seemingly unsurmountable problems could hit eu cross-border fund sales as countries all develop their own interpretation of the rules
It was sold to us as financial products' realisation of the pan-European dream - the Ucits III directive would allow seamless, retail cross-border EU distribution of products given Ucits certification in another member country.
What Brussels' visionaries did not take into account was different EU jurisdictions viewing the retail market and Ucits qualification for funds differently. Luxembourg has interpreted 'Ucits-compliant' arguably a little more broadly than other member states, then Germany made funds of hedge funds available to the masses from 1 January 2004, and all countries seem to be moving in the retail direction.
The UK FSA, while barring onshore-regulated pure hedge funds from UK shores, has made some onshore moves with quasi-hedge funds Qualified Investor Schemes (QIS) under its consultation paper CP185. The Ucits III directive that governs European fund regulation is open to differing interpretations across Europe's jurisdictions, while all products approved as Ucits-compliant in any European country can be marketed throughout the continent and UK.
Neil Simmonds, partner in the financial services practice at lawyers Simmons and Simmons, says a risk arises when Ucits III-compliant products are bought and sold in a European jurisdiction other than the one in which it received its stamp of approval. The problem has come up recently with products receiving Ucits III approval, with a 10% exposure to a hedge fund index, via a total return swap.
Matthew Judd, partner at Clifford Chance, says the Ucits compliance can be achieved because the total return swap is what is regarded for Ucits qualification - limited to a fund having at most 10% exposure to derivatives - rather than taking into account the 'underlying' beneath the swap - in this case hedge funds.
THE WAY FORWARD
Wolfgang Mansfeld, the European Fund and Asset Management Association's president, says such a product is unusual, but sees the development of structures with both vanilla and alternative components as precisely the way the industry should be moving. He says such products are "very appropriate solutions to help retail investors to find the way to benefit from the advantages hedge funds can bring." He notes there are "some concerns the Ucits product might represent a decreasing share" of the market, with an increasing amount of capital attracted to non-Ucits funds such as hedge funds.
Bringing an element of exposure to alternative assets into Europe's retail regulatory fold represents an effective means of reversing this trend, he argues. Mansfeld says hybrid products with an exposure to both traditionally Ucits-compliant and alternative fund elements represent an area of enormous potential growth.
Such products will give retail investors access to diversification, limited downside and absolute return benefits, while minimising risks imbedded in alternative structures like hedge funds, such as product failure risk and manager risk, he says. Retail investors as a group have a tendency to under-diversify their portfolios, he notes, but such products, if regulated correctly, are inherently diversified - a fact so far understood by Germany and Switzerland in funds of hedge funds.
CAUSE FOR CONCERN
The chairman of the Malta Financial Services Authority Joe Bannister, on the other hand, is concerned about the loss of control regulators have suffered in the face of passportable exotic fund products, such as Luxembourg FoHFs.
"If a consumer buys a Ucits (compliant fund) and he has a complaint, I can only refer him to the consumer bodies (of the jurisdiction in which it gained Ucits registration.) I have absolutely no jurisdiction if the fund manager is not under my jurisdiction," Bannister says. "There should be a pan-European committee of complaints managers for consumers to bring all these issues together and discuss them at a high level."
Sven Zeller, partner at Clifford Chance in Frankfurt, says the German market has been flooded with products from Luxembourg with Ucits III certificates that would not qualify for certification if produced in Germany. However, he says Germany's regulator, BaFin, has too many other issues to deal with, such as mixed funds, to concentrate man-hours on the issue. Disagreements over the interpretation of European directives are inevitable, given their flexibility.
"A directive is not the same as a regulation," says Robin Gordon Walker, spokesperson for the UK FSA, "a regulation's terms are so specific it cannot be deviated from in any way. A directive is not like that." Zeller cites Ireland and Luxembourg as two key "liberal" jurisdictions that issue Ucits III compliance stamps in cases where more "conservative" jurisdictions - like Germany - would not.
He says the amount of German money in Luxembourg and Irish funds is greater than in German funds. Simmonds adds the UK to his list of "liberal" jurisdictions, a point on which Gordon Walker seems to concur. He says the FSA's rule CP185 "implemented the directive in a way that does allow a much more open approach, and simplified the rule book a great deal to encourage collective investment schemes (CISs) to set up - as long as they are sound entities." Gordon Walker refuses to be drawn on the possibility of a mis-selling crisis in Europe as a result of diverging interpretations of the directives across the Continent.
However he does accept such differences of opinion exist, to the extent that even the definition of the word directive has been the subject of debate. "The term directive sounds stronger in English than in French, there is a bit of a debate about whether they are going to change the whole wording," he says.
VIVE LA DIFFERENCE
The effort to harmonise European financial regulation was always going to encounter problems. Disparate European regulators with their own cultures and habits are bound to interpret legislation differently, no matter how clearly worded. The Committee of European Securities Regulators (CESR) is currently putting together a consultation document, due in October, which will address the concerns of individual jurisdictions and regulators.
Besides this forum for discussion and debate, an individual jurisdiction's regulator has no right to veto the sale or marketing of a product if it has been issued with a Ucits stamp by the regulator of its country of origin.
"There is not really a mechanism for saying 'product X cannot be marketed in the UK because we do not feel the standard of regulation in country Y is good enough'," says Gordon Walker. "Then we could be taken to infraction proceedings. If we barred the product from cross- border marketing, it would almost be the biggest breech of the single market there could be. The whole basis of the market is mutual recognition and the ability to trade across borders."
Mansfeld wants to see an extension of the single market for retail investors beyond the scope currently covered by Ucits, and says the idea is being discussed at the European Commission level. "I believe the right way to go would be one consistent framework based on Ucits - although the name would not be Ucits anymore - that would embed Ucits and alternative collective investments," Mansfeld says.
Broad, inclusive definitions would allow product innovation, he says and products should then be segregated according to risk, providing clarity to retail investors. With an active retail FoHF market already thriving in France, Germany, Ireland, Italy and Luxembourg, it makes sense to enlarge and harmonise the market, he adds, and doing this at the marketing and distribution level would benefit choice, efficiency, profitability and competitivenes.
However he, along with most of the hedge fund industry, concedes single manager hedge funds are not appropriate for European harmonisation rules - but FoHFs are. He says concerns all this would "lead to a monster directive" that is slow, cumbersome and controversial, leading to a larger burden of regulation are not necessarily wrong, but could be overcome.
Mis-selling is also a risk particularly in Germany with retail FoHFs because the local licenses necessary for intermediaries to sell FoHFs are very easy to obtain, Zeller says. Basic checks to ensure those with criminal records or a history of fraud are the only real obstacle. This poses a specific risk in this market, Zeller notes, because FoHF products can be sold by people without adequate training or expertise on what products are likely to be suitable for a given, now mass retail investor.
The only safeguard in place is that through the local license the authorities have details of any FoHF vendor in the market, and an investor is able to sue any vendor if he feels he has been sold such a product under false pretences. Reported cases of mis-selling have been most frequent where investment advisers make unrealistic promises to investors about the return profiles of hedge fund-related products. Typically this occurs when an investor is given material that has not been looked at by a lawyer, Zeller says.
In addition, vendors of retail FoHF products are at risk if individuals advise clients in groups, because if an accusation of mis-selling is made the investor will have a witness but the advisor will not. Zeller says vendors of these products should therefore take minutes of meetings and not hand out any simplified prospectus or marketing material that has not first been sanctioned by a lawyer.
He adds this problem is potentially huge, but in the 15 months FoHFs have been available to retail investors in Germany there have been few problems because hedge fund performance has been relatively poor, and demand for products correlated with hedge funds therefore weak.
Zeller hopes experience in the sector would lead BaFin to relax its grip on the domestic hedge fund industry and follow the example of its more liberal EU partners. But BaFin could be caught in its own internal politics - between those in Frankfurt, who can be crudely labelled 'liberal/progressive' and those in Berlin, the 'conservatives'.
The German regulator was focused on protecting the investor, Zeller says, while Luxembourg's approach is to nurture and protect the market, an approach he feels is being vindicated. He notes the BaFin's hedge fund department is new to the market and says it is gradually coming over to the market approach favoured by its smaller neighbour.
As hedge funds increasingly become a mainstream, retail affair, fears over mis-selling of often complex products have arisen.
There have been major discrepancies over how Ucits directives have been interpreted, and thus how Ucits-compliance has been handed out to some hedge fund-linked products.
Germany faces a particular mis-selling problem in its licensing of intermediaries selling funds of hedge funds to retail investors.
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