4.4bn compared to E1.2bn non-Ucits. The number of funds has grown from under 10,000 10 years ago to over 24,000 in 2005. In terms of assets held within Ucits, equity and balanced funds represent 49%, bond and money market funds account for 47% and fund of funds and other funds represent the balance.
In terms of new fund launches, bonds, money market and guaranteed funds have seen the largest number as part of the 2,000 or more new funds launched each year.
A masked threat
It is estimated that around 10% of funds are registered in one or more jurisdictions throughout Europe. However, although this growth in the level of cross-border activity in Ucits is positive, it masks a wider threat. It is evident that offshore centres like the Channel Islands and jurisdictions such as Luxembourg and Ireland are flourishing by offering a favourable environment for non-Ucits funds for qualified investors that can offer new investment approaches traditionally available only to ultra-rich clients or institutions.
A recent research study by Oxera, commissioned on behalf of the Corporation of London and the IMA, concluded that the effects of regulation and taxation are deciding factors when considering where to domicile investment funds, particularly where specialised vehicles such as hedge funds and money market funds are concerned. Other jurisdictions like Ireland and Luxembourg have encouraged growth by adopting an approach that allows the creation of a favourable environment for specialised funds. The UK, in upgrading the Collective Investment Scheme Rulebook, has responded with the introduction of the non-Ucits Retail Scheme (NURS) and, for institutional investors, the Qualified Investment Scheme (QIS). The latter though has yet to make any impact due to uncertainty over taxation.
Fortunately, acknowledging you have a problem is half way to the cure. In this context the Committee of European Securities Regulators' (CESR) attempts to clarify and standardise the definition of eligible assets for investment in Ucits is vital if we are to have any hope of creating greater harmony and a single market for financial services products such as collective investment schemes. Of course, as the IMA has pointed out, in seeking to clarify matters, there are some serious consequences that were simply unforeseen by CESR, rather than intended.
Future product development
The growth in multi-manager funds has already started and will inevitably appeal to clients looking to outsource fund manager selection to dedicated specialists with a proven record for picking best-of-breed managers. This arrival of retail funds of funds in Europe also coincides with the opening up of bank distribution and could prove to be a compelling proposition for bancassurers who want to offer clients choice without losing control of their client base.
Those who follow the launch of new investment funds will be aware that we have already seen new style Ucits III funds. In Luxembourg we have seen the launch of open-ended funds that offer participation in European equities with capital guarantees. Typically such funds are using Continuous Portfolio Protection Insurance (CPPI) techniques that allocate between a risk free asset (cash or gilts) and OTC derivatives to provide upside equity exposure. Under the Ucits directive this is largely a synthetic structure with low turnover and transaction costs.
The Ucits III directive has also allowed a range of funds with absolute return investment objectives - to provide a positive return year-on-year, rather than a return relative to a benchmark. Insight's own research among retail investors in the UK suggests that the absolute return concept has strong appeal. Of course, there are a number of ways to try and generate positive returns. In the UK we have seen fund managers launch equity funds which combine the traditional long-only strategies with a limited level of short selling to allow the manager to make money from stocks whether they are rising or falling.
In addition to equity-based products we are seeing some interesting fixed income funds looking to deliver an absolute return. Typically such funds will aim to outperform cash by 3%-4%. However, the risk profile of such funds needs to be understood, as each will vary.
Insight's multi-manager team has looked at the benefits of offering multi-asset portfolios that combine traditional and non-traditional asset classes within a fund - a level of diversity now available post-implementation of the Ucits Product Directive. The evidence suggests that such a combination can deliver equity-like returns with the risk characteristics of a global bond fund. With the consensus of equity returns averaging a return of 8% and cash offering 4% per annum, the opportunity to double the return from cash with bond like risk should prove very attractive.
I also expect that the demographic, social and wealth dynamics facing the EU will mean that product development within Ucits funds will focus on the need to build savings for retirement and offer income solutions to pensioners. Again the use of derivatives such as inflation or interest rate swaps, alongside cash, can be used to create funds that aim to protect the buying power of savings from inflation. Such strategies when combined with absolute return funds can be leveraged to generate real growth in asset value with clarity and transparency of the actual risks.
Your flexible friend
Another trend emerging is the apparent polarisation within the asset management industry between those companies who provide passive management and those active managers who seek to isolate and generate alpha using a range of techniques and asset classes.
Ucits has responded to the needs of the former with a more flexible framework for index tracking funds and has created a more favourable environment for the latter. However, there appears to be little immediate prospect for fund of hedge funds within Ucits and there is an increasing likelihood that European investors will gain access to such products either directly through domestic funds (for example in Germany) or indirectly through their pension schemes and life funds.
Marketing limitations across the EU mean there is a danger that retail investors miss out on funds like fund of hedge funds, property funds, and the alternative funds from leading managers. Such funds and their managers may remain the preserve of institutions and sophisticated investors. This will enable jurisdictions like the Channel Islands to become established domiciles for mutual funds investing in such asset classes. Alternatively, the jurisdictions of Dublin and Luxembourg will cater for such demand with qualified and professional investor funds.
Perhaps the solution to this dilemma is to have a second tier of Ucits - a qualified version- available to retail investors throughout the EU. Such a scheme would offer greater flexibility and diversity of asset class while the potential to market the funds on a cross-border basis would be qualified by the pre-requisite for advice.
Ucits product directive allows funds of funds, money market instruments and derivatives, to give a broader fund range to European investors.
Offshore centres such as Channel Islands, Luxembourg and Ireland developing non-Ucits market rapidly.
European regulators (CESR) looking to clarify and standardise exactly what can be in a Ucits product.
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