green paper on the enhancement of the eu framework...
TRANSCRIPT
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COMMISSION OF THE EUROPEAN COMMUNITIES
Brussels, 12.7.2005 SEC(2005) 947
COMMISSION STAFF WORKING PAPER
Annex to the :
GREEN PAPER
ON THE ENHANCEMENT OF THE EU FRAMEWORK FOR INVESTMENT FUNDS
Background Paper
{COM(2005)314 final}
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Table of contents
Introduction ................................................................................................................................ 5
1. UCITS and asset management company ..................................................................... 7
1.1. The UCITS “model” .................................................................................................... 7
1.1.1. Economic trends........................................................................................................... 7
1.1.2. The UCITS passport................................................................................................... 11
1.1.3. Legal/administrative barriers to UCITS..................................................................... 12
Notification procedure ............................................................................................... 12
The product rules ....................................................................................................... 13
1.2. AM company framework: passport and other permitted activities............................ 13
1.2.1. The asset managers .................................................................................................... 13
Fund processing functions ......................................................................................... 14
An important role: voting rights exercise................................................................... 14
1.2.2. The management company passport .......................................................................... 16
UCITS asset management company .......................................................................... 16
Self-managed investment companies......................................................................... 17
1.2.3. Other permitted activities of management companies ............................................... 18
2. Investor protection ..................................................................................................... 20
2.1. Managing conflicts of interests in asset management................................................ 20
2.2. Organisational controls on funds and their managers ................................................ 22
2.2.1. Depositary as custodian of investor assets ................................................................. 22
2.2.2. Depositaries’ control over operation of funds............................................................ 23
2.3. Regulation of sales process ........................................................................................ 25
2.3.1. General disclosure requirements ................................................................................ 25
2.3.2. Disclosure of fees and commissions .......................................................................... 26
2.3.3. Legal uncertainties in UCITS distribution framework............................................... 27
UCITS-Directive: harmonisation of the public marketing of UCITS........................ 27
Advertisement rules under UCITS directive.............................................................. 28
MIFID rules................................................................................................................ 28
2.4. Investor confidence .................................................................................................... 29
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3. Changing features of EU fund industry ..................................................................... 30
3.1. Additional single market freedoms? .......................................................................... 31
3.1.1. Greater freedom of choice of depositary?.................................................................. 31
3.1.2. Cross-border mergers and pooling techniques........................................................... 31
Cross-border fund mergers......................................................................................... 32
Cross-border pooling techniques ............................................................................... 33
3.2. New distribution pattern............................................................................................. 34
3.2.1. Changing conflicts of interest?................................................................................... 34
Conflicts of interest in integrated architecture ........................................................... 34
New conflicts of interest in fund distribution ............................................................ 34
Considerations on distributor commissions ............................................................... 35
3.2.2. Clarification of rules for new distribution channels................................................... 36
E-commerce and distance marketing ......................................................................... 36
Listing of investment funds........................................................................................ 36
3.2.3. Needs for clarification of private placement.............................................................. 37
3.3. Changing risk patterns ............................................................................................... 38
3.3.1. Potential conflicts of interest and fund governance ................................................... 38
Debate on fund governance and fund management oversight ................................... 38
What impact on the current governance framework? ................................................ 39
3.3.2. Increasing operational risks ....................................................................................... 40
Is outsourcing a solution? .......................................................................................... 41
Capital requirements .................................................................................................. 43
4. Overall asset management landscape......................................................................... 44
4.1. Other collective investments: non-harmonised products ........................................... 44
4.1.1. Development of non-harmonised products competing with UCITS.......................... 44
4.1.2. Policy issues regarding non-harmonised products..................................................... 47
Market fragmentation and risk of regulatory arbitrage .............................................. 47
Retail investor protection ........................................................................................... 47
Financial stability concerns........................................................................................ 48
Depositary role in respect of alternative investment strategies.................................. 49
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4.2. Level playing field with other financial products competing with funds .................. 50
4.2.1. With pension funds (Fund schemes as occupational pension schemes) .................... 50
4.2.2. With life-insurance..................................................................................................... 51
Regarding disclosure requirements ............................................................................ 51
In particular: regarding unit-linked insurance products ............................................. 51
Regarding tax treatment ............................................................................................. 52
4.2.3. With investment certificates....................................................................................... 52
Annex A: Pooling techniques, advantages, risks ..................................................................... 54
Annex B: Some national frameworks related to alternative funds........................................... 57
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Background Paper on UCITS Review
INTRODUCTION
In most of Europe, the intermediation role between savers (money offer) and borrowers (money demand) has historically been played by the banks. In recent years, non-bank financial institutions have emerged to meet the demand from investors who prefer entrusting their money to specialised institutions (asset managers), better able to diversify risks and to improve the performance of their portfolio. This has led to an important expansion of the asset management industry which has developed a wide range of products1 (collective investment schemes alongside discretionary management), investing in a wide range of markets and instruments and more adapted to investors’ preferences. Asset management plays a key role in the economy by allocating economic resources and investing in companies, thereby enabling real sector activity to expand and develop. Investment funds have also potential to assume greater importance as public sector pensions remain under funding pressure and occupational pension funds shift to defined-contribution basis.
EU legislation (Directive 85/611/EEC, so called “UCITS I” Directive) introduced in 1985 aimed at two objectives:
To facilitate the cross-border offer of investment funds for the retail investor, it designed an Undertaking for Collective Investment in Transferable Securities (UCITS) model, intended for cross-border circulation.
As a corollary to this, to protect retail investors by limiting fund risks through strict rules on the investment policy of funds. Institutionalised risk-diversification, through fixed investment limits, has proven to be one of the successes of the UCITS model. The discretion of the fund manager is legally restricted so that investors do not have to rely on the skills and the due diligence of the fund manager alone.
Investment funds are emerging as the main market-based mechanism for asset-gathering and long-term savings management in Europe. In many Member States, they dwarf assets under management by life insurance and occupational pension vehicles. EU-wide, 28,830 UCITS funds have amassed some € 4,100 billion (78.75% of the European open-ended fund market) at the end of 2004.
On the one hand, these figures show that the UCITS “label” has been successful. On the other hand, the creation of a European passport for UCITS and a greater integration of the capital markets in recent years, have not lead to the anticipated acceleration in the sales of cross-border funds. Excluding so-called “round trips2”, not more than 16.1% of the total number of UCITS are truly sold on a cross-border basis, i.e. to one or more countries which are not the national home of the sponsor company of the UCITS. Nevertheless, this figure is increasing (from 13% in 2002). Moreover, among a total of €234 billion in new capital placed in UCITS throughout Europe in 2004, the share of cross-border sales has been “surprisingly3 high, at around 60%”.
The accession of 10 new Member States has enlarged EU financial markets, providing old Members with greater commercial opportunities. The fund market in most of the new Member States is still rather underdeveloped. According to FEFSI figures, at the end of 2003, net assets under management (UCITS and non-UCITS) in Poland, Hungary and the Czech Republic were respectively 0.153%, 0.075% and 0.072% of the total net assets for the EU-15. It remains, however, to be seen how the
1At the end of 2004, 41,800 funds managed around € 5,200 billion of assets within EU. (source: EFAMA) 2The funds registered abroad by a national promoter with the aim of selling them back into his home country. 3 EFAMA press release “Europe's fund industry looks back at a successful 2004” dated 1st March 2005.
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competition forces will affect the new Member States’ often less mature asset management industry and to what extent cross-border sales will increase.
Assets under management in Europe (€ billion)Figures are estimated and may include a certain degree of double counting, mainly with regard to private equity and alternative funds
2.262,18
3.070,003.333,26 3.487,11
3.200,273.598,70
4.104,31
685,70
955,00
1.004,04997,84
946,01
1.049,37
1.108,16133,02
97,02
61,0321,81
187,84
40,60
58,3594,03
106,82
123,64
139,03
155,54
0,00
1.000,00
2.000,00
3.000,00
4.000,00
5.000,00
6.000,00
end 1998 end 1999 end 2000 end 2001 end 2002 end 2003 end 2004
UCITS non UCITS ex. alt. mngt. & PE alternative management private equity
Source: www.hedgefundintelligence.com + Van Hedge Fund Advisors International + EFAMA + EVCA
Basically, fund distribution in most countries is still dominated by national financial groups which offer in-house products. It is therefore difficult and costly for foreign fund promoters to compete with well established distribution channels. Only in the case of the UK, is the share in distribution of independent intermediaries (Independent Financial Advisers or IFAs) much higher than that of banks. Other distribution channels are insurance companies and increasingly the internet. The situation is, however, changing gradually as banks are opening their distribution networks to third party funds. This allows them to attract clients seeking “the best product in the market”, enlarge their offer (particularly for specialised products) and improve their profitability (since fund manufacturers often “retrocede” part of the fees and contribute to the marketing costs). The move towards open architecture is, however, slow and the potential for a more “open” distribution still high.
The 2001 amending directives (2001/107/EC and 2001/108/EC) require the Commission to assess the functioning of the directive. The first objective of the UCITS review is to assess whether, and to what extent, UCITS legislation has facilitated the integration of the single market for harmonised funds. The UCITS review must also consider more far-reaching issues concerning the scope of the harmonising framework (e.g. hedge funds) and regulatory design (role of depositaries, self-managed investment companies).
Article 2 of the Directive 2001/108/EC of the European Parliament and of the Council of 21 January 2002 amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), with regard to investments of UCITS (Official Journal L 041, 13/02/2002 P. 0035 – 0042)
1. No later than 13 February 2005, the Commission shall forward to the European Parliament and the Council a report on the application of Directive 85/611/EEC as amended and proposals for amendments, where appropriate. The report shall in particular:
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(a) analyse how to deepen and broaden the single market for UCITS, in particular with regard to cross-border marketing of UCITS (including third-party funds), the functioning of the passport for management companies, the functioning of the simplified prospectus as an information and marketing tool, the review of the scope of ancillary activities and the possibilities for improved collaboration of supervisory authorities with respect to common interpretation and application of the Directive;
(b) review the scope of the Directive in terms of how it applies to different types of products (e.g. institutional funds, real-estate funds, master-feeder funds and hedge funds); the study should in particular focus on the size of the market for such funds, the regulation, where applicable, of these funds in the Member States and an evaluation of the need for further harmonisation of these funds;
(c) evaluate the organisation of funds, including the delegation rules and practices and the relationship between fund manager and depositary;
(d) review the investment rules for UCITS, for example the use of derivatives and other instruments and techniques relating to securities, the regulation of index funds, the regulation of money market instruments, deposits, the regulation of "fund of fund" investments, as well as the various investment limits;
(e) analyse the competitive situation between funds managed by management companies and "self-managed" investment companies.
In preparing its report, the Commission shall consult as widely as possible with the various industries concerned and with consumer groups and supervisory bodies. (…)
The assessment of the effectiveness of the UCITS legislation must be undertaken having regard to the twin goals of a high level of investor protection and integration of markets for harmonised funds on the basis of the UCITS ‘product passport’. From a longer term perspective, social and economic developments (contribution to finance pensions, Lisbon agenda, competitiveness of EU…) as well as new trends and emerging risks in asset management can fit deeper consideration on functioning of the asset management business. For EU legislator, the objective should be to facilitate the emergence of a cost efficient and dynamic European fund industry that deserves the trust of its retail investor base.
1. UCITS AND ASSET MANAGEMENT COMPANY
1.1. The UCITS “model”
1.1.1. Economic trends
The market for UCITS funds has grown rapidly, with the total number of funds in Europe rising4 from c. 10,000 in 1993 to over 28,000 in 2003. The fastest growth was recorded in the mid-1990s, although the number of funds has since reached a plateau; contracting slightly in 2003 (as shown in the table below). In the same year, this stagnation contrasted sharply with a 20% increase in the number of active cross border funds.
4 FEFSI Fact Book, 2004
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Cross border funds, as a proportion of the UCITS market
Fund type 2002 2003 change
Total funds 28,459 28,189 -0.9 %
Cross border funds 3,750 4,529 20.8 %
Cross border funds / Total funds 13.2% 16.1%
Source: FERI; Lipper
Next figure illustrates that in 2003 the number of cross-border notifications increased in all but three Member States compared to 2001.
Figure: Trends in cross-border notifications of UCITS
Number of notifications received in 15 Member States
0
500
1.000
1.500
2.000
2.500
3.000
3.500
4.000
Austria
Belgium
Denmark
Finland
France
German
y
Greece
Irelan
dIta
ly
Luxembourg
Netherl
ands
Portugal
Spain
Sweden UK
31/03/2001 31/12/2003
Source: PWC & Lipper
Despite this increase, the share of cross-border funds remains relatively modest, representing just 16% of the total number funds. In addition, having access to a market does not always mean being broadly sold. Thus, although the number of foreign funds in some Member States is an important proportion of the total number of funds available domestically, their market share may not be very significant. One of the reasons for this is the fact that big domestic financial groups, which control distribution networks, tend to offer in-house products.
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The diversity of EU Member State’s tax regimes is also considered as one important barrier to the trade of funds across borders5. Barriers are sometimes the result of historical developments (and cultural preferences) or the desire to privilege the use of a particular investment vehicle (e.g. pension funds). Tax constraints generate often additional administrative requirements and are powerful financial disincentives. Concrete examples of such requirements are the need to appoint a tax representative or to make a complex tax computation6. A clear illustration of a financial disincentive could be the fact that dividends distributed by foreign funds are subject to a withholding tax.
Further identified barriers to a greater integration of the European market for investment funds lies in the obstacles to cross-border fund mergers and pooling techniques. Finally, cross-border transaction processes are characterised by inconsistent operational protocols which put up costs.
Finally, the fact that client preferences vary from country to country makes it difficult for fund manufacturers to create a “one size fits all” product that can be sold across the EU market. Investors often prefer funds investing in a particular instrument (e.g. national stocks vs. international stocks, debt instruments vs. equity…). In some countries they may demand particularly products that “guarantee” their capital or a certain return. Sometimes clients may find it more acceptable to pay redemption fees than entry fees. Quite often they will rely in their bank for advice (because this has always been their partner for all kinds of financial operations). And finally, in a few countries, investors seem to feel comfortable using the new technologies to build their portfolios. It seems, however, that the main cultural obstacle highlighted by the industry would be the existence of different languages7. All in all, very few consider that cultural barriers are insurmountable8.
As a result of those hurdles to the circulation of investment funds, the offer to investors continues to be fragmented and biased towards national products. Market fragmentation has led to a proliferation of the number of funds. These often have a sub-optimal size9 which impedes fund managers and administrators to properly benefit from lower costs derived from economies of scale. This translates into higher costs for the investors10.
Distribution in most EU countries has been traditionally dominated by local banks. This is the result of historical and cultural developments which led to a situation where universal banks were for many years the main intermediaries between borrowers and savers. Their prevalence on the European financial scene has been consolidated through mergers and acquisitions and an enlargement of the services provided (including asset management). They are the logical choice for many Europeans used to employ the services of “the bank around the corner” to deal with all kind of financial matters. Banks have traditionally offered customers only in-house products.
The situation is different in the UK where banks have long faced competition in their role as financial intermediaries. Thus, the “polarisation” regime11, introduced in 1987, has supported the development
5 “Financial Services Action Plan: progress and prospects; Asset Management Expert Group (AMWG) Report” published by the Commission in May 2004 (post-FSAP AM report), “Towards a Single European Market in asset Management” (Heinemann report), ZEW, May 2003. 6 “Cross-border marketing of harmonised UCITS in Europe”, FEFSI and PWC, November 2001 7 “Towards a Single European Market in asset Management” (Heinemann report), ZEW, May 2003 8 For example Heinemann considers that they can all be accommodated by asset managers (Heinemann report). 9 This is reported to be 5 times smaller than the average size of US mutual funds (ICI and FEFSI data as at December 2004). 10 The Heinemann report points to annual costs savings of € 5 billion if integration resulted in European funds reaching the same average size as US funds (“Towards a Single European Market in Asset Management”, ZEW, May 2003) 11 According to the « polarisation » regime, a firm which advises a private customer on packaged products must either be a product company or its marketing group associate (and must not advise private customers to buy packaged products which are not those of the marketing group) or do so as an independent intermediary.
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of Independent Financial Advisors (IFAs) as a distribution channel12. The recent entry into force of the “de-polarisation” regime may, however, affect the UK’s distribution structure13.
Despite their traditional tendency to distribute “proprietary” funds, banks are starting to open their distribution networks to third party funds (open architecture). This allows them to attract clients seeking “the best product in the market”, enlarge their offer (particularly for specialised products) and improve their profitability. However, the move towards open architecture is slow. Most European third party funds (TPF) distributors are “semi-open” with 33% of them offering less than 5 TPF and only 6% putting in their list of products more than 49 TPF14. In addition to this, 46% of fund distributors do not offer even one TPF15.
Moreover, gradually, other non-bank financial institutions are starting to offer financial products (such as funds) and services. Nevertheless, they have to compete with the well established and widespread bank networks.
Insurance is another traditional distributor of funds16 which is particularly prominent in the UK, Sweden and Germany. Distribution via insurance companies often benefit from favourable fiscal treatment and, as in the case of banks, from widespread networks. The range/classes of products that they offer, even if similar to investment funds, may have other purposes such as the coverage of certain risks. They can also be less liquid since the policy is designed to be held for an agreed term and earlier redemptions may lead to heavy penalties.
IFAs, which are generally not tied to a particular product provider, act on behalf of the investors advising them on the most suitable product. In the UK, following the “de-polarisation”, to be able to hold themselves as “independent”, IFAs should provide advice on products from across the whole market and offer their clients the possibility to pay fees for the advice they receive. In other EU countries, with the exception of Germany, the role of IFAs in fund distribution is negligible.
Internet is another channel that allows fund manufacturers to sell their products without having to develop costly local distribution networks17. It is increasingly used by (ever more sophisticated) investors not only as a source of information but also to directly purchase investment funds. Additionally, it is becoming an important working tool for advisors. Many studies in the past years have predicted an important surge of volumes traded via fund supermarkets. For instance, the Heinemann report18 identified fund supermarkets (together with insurance companies) as a channel expected to expand the most in the 2003-2013 period. Likewise, the CERULLI report on European Fund Supermarkets19 estimated that between 10% (in Spain) to 25% (in UK and Germany) of the net new inflow into mutual funds by the end of 2005 would be via supermarkets. A high degree of market penetration has however not materialised yet. For instance, according to the FSA, the market share of fund supermarkets in funds distribution in the UK market is around 5%20. To date, only in some Nordic countries does internet have an important market share in the distribution of funds21. Recent
12 « Towards a single European market in asset management » (Heinemann report), May 2003, p. 38 13 As from 1st December 2004, the “de-polarisation” will allow bank networks to distribute also non-proprietary products. 14 Eurofund Magazine, DWS Investments, 2003 15 Idem 16 e.g. unit-linked funds (part of the premium is used to buy life assurance and the other invested in a fund), “with-profit” funds (policyholders share the return of the fund)… 17 “Cross-border distribution of funds : hurdles and developments”, Moody’s Investors Service Global Credit Research, August 2000 18 “Towards a Single European Market in asset Management” (Heinemann report), ZEW, May 2003, p. 42 19 “European Fund Supermarkets”, Volume II, Cerulli Associates, 2001 20 Unit trusts and Oeics conference, June 2004 Speech by Mr Dan Waters 21 According to FEFSI, 27% and 10% of funds are placed via internet in Finland and Sweden respectively (FEFSI Fact Book 2004).
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estimates indicate that mutual funds’ assets on all platform-based systems were above € 60 billion at the end of 200322 which is a relatively small part of Assets under management for the whole industry.
‘Funds of funds’ have emerged as an easier way for asset managers to circumvent rigid distribution structures and to avoid the costs of setting local distribution systems. The diversification they offer seems to be appreciated by investors. However, they are often not aware of the double layer of fees that they are incurring23. Recent studies point to a high annual growth rate for funds of funds in the near future24. Wrapping the product and applying a management commission compensates for the lower margin associated with open-architecture and makes it an attractive strategy25. Similarly, the changes introduced by the UCITS III26 directive should facilitate the marketing of fund of funds within the internal market.
1.1.2. The UCITS passport
Development of a single market for investment funds was the legislator’s first concern. The product “passport” was the tool the UCITS Directive introduced in order to facilitate the free circulation of fund units. To this end, the UCITS Directive aimed at creating a diversified financial product with a low risk-profile suitable for retail investors. The directive contains both general and specific requirements. Regarding the general requirements, one can refer to the following:
• authorization of UCITS by the competent authorities of a Member State; • sufficient good repute and sufficient experience of the directors of the depositary and the
management company; • with respect to the unit trust, approval of the management company, the fund rules and the choice
of depositary; • with respect to the investment company, approval of its instruments of incorporation and the
choice of depositary.
Furthermore, in order to protect investors, notably against market risks, the Directive applies a formal/quantitative approach by means of specific elements:
• Exhaustive enumeration of eligible assets (securities, money market instruments, deposits, investment funds and derivatives);
• Establishment of fixed quantitative investment limits (issuer concentration limits, counterparty risk, limits referring to a certain type of asset, limits referring to the issuance of an issuer; limit to market risk);
• Explicit exclusions or permission of certain investment techniques (no short sales, no borrowing, permission of index replication, permission of leverage through derivatives).
The passport is based on the principle of mutual recognition. A UCITS which shall be marketed in another Member State needs to be authorised in its Home Member State. This authorisation is valid for all Member States because the conditions for the authorisation, the structure and the investment policy of UCITS have been coordinated. The UCITS is exclusively subject to the supervision of its Home
22 Cerulli report on European Advisor Distribution, June 2004 23 Additionally, the (underlying) funds’ selection criteria used by the manager of the fund of funds is not always clearly explained to the client. 24 Based in Cerulli Associates estimates, an Edhec study foresees an annual growth rate of about 15% for multi-management (which also includes managers of managers) for the period 2003 to 2008 (European Asset Management Practices Survey, March 2003). 25 “Sizing up the benefits”, Professional Wealth Management (FT Business), February 2005 26 Directive 2001/108/EC allows UCITS to be invested in units of other collective investment undertakings. Thus, funds of funds, under certain conditions, can benefit from the UCITS passport.
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Member State. The UCITS has only to comply with a simple notification27 procedure in the Host Member State which neither constitutes a re-authorisation nor a re-approval of the marketing of the product. The Host Member State authority has two months to verify whether the marketing arrangements comply with the provisions of the Directive and with its own marketing rules. The Host Member State will be able to require the fund to comply with the rules governing the marketing/advertising of UCITS on its territory as these rules have not been harmonised by the Directive.
1.1.3. Legal/administrative barriers to UCITS
Notification procedure
Difficulties, costs and delays associated with the notification procedure, are perceived by market participants as a major obstacle to market integration.
The “simple” notification procedure is being beset by practical problems. It is often confused with “registration” and seems sometimes in practice more to amount to an “authorisation of distribution” than to a mere notice of information. This is also due to divergent interpretations of the notification requirements themselves: some Member States require further information, translation requirements are diverse and more or less onerous, some Member States require the appointment of a local representative whereby the details of this appointment can vary. In terms of procedure, the average time limits for the notification procedure are widely variable and very often longer than two months. Supervisory authorities also have different practices regarding the start of the 2 months-period provided for by the Directive. Finally, the fees levied on the notification procedure and on the maintenance of the notification can considerably vary. Consequently, the notification procedure seems perceived as expensive and time-consuming. Some industry voices consider that the notification procedure sometimes does not facilitate the distribution of funds on a cross-border basis28. It should be noted that the procedure is deemed to enable the Host Member State authority to exercise its control functions over the advertisement of the UCITS in accordance with local marketing rules, which are not harmonised. This automatically implies – at least to a certain extent – that the notification requirements are heterogeneously interpreted and applied because the authority has to ensure that the information delivered within the margins of the notification procedure corresponds to local requirements on marketing and advertising.
Some industry actors29 have estimated that direct costs of initial notification can be roughly estimated to have totalled more than € 20 million euros by the end of 2003 for the whole industry. Adding the costs of maintaining notification across the EU, this would mean a cost of € 25 million per year for the industry as a whole. Apart from these direct costs, another one is the operational risk to asset management companies of failing to maintain registration. Consequently, provided that direct sales to retail investors are uncommon and that providers predominantly sell UCITS indirectly through third party distribution, some industry players question the need for notification procedure. At this stage, regulators have not expressed a clear position about the costs and the benefits of the notification procedure. In addition, it should be noted that reduction of costs should be profitable to final investors, provided that savings are passed on to them.
27 According to the Directive the following documents have to be submitted to the Host Member State: a statement of compliance established by the Home Member State authority certifying that the fund fulfils the conditions laid down in the Directive, the fund rules or statutory documents, the full and simplified prospectus, an annual report and subsequent half-yearly report, description of marketing arrangements. 28 IMA has described the notification procedure as a “market failure” in its own right. 29 IMA, January 2005
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The product rules
The product rules are divergently interpreted by the different Member States. The same product can be deemed as UCITS in one Member State and ruled out in another.
UCITS have been successful in gaining consumer confidence mainly because of their determined scope. However, the complexity of many financial products and the speed of financial innovation results in a permanent emergence of new products. This makes it more and more difficult for national authorities, but also for fund managers to determine whether a product complies with the rules of the Directive. In some areas, such as the wider use of derivatives and the possibility to leverage a UCITS, these developments have been taken into account. Thanks to the Commission recommendation on derivatives 2004/383/2004 the rules on leverage and the use of derivatives can be applied in a way that gives fund managers more flexibility and certainty as regards the management of UCITS portfolios.
Divergent interpretations of core directive provisions (e.g. on eligible assets) can lead to uncertainties as regards the question of whether the notified product actually fulfils the UCITS criteria or not.
In this respect, the ongoing work to clarify definition of eligible assets is certainly one important step to achieve a harmonised understanding of investment rules characterizing the UCITS product.
1.2. AM company framework: passport and other permitted activities
1.2.1. The asset managers
The asset management firm is responsible for the management of the investor’s assets. It “creates” the products according to clients’ preferences, market tendencies and their own in-house specialisation. Some asset managers are more or less independent departments or subsidiaries of a universal bank. In other cases, they are fully independent firms which have been created around the expertise of some managers in particular geographical markets, financial instruments or strategies. They are, therefore, often more specialised and offer a narrower range of (sometimes more sophisticated) products than the AM firm of a banking group.
As other functions of the AM business, the fund management is also subject to changes aiming to rationalise costs and to increase the supply to clients. Thus, the asset management function may be outsourced to another asset manager. This can be done through the distribution of third party funds or by the use of multi-management. By spreading assets among multiple managers, investors can benefit from a diversification of management styles (and therefore of risks). Multi-management includes funds of funds (mainly for retail investors) and manager of managers (typically offered to institutional clients). Nevertheless, the double layer of fees may partly counter-weight the positive effects of diversification.
As regards the concrete situation in the EU, different countries mean different situations. In continental Europe, the predominance of universal banks in the financial arena translates into a high proportion of asset managers belonging to those financial groups. The picture is somewhat different in UK where small independent asset managers (boutiques) are more heavily represented. It is, however, not clear which combination of tied/independent asset managers is the optimal one (i.e. which would enhance the efficient functioning of the AM industry). Furthermore, it is not established if both types of managers face the same constraints.
Geographically, asset managers having the highest amount of assets under management are located in the UK, France and Germany. Unfortunately, it is difficult to find comparable sources of European data.
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Fund processing functions
The Asset Management Working Group (AMWG) highlighted in its final report that cross-border processing of fund units is a key issue for the European investment management industry. Actually, the industry claims that the European cross-border fund processing landscape is suffering from a high level of fragmentation30 at both trading and post-trading levels. For instance, orders are typically placed through bilateral arrangements between the distributors and the manufacturer. They are largely processed through domestic market infrastructures which are different from one market to the other. In some markets this is also true of settlement, whilst in others the settlement infrastructure is provided almost totally by central securities depository31 (CSD). In addition, execution of fund orders and initiation of settlement32 processes are often manual and differ among the many domestic markets. Fragmentation is also reflected by the huge variety of communication standards (still including phone calls or faxes, nevertheless being replaced by standardised protocols), distribution channels and business practices33.
This results in higher operating costs and operational risks in the transaction value chain and could represent a limitation to the future development of the fund sector/industry in EU. The move toward an open architecture increases the number of distribution channels and transfer agents34 (TA). The continuous growth of fund types will increase their number. Hence, processing volumes are expected to expand not only in terms of number35 of orders but also in terms of fund data. The funds industry in Europe would need to adopt an integrated flexible infrastructure and to improve processing efficiency in both domestic and cross-border fund sectors.
These improvements require first co-operation among market players. The creation of the EFAMA/FEFSI’s fund processing standardization group at European industry level or the association DIAMS36 are two examples of this needed co-operation. Once European standards37 are embraced by the industry, they will need to be endorsed by organisations and implemented among industry actors.
An important role: voting rights exercise
The fund managers’ primary responsibility is to manage the investments in the sole interest of their clients. In order to pursue this objective, fund managers have to act responsibly as shareholders among others by making considered use of their voting rights in companies they invest.
30 The operational problems of the European industry are mainly driven by domestic distribution and processing requirements. As a result, there is no such thing as a pan- European funds execution and processing life-cycle. 31 CSD is an entity which holds securities and other assets so that domestic/cross-border transactions may be effected for beneficial owners and settled by way of entries within its own books 32 The process of transferring the cash value of a transaction to/from a fund-side institution in exchange for the registration/de-registration of title to the units concerned 33 e.g. different times of fund valuation in a market day, a different number of decimals for unit/share valuation, different settlement and delivery schedules, different policies regarding how public holidays impact the valuation of funds 34 A TA is, in many jurisdictions, a fund-side institution that executes the issue and redemption of units on the fund's behalf and usually maintains the register of title. In France the equivalent entity is the “centralisateur", which does not maintain the register. 35 According to EFAMA, transaction volumes are expected to double over the next 3-4 years, with message volumes increasing accordingly. 36 Distribution and Integration for Asset Management System. The purpose of DIAMS group is to work out a Reference Business Repository in order to standardise communication in the asset management sector. This dictionary is the answer - data definition as well as information component definition - used to build communication messages, while DIAMS acts as an interface format between players. 37 Operational standards would be needed in all the following administration functions: account opening and referencing, order placement, order acknowledgement and confirmation, settlement, messages (between distinct actors of the fund processing).
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As soon as March 2001, the Myners Report38 reviewing institutional investment in the United Kingdom, recognized that “effective intervention, when appropriate, is in the best financial interests of beneficiaries” and recommended that “[fund] managers should routinely consider the possibility of intervening in investee companies as one of the means of adding value for their clients”.
While the UCITS Directive remains silent on shareholder activism, the so-called “Winter Report39” and the Corporate Governance Action Plan40 go further without, however, proposing to make shareholder voting mandatory. Some Member States regulations strongly recommend41 the voting rights exercise, whereas other EU-countries42 require information from fund managers about the way they have used or not used their shareholders’ rights.
The principle of transparency on the fund manager vote is broadly recognised. Thus, according to IOSCO43, two principles should be respected by asset managers:
shareholder rights attaching to collective investment scheme (CIS) portfolio securities belong to the CIS – these rights should be considered by CIS operators and any exercise of those rights must be carried out in the best interests of the CIS and
public disclosure of CIS practices relating to corporate governance both encourages proper exercise of rights and allows CIS investors to make informed investment decisions.
That being said, the voting rights exercise by investment funds raises two kinds of issues.
First, as far as the voting right exercise should be carried out in the sole interest of investors, the issue of possible situations of conflicts of interest which may arise in exercising shareholder rights by asset managers can be raised (e.g. when the asset management company is part of a financial group which could have various financial relationships with the issuer where the asset management company invested). The final investor and regulatory authorities should also be clearly informed about the asset management company position/policy related to the issuer and about the final behaviour of the asset management company.
Second, exercising voting rights will not be cost free. The costs might, sometimes, outweigh the potential benefits of voting for the funds potentially leading to "free riding". When exercising voting rights, a management company must consider the sometimes extensive list of issuers in which its funds are invested, take into account more and more complex resolutions, attend General Meetings, expect timely and useful information from the issuers etc… This is even more relevant when the issuer is based abroad, which raises the question of vote in absentia and proxy voting. Considering such
38 “Institutional Investment in the United Kingdom”: A Review by Paul Myners (March 2001) 39 Report by the Group of High-Level Company Law Experts, under the chairmanship of Professor Jaap Winter, European Commission, Brussels, 10 January 2002 40 Communication from the Commission to the Council and the European Parliament, “Modernising Company Law and Enhancing Corporate Governance in the European Union, a Plan to Move Forward”, 21 May 2003, COM (2003) 284 final 41 UK FSA Combined code on corporate governance (www.fsa.gov.uk) stipulates that “Institutional shareholders have a responsibility to make considered use of their votes. Institutional shareholders should take steps to ensure their voting intentions are being translated into practice. (…) Major shareholders should attend AGMs where appropriate and practicable. Companies and registrars should facilitate this”. 42 Cf. French Decree 2003-1103 of 23 November 2003 (on eligibility criteria and tracking error calculation methods for index funds; exercise of funds' voting rights by management companies) and AMF General Regulation which specifies, inter alia, the conditions under which portfolio management companies report their policies on the exercise of voting rights attaching to securities held by the collective investment schemes that they manage. 43 Collective Investment Schemes as shareholders: responsibilities and disclosure, Report of the Technical Committee of IOSCO October 2003
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costs, some AM companies delegate the exercise of voting rights to specialised providers (voting agents offering research, analysis, proxy or electronic voting and vote disclosure services).
Finally, it should be highlighted that the Commission’s services are considering proposal for a directive on shareholders’ rights. It would include a system designed at EU level, which would address some critical issues attached to cross-border voting.
1.2.2. The management company passport
UCITS asset management company
The core business of a UCITS management company is the collective investment business. UCITS management company needs to be authorised in its Home Member State in accordance with the relevant provision of the Directive. The introduction of the management companies’ passport would therefore imply that a management company would be empowered to manage a UCITS constituted in another Member-State by the means of a branch or under the freedom to provide services. Cross-border collective investment management would therefore encompass setting up or managing UCITS in another EU-jurisdiction. Until now, management companies have not been able to avail of this possibility.
The option to set-up a UCITS in contractual form in another jurisdiction is clearly excluded by the text of the Directive. The Directive sets out that a UCITS shall be deemed to be situated where the management company of a contractual fund or a unit trust has its registered office.
With respect to corporate type of funds, the text of the Directive seems to evoke the possibility for a management company to set up UCITS in another EU-jurisdiction. However, the Directive does not provide for the necessary set of tools to put such a scenario into practice. The UCITS would be supervised by the authority of its Home Member State whereas the management company would be under the supervision of the Member State in which it had been authorised.
Noting that the full management company passport is not really functional, respondents to the AMWG report’s consultation widely agreed with the Expert Group’s recommendation to broaden its scope. It is difficult, however, to assess the extent to which this will deliver significant commercial benefits (e.g. in terms of reduction of costs, acceleration of the market integration, supervision difficulties…).
So far, the only solution to enable a management company to manage the assets of UCITS located in another jurisdiction is through delegation arrangements. But, this solution is limited. Under a typical scenario, the UCITS appoints a management company in its own jurisdiction which delegates its functions to a management company in another Member State. Otherwise the UCITS may take the form of a self-managed investment company which delegates functions to another management company located in another Member States. Delegation arrangements have the advantage of clear-cut legal responsibilities of the parties involved. The delegating entity will always remain legally responsible for the management of the UCITS and directly vis-à-vis the UCITS Home Member State authority. This includes its responsibility in case of misbehaviour of the management company to which the relevant functions have been delegated. Having supervisory perspective, such solutions may ensure that legal responsibility and lead supervisor responsibility remain in jurisdiction of delegating entity. It is not clear how the lead supervisor will perform the necessary regulation controls in respect of functions that are delegated cross-border.
Despite providing some welcome flexibility, delegation is not a panacea. From a business perspective, delegation arrangements always require the involvement of a fully equipped and completely functional fund manager in the Home Member State of the UCITS which would then delegate the functions to the management company which genuinely intends to provide the respective service. This is a way round which is likely to produce additional and unnecessary costs. In addition, from a legal point of view delegating would never allow a full transfer of competences to the delegated management
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company intending to provide the service, since the delegating entity must not become an “empty shell”.
In contrast, in the case of a “true” management companies’ passport there would be no need to have a separate entity in place in the jurisdiction of the UCITS. The management company could directly provide its services to the fund in another jurisdiction. Since it would be the genuine manager of the fund it could also provide all the services without any legal restriction. Special know-how or expertise of certain management companies could effectively be exploited. A “true” management companies’ passport could therefore contribute to facilitating the business of fund managers and might offer the prospects of a cost-efficient business organisation. This might also be beneficial for investors provided these advantages are passed on to them.
On the other hand, the “true” management companies’ passport would lead to a split of supervision of the UCITS and the UCITS management company. The Directive does not provide for the specific measures to address this situation, e.g. to organise the joint collaboration of both supervisors involved or to resolve questions related to a potential misbehaviour of the management company. Currently, the supervisory authority responsible for the UCITS would have no legal means to call the management company directly to account because it is located in another jurisdiction. It is argued that spilt supervision would go against the inherent advantage of having one supervisor responsible for the manager and the fund (and its administration).
Self-managed investment companies
The amendments of the UCITS-framework aimed at harmonising the operating conditions for self-managed investment companies, i.e. those investment companies which do not appoint a management company. In particular, the Directive aimed at aligning the operating conditions for self-managed investment companies with those of management companies. Therefore, minimum capital requirements and requirements for the internal organisation of the self-managed investment company were introduced.
However, in contrast to management companies where the introduction of these requirements entailed the creation of an activity-related passport and an enlarged scope of permissible activities, self-managed investment companies, by virtue of their construction, do not benefit from further freedoms as regards cross-border business. In this respect they are still considered as a “product” which benefits from the product passport. The introduction of minimum requirements for self-managed investment companies was mainly motivated by investor protection considerations. In parallel to other types of UCITS which shall only be marketed if the management company complies with certain pre-requisites, it should be ensured that the management of a self-managed invest company equally fulfils certain qualitative criteria. Furthermore, a level playing field regarding the conditions for market access for UCITS- managers should be ensured.
For the time being; it is too early to know the extent to which the model of the harmonised self-managed investment company within the meaning of the Directive has been substantially availed of. However, experience from some Member-States suggests that the model of self managed investment company is appreciated. In particular, self managed company allows creation of funds with a limited management capacity/cost component which can delegate the AM functions to other entities.
Accountability of AM companies: IAS 27
IAS 27 (Consolidated and Separate Financial Statements) was issued in December 2003 and is applicable to annual periods beginning on or after 1 January 2005. It has the twin objectives of setting standards to be applied in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent; and in accounting for investments in subsidiaries, jointly controlled entities, and associates when an entity elects, or is required by local regulations, to present separate (non-consolidated) financial statements.
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IAS 27 applies to the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent44. It also applies to accounting for investments in subsidiaries, jointly controlled entities and associates in the separate financial statements of a parent. This accounting norm replaces the former fragmented approach whereby funds benefited from national exemptions in consolidation requirements.
It seems that the AM industry does not support the concept of fund consolidation and, hence, is not prepared to the current implementation. The industry, notably the private equity sector, argues that this new rule would be meaningless (NAV calculation under IAS 27 would only give a vague picture of the situation of the group) for most of funds and that its implementation is costly.
1.2.3. Other permitted activities of management companies
It should be recalled that, originally, in order to ensure investor protection, collective investment management should only be carried out by entities specifically dedicated to this business purpose. Therefore, the original Directive restricted the scope of activities to this business alone. This approach of specialisation was intended to help prevent conflicts between the management companies’ business interests and those of fund investors. It was also meant to prevent management companies to carry out business activities whose risk-profile would be detrimental to the fund investors’ interest.
To date, the Directive allows management companies to carry out other activities in addition to the collective investment management: the investment services of individual portfolio management, advice and safekeeping of fund units. Furthermore, management companies are now empowered to distribute the units of the funds that they manage directly by themselves in a Host Member State via a branch or under the freedom to provide services and without the need to rely on a third party.
In contrast to collective investment business, the Directive provides for the necessary legal instruments to give effect to these business scenarios on a cross-border basis. In this respect, one important step towards a single market for asset management was made. However, the cross-border provision of these activities may encounter further obstacles (e.g. hurdles resulting from the notification requirements, tax issues, etc.). Two potential areas which might impede the cross-border business of management companies can already be identified:
• Distribution of third party products: The possibility to market funds on a cross-border basis encompasses the distribution of the own products of a management company. Whether this possibility also would encompass the distribution of third party funds is not clear according to the text of the Directive: Distribution of third-party funds is not explicitly mentioned as an additional service management companies are allowed to provide. Annex II of the Directive mentions the function “marketing”, but without any further specification (third-party funds or only “own funds”). Currently, this uncertainty does not seem to cause an insurmountable hurdle to the cross-border business of management companies: at present, apart from developments in Italy and Germany the cross-border distribution of third-party funds does not play a major role for the functioning of the European asset management industry. To the extent that this “marketing” entails a process of selection of funds and assistance of offers in choosing/promoting certain funds to individual investors, it needs to be considered whether this involves acting as an intermediary or UCITS manager.
44 Summary of IAS 27: A parent presents consolidated financial statements in which it consolidates its investment in subsidiaries (those entities that it controls), unless certain conditions are met allowing it not to prepare consolidated financial statements. The consolidated financial statements are prepared using uniform accounting policies. The reporting date of the parent and its subsidiaries shall not be more than 3 months apart. When separate financial statements are prepared, investment in subsidiaries, jointly controlled entities and associates should be accounted for either at cost or in accordance with IAS 39. The same accounting should be applied for each category of investments. IAS 27 specifies disclosures to be made in consolidated and separate financial statements. (source www.iasb.org)
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• Lack of coherence in the regulatory framework applicable to the collective and the individual portfolio management (UCITS-Directive, Markets in Financial Instruments directive - MIFID): In case UCITS management companies make use of the extended business opportunities and carry out both collective and individual portfolio management they are subject to two different set of rules regarding the organisational structure of the company. For the management of UCITS the provisions of the UCITS-Directive have to be observed whereas the rules of the MiFID have to be applied to the individual portfolio management. In certain similar areas such as the management of conflicts of interest45, client reporting or outsourcing, the regulations in the MiFID considerably deviate from those of the UCITS-Directive. The MiFID-Directive partly contains more elaborated or more demanding standards and – due to the fact that it is a Lamfalussy-Directive- also features a higher level of detail. For legal reasons, the UCITS manager might therefore be obliged to separate the two business segments although this might be hardly feasible in practice.
A question remains in the activity of setting up structured and/or guaranteed funds. Those funds enjoyed significant growth and increasing popularity among retail investors since the mid-eighties. By September 2004 the total net assets of some 2,668 guaranteed/capital protected funds in Europe amounted to € 174.3 billion. France, Spain, Netherlands, Belgium and Luxembourg are the markets where these types of funds have acquired a significant market share. Today’s market conditions have only amplified the role of fund products that offer an investment guarantee or a capital protection element to investors. With respect to the type of guaranteed funds two types of product should be distinguished:
• Guaranteed funds in the economic sense, where by the means of portfolio management techniques (employment of derivatives etc.) investors should be protected from the volatility of markets; and
• Guaranteed funds in the legal sense, with an additional formal guarantee provided by an external guarantor (either by the management company or a third party).
The use of hedging or capital protection techniques is foreseen in the UCITS III directive. However, the question exists whether these guarantee techniques are properly disclosed in the sales documents. The provision of guarantees in the legal sense (i.e. providing an additional formal guarantee by the management company) is not explicitly mentioned in the exhaustive enumeration of services a management company is empowered to provide. It needs to be considered that providing guarantees amounts to an own financial service separate from collective investment management with own characteristics and gives rise to specific risk-profile. Such an activity could require safeguards to ensure that the management company is actually able to fulfil its obligations in case the guarantee is called upon. Where the guarantee is underwritten by the management company any inability for the company to meet its engagement could give rise to significant difficulties for investors and questions of unfair trading as well as misleading information. This could damage the reputation of the sector as a whole. Therefore, appropriate capital adequacy rules for the management company may need to be considered as a corollary to provision of guarantees. They are not considered by the current framework and suitable convergent methods need to be found in order to ensure an EU-wide harmonised approach.
Another business opportunity which is occasionally mentioned as an activity of interest for management companies is the reception and transmission of client orders related to other financial instruments. This would enable management companies not only to sell investment funds to their clients, but also other types of financial products such as transferable securities or money market instruments. This could be interesting with respect to institutional clients and would possibly enable management companies to complete their range of services.
45 As far as applicable, cf. point 2.1
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In conclusion of the first section, this portrays a heavily qualified picture of progress in integrating European markets for UCITS products. The key-objective of the European UCITS-framework (i.e. to facilitate the circulation of fund-units across Europe as a contribution to a European capital market) is being gradually achieved. Actually, UCITS is the only retail financial product which is subject to substantial cross border trade in the EU. The UCITS model is considered well-established within Europe and also accepted beyond. Thus, many consider important to maintain a so-called “UCITS label”.
However, the cross-border offer of UCITS is frequently hampered by administrative obstacles: the product rules are sometimes divergently interpreted by the different Member States; the management company passport has not materialised in practice; the simplified prospectus has yet to prove its worth in helping investors to exercise informed investment decisions.
This underlines the need for considering whether the product passport could be improved from a practical perspective and whether the competition could be increased in order to promote financial innovation and product quality. Finally, delegation has emerged as a key-tool in giving management companies flexibility in organising their business; it has permitted the development of cross-border out-sourcing arrangements under the ultimate responsibility of the delegating management company. This solution is probably not the optimal one from an economic point of view. What further steps, if any, are needed to allow management companies to manage a fund constituted/administered in another Member State?
2. INVESTOR PROTECTION
Investor protection consists in the prevention of misleading, manipulative and fraudulent practices. It is also related to the prevention of loss due to malfeasance or negligence on the part of those that organize and operate funds. With respect to market risks, the goal is not to protect investors from suffering any market-driven loss, but rather to enable investors to understand the risks that pertain to investments in a specific fund. However, to some degree, the UCITS directive attempts to limit investors’ exposures to excessive losses, for instance by limiting investment in derivative instruments or by setting some diversification requirements.
In order to limit investors’ exposures to excessive losses, the directive applies a formal/quantitative approach rather than qualitative risk controls. Nevertheless, some first elements of a risk-based approach touch have been introduced in UCITS III directive. The latest amendments of the Directive impose an adequate risk-measurement process for UCITS, some basic principles to capture the overall risk of a UCITS-portfolio (market risk, counter party risk or issuer default risk). The Commission recommendation on derivatives (2004/383/EEC) aims at specifying some of these principles within the margins of the current framework as a first step towards the development of a risk-management system for the area of fund management. Indeed, more flexibility in quantitative terms (leverage of 2, use of derivatives) is accompanied by a high-benchmark in qualitative terms (sophisticated risk-management systems).
Apart from the basic investor protections inherent in the product/investment rules, the directive foresees investor protection safeguards. Beyond the product approach, the investor protection from losses due to malfeasance or negligence relies on the oversight of fund operation by the depositary and on disclosure requirements.
2.1. Managing conflicts of interests in asset management
Conflicts of interest are inherent in almost all principal-agent relationships. The collective investment industry is no exception. The operation of a fund potentially entails conflicts of interest between those invest in the fund and those who organise and operate it.
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Some text-book situations which might give rise to conflicts of interest:
Personal trading by staff and investor interests (‘front running’); Management companies carrying out business activities whose risk-profile might be detrimental to
the fund investors Management company and distributors/promoters relationships: The choice of funds that the
promoter offers to investors may be influenced by sales commissions (trailer fees, retrocession) paid by the management company which may not be disclosed to the investor. Alternatively, the choice of funds offered to the investor might be subject to conflicts of interest if the promoter belongs to a parent undertaking which manages funds.
Management company and depositaries relationships: Conflicts of interest may also arise in the relationships between the management company and the depositaries. Both must act in the best interest of the investors. But, how does the selection of depositaries lead to potential issues for independent oversight?
Management company and broker: high levels of portfolio turnover in order to generate transactional income for broker (‘churning’). Alternatively, the choice of broker might be influenced by so-called “soft dollar” arrangements or bundling which benefit the management company but where payments in kind are not shared with or disclosed to investors.
Management company and placement agent/underwriter relationships: entities which combine the activities of fund management with underwriting of security issues may be faced with the temptation to “stuff” its funds portfolios.
Etc.
Conflicts of interest may be more pervasive in situations where a number of functions or relationships are internalised in a single entity as is frequently the case in the European marketplace where fund management is, by and large, undertaken by entities which are subsidiaries of banking or bank-assurance groups (90% in continental Europe, 70% in UK). However, conflicts of interest are not confined to companies tied to a universal bank: independent asset managers may also be faced with the need to manage conflicts of interest.
The effective management of conflicts of interest is necessary to ensure that the interests of the fund manager are aligned with those of the investor and to minimize or otherwise address these conflicts of interest.
The UCITS Directive46 provides that each home Member State has to draw up prudential rules which require that each management company is structured and organised in such a way as to minimise the risk of UCITS’ or clients’ interests being prejudiced by conflict of interest between the company and its clients, between one of its clients and another, between one of its clients and a UCITS or between two UCITS. According to the UCITS Directive, each management company shall not be permitted to invest all or a part of the investor’s portfolio in units of units trusts/common funds or of investment companies it manages, unless it receives prior general approval from the client.
However, conflicts of interest arise not only at the level of the management company. They may manifest themselves elsewhere in the distribution chain.
MiFID provides for a more comprehensive approach to the policing of conflicts of interest as they arise in investment firms. The approach of MiFID is that all conflicts of interest that could compromise investor interests should be identified. Once identified, structures should be put in place to manage them. To the extent that they cannot be managed in a way that provides confidence that investor interests are not effectively safeguarded, the conflicts of interest shall be disclosed to the client. MiFID does not envisage structural solutions (apart from designation of compliance officer), such as ‘unbundling’ of activities giving rise to conflicts. These requirements will govern conflicts of interest arising between different activities of investment firms (as defined in the MiFID). However,
46 See art.5(f)
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for the time being, the application of these MiFID provisions to UCITS management companies is not foreseen by the legal framework - even when providing individual portfolio management services in addition to their UCITS management activities47.
2.2. Organisational controls on funds and their managers
Functionally separate depositaries are one of the pillars of the UCITS framework. The “UCITS III” Directive has not amended the applicable rules for the depositary, which are still based on the 1985 version of the directive. Moreover, it requires that the depositary be located in the same Member State as the management company/fund thereby excluding the possibility for a UCITS to designate a depositary in another Member State.
From the beginning, the depositary has been entrusted with the double mission of safekeeping of funds assets and carrying out a certain number of oversight functions to ensure that the assets are managed legally by the management company (cf. Art. 7 and 14 of the UCITS Directive). This covers namely supervision of unit issuance, sale, redemption and cancellation, ensuring that instructions of the management company and calculation of unit value are carried out in accordance with fund rules and regulations (for contractual funds and unit trusts), and supervision of transactions involving fund’s assets as to delivery of consideration and application of fund’s income. Beyond such provisions, Member States have followed different traditions in relation to oversight, sometimes strengthening the role of the depositary, sometimes empowering auditors or independent directors. However, we will focus here on the depositary.
2.2.1. Depositary as custodian of investor assets
The UCITS Directive simply states that the “unit trust’s assets must be entrusted to a depositary for safekeeping”. The Directive does not specify the contents of this responsibility. According to the Vandamme commentary48, safekeeping naturally encompasses the everyday administration of the assets (collection of dividends, interest payments, subscription charges…). The Directive also expressly provides for the possibility of “sub-custody” as it mentions that “the depositary’s liability shall not be affected by the fact that it has entrusted to a third party all or some of the assets in its safekeeping”.
Even if it is relatively easy to agree on the rather general concept of “safekeeping”, the general provisions of the Directive in this respect have led to various views in Europe: “bare” custody (safekeeping + administration), surveillance over sub-custodians, segregation of assets, more or less active role as to the administration of the assets… and lack of clarity on liability and compensation of investors.
This may imply safeguarding not only assets and administering them, but also dealing actively with the preservation of rights and the delivery of obligations attached to assets held under custody (shareholders’ rights, tax returns…). One can mention, inter alia, the following examples from the Member States:
47 It should be noted that Article 13 of MiFID is applicable to UCITS management companies carrying out investment services and that this it makes reference to Article 18 (conflicts of interest). 48 “Toward a European market for the undertakings for collective investment in transferable securities” 1988Commentary on the provisions of Council Directive 85/611/EEC of 20 December 1985 It should be noted that this commentary is not an official document of the Commission. It is an internal document which was made public at the time of the first UCITS Directive, but cannot be considered an official position of the Commission. Thus, from a legal point of view, it is only of an academic and historical interest and shall in no event bind the Commission in its interpretation of the provisions of the current "UCITS III" Directive.
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Informing clients of: relevant corporate actions, items needed for drawing up tax returns, events affecting the client’s rights in respect of the assets, and execution of trades on behalf of the client.
Issuing at least a yearly attestation on the number and nature of securities held in custody. Ensuring that assets of client (management company), custodian assets and UCITS assets are
segregated with a Central Securities Depositary. Performance of a certain number of quality checks on the clearing & settlement of trades.
These additional roles imply usually additional organisational requirements such as information processing systems, accounting procedures and internal controls.
2.2.2. Depositaries’ control over operation of funds
The UCITS directive gave depositaries a key role in ensuring high standards of investor protection by exercising certain control functions over the AM company and ensuring sound administration of the fund. The depositary exercises a range of micro-controls usually at the level of the fund and its administration (check trades are compliant with fund rules, check valuation, reconcile orders, monitor trade errors,…). Because of this essential role for investor protection, the 1985 Directive provided for protection against conflicts of interest by way of two provisions: (i) impossibility for a single company to act both as management company/ investment company and as depositary and (ii) both management company and depositary shall in any event act in the best interests of the unit/share holders.
As explained above, Member States have developed different approaches for oversight, thus for depositaries fund control tasks. Following the “a minima” harmonisation of the UCITS Directive, different depositaries models have been developed throughout the Member States. In certain Member States, the depositary is thus performing additional or reinforced controls. One can take as examples:
Core role in “corporate life” of the fund, where the depositary is to represent investors’ interests (for instance at the fund’s creation, but also in case of change of investment manager, mergers or liquidation).
Auditing of fund’s portfolio and accounting methods, approval of assets statement, annual report on the compliance of the fund management with the applicable rules and regulations.
Whistleblower role in case of irregularity (vis-à-vis fund manager, fund operator, auditor or regulator).
Checks on execution prices, on negotiations, on the qualities of the counterparties. Other additional provisions like, for instance, faculty to introduce actions on behalf of clients.
Thus, in many countries, the depositary can be compared to a gatekeeper, i.e. a first line of defence for the investor. This is for instance the case when it is entrusted with a whistleblower function. In some countries, it performs functions which in other countries are performed by auditors, such as auditing of portfolio and accounting methods of the fund. One could argue that the day to day relations of the depositary with the management company give it a unique insight into the functioning of the fund and the best opportunity to detect and address anomalies. On the other hand, the development of sub-custody agreements may give less weight to this argument.
Recently a broader question has arisen as to the coexistence of the two functions (safekeeping + control), which are of different nature, within the same entity. There are some good arguments to allow depositary and safekeeping to be undertaken by the same entity. The depositary, especially through its custody mission, is involved on a daily basis into the life of the fund. No significant operation (trading, rebalancing) involving the assets of the fund can be done without its assent (passive or active). This gives the depositary a unique position to perform its oversight controls. These controls also occur on day-to-day basis as opposed, for instance, to the auditor, who only intervenes ex post. It can be said that this daily involvement in the functioning of the fund provides the best possible guarantee for investor protection and explains the relatively low record of high profile funds failures in Europe until now. The development of alternative investment strategies (see part 4. below) provides another good argument: more and more complex strategies can be better supervised if the depositary – or some external party – is involved in the day to day monitoring of the assets controlled by the fund
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manager. It can be argued that an external third party supervisor for such strategies (as opposed to a depositary) would be technically more costly and might also entail, for instance, confidentiality issues.
However, one could argue that the “control + safekeeping” model is under more and more pressure due to market trends. The emergence of global players providing custody services has lead to a concentration in the custody. Confronted with increased competition (more pressure on prices from the fund managers, notably due to bear markets) and investments (notably in the field of IT), custodians have indeed opted for a race to size. The domination by “global custodians” is more and more evident (large investment banks, securities houses and trust companies). American custodians are expanding in Europe: in 2004 alone, Deustche Bank custody business was purchased by Citigroup, ABN AMRO by State Street and ING Barings by Northern Trust. Current league table for global custodians is as follows (Source: www.globalcustody.net, January 2005):
Ranking Provider Nationality Worldwide assets ($ Bn)
1 State Street US 9,100
2 Bank of New York US 8,906
3 JP Morgan US 8,014
4 Citigroup US 6,640
5 BNP Paribas securities services F 2,958
6 Mellon Group US 2,946
7 UBS AG CH 2,436
8 Northern Trust US 2,400
9 HSBC UK 1,572
10 Société Générale F 1,352
Concentration of players can be first seen as a chance for asset managers as economic of scale savings should deliver lower costs. It could also be seen as a risk for competition – and, so, for the reduction of prices - as strategic barriers to entry will develop. However, some argue that there will always be room for “niche” custodians who will be able to deliver a more tailored approach, better expertise on high added value services or a more individualized customer relationship. Moreover, there has been a recent trend among asset managers for solutions involving outsourcing49 of activities to different service providers rather than the use of one single outsourcer, which shows the limits of the “custody +” model, as outsourcing to one single contractor might be seen as a risk in itself for fund managers.
Finally, it should be noted that the role of the custodian in addressing operational risks is extremely broad. Studies50 carried out on the most significant or probable operational risks within asset management occupations reveal that the main operational risks to which management companies are exposed can be limited or hedged by the custodian, with the notable exception of misleading the investor, which can be subject to consistency control or warning procedures implemented by the broker. The surveyed firms’ perception is the following (Source: Oxera 2001 and Edhec 2003):
49 In the 2001 OXERA survey, firms were asked to provide information on the proportion of clients’ assets that were held by custodians outside the firm’s group. The mean percentage of clients’ assets held by non-group custodians was 63%. The median percentage was 85.5%. 50 « Edhec European Asset Management Practices Survey » 2003 EDHEC-RISK and OXERA survey 2001
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2.3. Regulation of sales process
2.3.1. General disclosure requirements
According to the UCITS directive the following disclosure requirements have to be observed: Simplified prospectus, full prospectus, financial reports (annual and half-yearly) and the fund rules/instruments of incorporation.
The Directive requires that the simplified prospectus be offered to investors free of charge before the conclusion of the contract. The full prospectus and the annual and half-yearly reports shall be supplied to investors on request. The fund rules or instruments of incorporation shall also be made available to investors (either as an integral part of the full prospects or by informing investors that they may obtain this information on request).
One of the key-requirements for cross-border distribution according to the amended Directive is the simplified prospectus. The requirements for the simplified prospectus have been specified by the Recommendation on the simplified prospectus51 which has only recently entered into force. Thus, it is too early to assess its application. The report to be produced by CESR (see below) on this will provide a good basis for that assessment. Some concerns expressed that some Member-States implemented it in a demanding way resulting in the inclusion of too much information not relevant to investor.
51 2004/384/EC of 27th April 2004.
leading operational risks in terms of the amount of potential losses
Risks Possible mitigation by custodians
Breach of client guidelines Strong
Misdealing Weak
Unit trust mis-pricing Medium
Risks from new business (manager transition) Strong
Fraud Medium
leading operational risks in terms of frequency
Risks Possible mitigation by custodians
Breach of client guidelines Strong
Misdealing Weak
Settlement problems Strong
Unit trust mis-pricing Medium
Failure to reconcile assets Strong
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2.3.2. Disclosure of fees and commissions
An investor considering investing in funds may be faced with a wide array of fees and charges. These include not only management fees and administration charges but also entrance and exit fees, (possibly) success/performance fees and load fees. In addition, the investor may ultimately be forced to foot the bill for hidden costs in the management, trade-execution and distribution chain. There are features of the remuneration process for management companies and promoters which may amount to higher aggregate charges for investors. This is notably the case for bundling, soft commissions at the level of brokerage services, and retrocession fees at the distribution end.
A proscriptive approach to some of these issues has been considered by some regulators. However, in general, it has been preferred to place52 the emphasis on disclosure of fees and commissions. A disclosure-based approach may be particularly appropriate in a European context where business models and distribution architectures are beginning to open up. Interfering with management companies revenue or incentive structures could prevent them from developing certain market access strategies. It also does not give sufficient credit to investors who are becoming more aware of the costs and charges associated with investing in funds. As investor familiarity with these products develops, management companies which fail to provide for sufficient fee disclosure may find themselves punished by investors voting with their feet.
Improved transparency - in particular, as regards of costs and fees - is a key issue which must be addressed to maintain investors’ confidence. Provisions to this aim have been included in the UCITS Directive and the Recommendation on the Simplified Prospectus. For instance, the Prospectus for UCITS has to include information on the remuneration payable to third parties53. The Commission Recommendation on the Simplified Prospectus has sought to promote a composite measure of fees and charges. Therefore, based on IOSCO standards, the total expense ratio should be disclosed. Furthermore, it is recommended to disclose the portfolio turnover rate, the existence of fee-sharing agreements and soft-commissions as well as the transactions costs when they are deemed to be available. The Recommendation also contains elements for the presentation of past-performance.
Nevertheless the question of to what extent is the Recommendation put into practice remains. Additionally, are TER figures really comparable across funds and countries? Are all the relevant charges visible to the investors? Could a clearer break-down of fees help to promote investor-driven competition between different players in the distribution process? Hence, at the end of 2004, CESR circulated a questionnaire on the Recommendation. Almost all of the supervisory authorities have responded. CESR will now analyse to what extent national authorities have given effect to the UCITS Recommendations before reporting to the ESC in the course of this spring.
Some industry initiatives have also tried to address potential issues that may undermine investor’s protection. In many Member States, the industry has established codes of conduct which include standards for the distribution of funds. These codes of conduct may complement or sometimes even make up for legislative measures. They may sometimes specify general distribution or advice requirements for investment funds. However, two questions remain: 1) to which extent are these codes/self-regulations respected? 2) What is their enforceability (national authorities’ competence) in case of non compliance?
52 Cf. Winter report. 53 1.18 “Information concerning the manner, amount and calculation of remuneration payable by the unit trust to the management company, the depositary or third parties …”, Annex I, Schedule A
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2.3.3. Legal uncertainties in UCITS distribution framework
The most relevant sets of rules applicable to UCITS-distribution are the UCITS-Directive and the MiFID54. The UCITS-Directive primarily focuses on the public marketing of UCITS, i.e. the placement of the product on the market and on disclosure requirements relevant for this marketing. The MiFID governs cases where the distribution of collective investment schemes or the provision of advice is undertaken by an investment firm. The possibility given to Member States by the MiFID to exempt the reception/transmission of orders and the advice exclusively related to collective investment undertakings from the obligations of the Directive creates, however, some uncertainty. In addition, even if UCITS-Directive and MiFID are closely interconnected with respect to the sales process, the concrete implications of this relationship are not always easy to determine: Which documents have to be provided in case UCITS are distributed by an investment firm? What is the relationship between the “public marketing” referred to in the UCITS-Directive and the distribution activities addressed by MiFID? Which rules apply in case a management company wishes to sell third-party funds (as far as permissible)? These issues beg the question of the need of clarification on the interactions between both directives.
UCITS-Directive: harmonisation of the public marketing of UCITS
The UCITS-Directive focuses on the public marketing of UCITS: in this respect, the Directive provides the legal basis for the right of the UCITS to be marketed (i.e. to be placed on the market) to the public in its Home Member State (on the basis of its Home Member State authorisation) and in other Member States of the EU through the introduction of the product passport and the related notification procedure. The Directive clearly focuses on the establishment of these rights. The disclosure requirements previously mentioned are part of this process. For instance, the full and the simplified prospectus have to be submitted to the Host Member State authority in order to complete successfully the notification procedure.
The rules on the sales documents and the related disclosure requirements of the UCITS-Directive are also relevant for the promotion for sale of UCITS to individual investors themselves. For instance, any potential subscriber of a UCITS needs to be offered the simplified prospectus before the conclusion of the contract. This document shall enable investors to make an informed judgement of the envisaged investment and the risks attached thereto.
With respect to the efficiency of these instruments it should be noted, that for none of these sales documents the Directive requires compulsory delivery. The Simplified Prospectus is the only document which shall be offered to the investor. However, even in this respect, the Directive is content with a mere offer and does not require “hand” delivery. The other documents have only to be supplied on request.
It should further be noted that the addressees of the obligations to offer or to supply the sales documents are not explicitly mentioned. There are certainly strong reasons to believe that any potential fund distributor should be obliged to fulfil these obligations. However, the drafting of the Directive may cause some uncertainty as regards the concrete circle of addressees of these requirements.
There are no rules in the Directive specifically dedicated to the question of how the sales process of UCITS is organised (i.e. the way in which manager, promoter and adviser interface with the potential end investor), how advice related to funds should be delivered or regarding suitable fund promoters.
54 The distribution of investment funds via Internet and the related legal framework (e-commerce Directive etc.) will be addressed under point 3.2.2.
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Advertisement rules under UCITS directive
The UCITS-Directive harmonises the public marketing of UCITS. However, it has refrained from harmonising the rules for the advertising of UCITS. The advertising rules are therefore under national discretion. Rules on advertisement for instance concern rules on promotion or misleading advertisement (rules on unfair competition). Some Member States require an advance approval for the advertising material or establish restrictions as regards the entities which are entitled to carry out advertisement. However, it should be noted that there are a number of developments which might lead to a further harmonisation of the advertisement of funds: For instance, it needs to be clarified to what extent MiFID and initiatives such as the Directive on unfair business to consumer commercial practices which is to be formally adopted in June 2005 will lead to further harmonisation. With respect to MiFID this will also depend on the final content of the Level 2 measures implementing MiFID. The outcome of this process needs therefore to be awaited.
MIFID rules
The execution of orders or provision of advice in respect of UCITS to individual investors as a financial activity is an investment service subject to the rules of the MiFID. The reception and transmission of orders and the advice related to other collective investment undertakings (real estate funds, hedge funds or private equity funds) also constitutes an investment service. In principle, all the rules applicable to investment firms should therefore be applied to fund intermediaries/investment firms involved in the offer, provision of advice in respect of collective investment schemes. This includes provisions on authorisation, supervision, requirements for the internal structure and the management of conflicts of interest, client reporting etc. Thus, even if MiFID does not contain rules specifically dedicated to the distribution of fund units it aims at ensuring that the distribution of fund units is subject to the same quality standards than the distribution of other financial instruments. Whether these rules of the MiFID also apply to management companies distributing third party funds (as far as permissible, see point 1.2.3) might be subject to further clarification.
It should be noted that the Directive grants Member States the option of exempting the business of reception and transmission of orders and advice exclusively related to collective investment undertakings from the obligations of the Directive. In these cases, the Member States have nevertheless to ensure that the activities of the entities carrying out these investment services in relation to collective investment schemes are regulated on a national level. The minimum requirements are thus established at national level.
Accordingly, the duties set out by the MiFID will apply to those distributors and advisors which provide their services not only in relation to funds but also in relation to funds in combination with other financial products. For reception/transmission of orders and advice in respect of collective investment schemes, it will depend on whether Member-State exercises its option to exclude these services.
With respect to UCITS, the Directive contains a further derogation: in case of the reception and transmission of orders related to non-complex financial products, the Directive allows that the investment service is provided on an execution-only basis, i.e. there is no need to undertake a comprehensive test of whether the envisaged product is appropriate for the client. UCITS are explicitly mentioned in this context. However, UCITS products can rather diverge as regards their complexity and their risks (for instance, plain-vanilla products, more sophisticated products using leverage through derivatives etc.). This might beg the question of whether there is a need to consider a more differentiated approach to these investment services related to UCITS. In addition, there might also be a need to clarify the application of the execution-only rule to non-harmonised funds such as real-estate funds, hedge funds or private equity funds.
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2.4. Investor confidence
In 2002, the Basel Committee’s quantitative study pointed out that internal fraud events in asset management business were less than 1% of internal fraud events in financial services. Two OXERA studies55 show that fraud is one of the least frequent risks in the industry ranking. However, fraud is the fifth risk in the ranking of potential impact in terms of loss.
A Bank of New-York study56 reveals that 60% of the financial firms surveyed reported that the level of client’s trust had deteriorated over the past 10 years. Overall 44% of participants believe that the mutual fund industry has lost business over the last five years directly as a result of lack of trust. Mis-selling is believed to be an important factor having damaged trust by 65% of contributors, where only 37% think late trading is an important factor. Hedge funds are identified as an area of particular concern by over 50% of respondents. Long only mutual funds are viewed as an unlikely source of problems with just 5% of respondents expressing concerns. Investors are not reporting increased cases of fraud in asset management business.
The UK financial ombudsman report shows that complaints in the area of portfolio and fund management decreased to 921 in March 2004 from 1,044 in March 2003. In France, the AMF mediateur noted an increase in complaints on collective investment schemes, mainly due to complaints about guaranteed funds. These figures are, of course, not representative of the EU-market. Unfortunately, data on fraud in asset management on a European basis are not readily available.
An explanatory factor may be that industry does not want to incur “reputational risk”. In case of fraud, the AM companies or banking group to which the former belong may prefer to compensate customers from their own assets via out-of-court settlements.
Market timing57 and late trading58 have been found to be relatively rare practices in EU. CESR members conducted extensive investigations to assess whether these mis-practices were prevalent in Europe’s investment fund industry, following the US regulatory authorities’ findings in autumn 2003, in which they found evidence of abusive practices in the US mutual fund market. In November 2004, CESR reported that abusive business practises which exploit the mutual funds for the benefit of some privileged investors (such as late trading or market timing) are rare in Europe. Nevertheless, a key finding of the investigation was that internal processes of the management companies should be improved as this may be a source of potential weakness in the future which could lead to cases of mis-practices developing. Finally, some Member-State authorities have undertaken national investigations resulting in changes to regulatory/supervisory practices.
55 “Risks and Regulation in European Asset Management: Is There a Role for Capital Requirements?” OXERA, in conjunction with Professors Julian Franks (London Business School) and Colin Mayer (University of Oxford) January 2001 and Description and assessment of the national investor compensation schemes established in accordance with Directive 97/9/EC, January 2005 based on BIAIS and alia (2003), ‘Operational Risk and Capital Requirements in the European Investment Fund Industry’, a report prepared for the FEFSI 56 “Restoring broken trust” Bank of New York survey. July 2004 57 Market timing refers to practises where investors place trades (subscription or redemption orders) for unit prices determined with stale prices of the funds assets which do not fully reflect recent market movements. Inefficiencies in investment fund pricing are exploited by the practise of short term buying and selling of investment fund units. Market timers can use the information about market movements which are not reflected in the previous unit price to predict the movement of the following day’s price to advantageously buy or sell units. 58 Late trading can be described to be a practise where the fund manager accepts to receive and carry out subscription or redemption orders from certain investors after the deadline set for these transactions in the regulations of the jurisdiction in question or in the fund rules. This gives them the opportunity to utilize information received after the fund is closed and that has an influence on the market.
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It should be noted that some EU-countries59 have set up investor compensation schemes in case of asset losses, despite the fact that the 1997 investor compensation schemes Directive does not apply to collective asset management. These schemes protect investors’ monies and securities against the risk of theft, embezzlement, other forms of fraudulent misappropriation or the loss of investor assets in the event of firm default resulting from negligence or breakdowns in the firms’ systems and controls. However, there are a range of risks that do not qualify for compensation cover, at least in some Member States, or where compensation is not certain (e.g. bad advices, third-party default no leading to the AM company default, poor investment management, etc…). This raises the question of whether ex-post compensation of investors’ losses should be improved in EU in the field of AM.
In conclusion of the second section, the figures show that asset management sector is so far less affected by fraudulent activities than other sectors. This does not amount to consider that AM is exempt of fraud, conflicts of interest or dysfunctions.
The UCITS investor protection framework would thus appear quite complete and well adapted. Nevertheless, considering the paramount importance of investor confidence, investor protection remains a permanent regulatory concern. In order to maintain continued confidence in the asset management industry, there will be a need for unwavering commitment to effective controls which ensure that decisions taken by fund managers are motivated only by the interests of the investor. The crux of the issue will probably be to ensure the effective management of conflicts of interest which might affect decisions taken by management companies and/or promoters and an effective and independent oversight on fund operation.
A second area for consideration concerns the fair disclosure to investors of fees and charges relating to investments in funds. The Recommendation on the simplified prospectus advocated that Member States provide for clear disclosure of all relevant costs, charges and soft commissions to investors. An assessment of the functioning of simplified prospectus could consider whether regulatory principles to avoid investor abuse are sufficiently clear in terms of substance and addressee.
The sales process of UCITS is mainly governed by the UCITS-Directive and MiFID. UCITS provisions focus on the sales documents and related disclosure requirements. MiFID governs cases where the distribution of collective investment schemes or the provision of advice is undertaken by an investment firm. The possibility given to Member States by the Directive to exempt the reception/transmission of orders and the advice exclusively related to collective investment undertakings from the obligations of the Directive creates, however, some uncertainty. In addition, even if UCITS-Directive and MiFID are closely interconnected with respect to the sales process, the concrete implications of this relationship are not always easy to determine. This begs the question of the need to clarify the interactions between both the directives.
3. CHANGING FEATURES OF EU FUND INDUSTRY
This section will consider three broad sets of issues:
needs in AM industry for more single market freedoms; new distribution patterns leading to new risks and to needs for legal certainty related to new
EU-texts; and changing risk patterns which are emerging in AM business.
59 For instance, Sweden and Denmark
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3.1. Additional single market freedoms?
3.1.1. Greater freedom of choice of depositary?
The UCITS Directive requires that the depositary be established in the same Member State as the management company of a contractual fund or of the UCITS itself in the case of an investment company. This restriction was originally justified by two considerations: due to the very close relation between the depositary and the management company/ investment company, it was considered logical that the same competent authority be in charge of authorizing and supervising both entities and, accordingly, that the two entities be in the same location.
However, more and more players, including industry and national authorities are promoting the idea of freedom of choice of depositaries for European management companies. This could increase competition on a fragmented market and lower costs for the investors. Thus, the AMWG report evokes the question of whether the depositaries should have passporting rights, i.e. be able to provide their services on a cross-border basis, or, alternatively, to promote greater freedom of choice of depositaries. It is argued that the current fragmented state of the depositary market throughout Europe entails increased costs for management companies and for investors and impairs the development of a pan-European investment fund business. The possibility to be able to choose one’s depositary cross-border is also perceived by the industry as an additional flexibility in the way management companies organise their activity. Many respondents to the public consultation which took place following the release of the AMWG report showed a consensus on the merits of such a passport.
However, due to the current discrepancies in national regulations, supporters of this idea usually agree on the prior need to better define the role, the missions and the liability of the depositary at European level. Indeed, the rules of the UCITS I Directive have left ample room for discrepancies in the depositaries regimes from one Member State to the other. There is, for instance, a great variety of institutions performing this role (credit institutions, investment firms, central banks, insurance undertaking, “other regulated legal persons”…), even if credit institutions have a leading share of the market. The AMWG report and the Commission communication on depositaries both insist on the prior need for convergence on prevention of conflict of interest, control duties and liabilities. IOSCO has launched a work to analyse risks associated with AM functions and examine the possible risk control solutions which might be appropriated. A recent IOSCO report60 describes oversight of fund managers in the different jurisdictions. It stresses that the independent entities responsible for such an oversight should be empowered with sufficient tools to exercise its functions in an effective independent manner. This debate thus leads to questions without “off the shelves” answers. Furthermore, depositary is often some kind of “pre”-supervisor in its oversight functions and it might be difficult to passport these oversight functions.
3.1.2. Cross-border mergers and pooling techniques
The number of funds in Europe is relatively high. It is some three times higher than in the US for a market size which is about the half of the US one. Consequently, it is considered that the average European fund size is sub-optimal. This would impede fund managers and administrators to properly benefit from lower costs derived from economies of scale. It is also argued that a greater fund rationalisation within the EU would considerably reduce fund management and administration costs.
The reasons for this proliferation of funds are varied. Often, the creation of new funds responds to cultural preferences or marketing reasons (“new is better”). Sometimes, it is just due to the desire of asset managers (in particular those belonging to banking groups) to enlarge their offer of products to
60 “Examination of governance for collective investment schemes”, Report of the Technical Committee of IOSCO, February 2005
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clients. Image concerns may lead to a situation where a bank resulting from the merger with another one maintains the range of products offered by each of them.
There are many obstacles to merging investment funds on a cross-border basis. Most of the obstacles are of fiscal61 or regulatory62 nature. The obstacles to asset pooling and cross-border fund mergers were highlighted by the AMWG as important barriers hindering the efficient functioning of the market for investment funds and preventing the industry from reaping economies of scale that could drive costs down.
Cross-border fund mergers
The UCITS-Directive itself is silent on the conditions under which funds could be merged on a cross-border basis. It contains rules for the replacement of the management company and the depositary of a fund (approval of the competent authority); however it does not explicitly mention the issue of mergers of either domestic funds or of funds with different nationalities. Even if cross-border mergers are not explicitly excluded, the Directive does not seem to put in place the necessary safeguards to carry out such type of operation and to address issues related to moving a fund from a jurisdiction to another. This has, however, not prevented individual instances of cross-border merger.
According to some industry research63 there is a potential for annual savings through cross-border fund mergers ranging between 5 and 15 basis-points (i.e. between € 3.1 billion and € 8.6 billion for the whole European industry). Increasing the size of funds by the means of mergers would allow benefiting from economies of scale which should also lead to a lower average TER. This cost-reduction would be beneficial to investors provided that these potential advantages are passed on to them.
Managers experience cost/economic obstacles. According to them64, fund mergers can be an expensive and time-consuming project. Regarding consumer behaviour, there is the danger that investors will pull their money out of the fund which should be merged. Furthermore, a merger is costly and demanding in terms of the associated technical processes related to transfers and custodian/depositary services. However, it seems that according to industry experience these issues are not critical. If a merger is well prepared and communicated to investors, there should be less risk of withdrawals.
Fund mergers face also tax hurdles65 and some regulatory obstacles. For instance, many Member States apply a rather strict66 approach in case the fund to be merged is under their jurisdiction and is to be transferred to another Member State. Heterogeneity of institutions acting as depositary and the lack of convergence regarding their operation conditions might also have a negative impact on the possibilities to merge UCITS cross-border.
61 The most common example for a fiscal one is the fact that some EU-countries consider fund mergers as a taxable event. 62 An example for a regulatory one is the requirement that a change of nationality (of a corporate fund) supposes unanimous shareholder approval. 63 “Building of an integrated European Fund Management: cross border merger of funds, a quick win?”, INVESCO, January 2005 64 “Towards a single market in asset management” (Heinemann-report), ZEW, May 2003. 65 Member States apply varying approaches to the question of whether a merger of two funds with a similar asset structure qualifies as a taxable event, for instance whether it is considered as a realisation of capital gains. In this respect, many Member States discriminate cross-border mergers; whereas mergers of domestic UCITS are tax free, a tax charge at the investor level occurs for mergers between a domestic and a foreign fund. 66 For instance, some Member States require 100% consent of the investors holding the fund to be merged which is practically impossible to achieve.
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Fund mergers may not be the magic potion that their advocates suggest. Although domestic fund mergers are certainly much easier to carry out, it seems that they have not yet brought a greater rationalisation of the local markets. Apparently, local companies do not make frequent use of the possibility to merge funds even if provided for by local legislation. The reasons for this might be rather complex and certainly deserve further exploration. The question of whether the costs and the time needed to organise a merger constitute one of the reasons should also be considered.
Cross-border pooling techniques67
Pooling is the technique by which several investment funds or sub-funds of an umbrella fund pool their assets. It enables participating funds to invest through one or several pools, the objective being to benefit as if invested directly in the portfolio of pooled assets. In case of cross-border pooling the participating funds are established in different jurisdictions. There are two different ways in which pooling can be achieved: “virtual cross-border pooling68” and “entity pooling69” (or master-feeder” funds). Certain IT-based “virtual” pooling techniques are not per se excluded by the current UCITS-framework.
However, there are de facto, a number of obstacles to these techniques:
Taxation barriers: entity pooling is confronted with specific problems regarding withholding tax. These issue can be resolved if a pool is considered transparent for taxation purpose. As each country uses different criteria to determine whether an entity is transparent or not, it is difficult to create a structure which is considered transparent by all Member States.
Different accounting regimes. Custodial arrangements: requirement that the custodian needs to be domiciled or established in
the same jurisdiction than the investment fund. No harmonised approach to master-feeder-structures: entity pooling and master feeder
structures are particularly difficult to establish because they are not recognised under the current UCITS regime70.
Barriers resulting from reluctances from supervisors in relation to operational risks, spam of control, and split of nationality71 between the pool and the participating funds.
Noting that a more suitable framework for pooling techniques is not insurmountable task, the industry advocates that pooling techniques should be promoted.
See in annex A the description of these two techniques, their potential advantages and the risks resulting therefrom.
67 Cf. also “Pooling”, Report IMA December 2004 (draft version only!) 68 At present, virtual pooling between sub-funds of an umbrella fund is common in Luxembourg, but also in most other Member States. Pooling of single entity funds has proven to be more difficult, particularly on a cross-border basis. 69 Entity pooling for investment funds in Europe is still uncommon; in particular master-feeder-structures are not permitted under the UCITS-Directive. There are some Member States which permit master feeder funds on the domestic level (e.g. France, Spain and Luxembourg). In contrast, entity pooling is already common in the area of pension funds mainly due to tax reasons. Some Member States like Luxembourg and Ireland have introduced specific vehicles for this purpose. 70 The UCITS-Directive does not allow funds which are exclusively invested in the units of another fund. Therefore, even if the master-fund is compliant with the UCITS regime, the feeder funds are deprived from the passport. 71 The master fund which determines the investment policy of the overall structure is located in Member State other than that of the feeder funds. Hence, the authorities which are responsible for the authorisation and supervision of the feeder funds are not empowered to monitor directly the investment policy of the feeder funds.
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3.2. New distribution pattern
3.2.1. Changing conflicts of interest?
Conflicts of interest in integrated architecture
In the integrated architecture, which is still dominant in many European countries (particularly in continental Europe), banks and insurance companies distribute only in-house products. In other words, investors are being offered funds designed and managed by the AM company belonging to the banking or insurance group that distributes them. This raises the question of whether such integrated distributors advise investors on the basis of the group’s interests or the investor’s own interest. On the other hand, commercial banks, as well as insurance companies distributing in house products emphasise their eagerness to protect the house-reputation (reputational risk) and their good awareness/knowledge of client situation and needs.
New conflicts of interest in fund distribution
Integrated architecture is losing ground to “open architecture” whereby two new kinds of actors distribute funds: more or less independent (not capitally linked) advisory marketing structures72 and individual financial advisors73, which are generally not tied to a particular product provider. Both categories act on behalf of the investors and advise them on the most suitable product. Open architecture represents a broader offer for investors who can really access to the best funds in the market. Moreover, some reduction of costs can be expected from a specialisation of the fund manufacturer in asset management and of the distributor in the marketing of the fund.
In this case, the risk of conflict of interest relating to in-house product (i.e. advising only in-house product, even if they are not the most suitable for investors) takes another possible form. Indeed, the non-tied distributor offer might be influenced by remuneration considerations (i.e. they might advise investors on funds from which it/he/she receives a higher “retrocession”. Refer to “considerations on distributors commissions” below). 68% of respondents to the BoNY study mentioned in section 2.4 above agree that intermediaries are more interested in earning commission than genuinely advising their clients.
Distribution of investment funds is also influenced by the contractual relation between distributors and management companies. This relationship has been in many cases specified by domestic laws. Most Member States require a written contract between the distributor and the management company and some of them have also introduced requirements regarding the contents of the contract74. In some Member States these contracts have even to be approved by the competent authorities. This is sometimes flanked by additional requirements such as an obligation of the management company to supervise the distributors. As regards the respective responsibilities, the management company is responsible for the prudent selection, instruction and supervision of the fund distributors in many Member States75.
The internet is growing in importance as a distribution vehicle. This distribution channel reinforces the market integration into an open architecture. Nonetheless, it could exacerbate the risk of conflict of
72 Fund distributors, fund supermarkets and, to a lesser extent, retail banks proposing third-party funds to their clients 73 Essentially in the UK where IFAs provide advice on products from the whole market and offer their clients the possibility to pay fees for the advice they receive, in Germany and to a lesser extent in France (Conseillers en investissement financier). 74 “The distribution of investment funds”, FEFSI Fact Book 2004 75 Idem
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interest specific to distributor’s remuneration considerations, if transparency on commissions and fees is not adequate. 75% of the BoNY study’s respondents say that greater transparency in the costs, charges and fees for mutual funds would greatly improve investor confidence in the products.
Finally, open architecture is not perceived by manufacturers and distributors as being risk-free. This kind of outsourcing leads the manufacturer to loss of know-how and, hence, little control over the distributor. Mis-selling by the distributor can, even more, affect the asset manager’s image. On the other hand, distributors of third-party funds have to cope with a loss of control over the quality of the product, with an incomplete and/or slower access to the product information and with potential reputation risks in case of fraud (or failure) by the fund manufacturer. Partner selection is, therefore, of particular importance in order to make open architecture work efficiently.
Considerations on distributor commissions
Remuneration may clearly influence advice when distributors are paid through manufacturer’s commissions. Not all distributors provide investors with the full range of products available in the market.
Their offer may be determined by their links to a particular fund provider (tied distributors), by their particular specialisation or by remuneration considerations. Remuneration frequently comprises commissions from the manufacturer (part of the fund’s entry fee/annual management fee). The distributor has, therefore, an important incentive to offer its client those funds from which it receives a higher “retrocession”.
Their offer may be also determined by marketing costs considerations. The fund manufacturer can cover all of part of the marketing costs. Additionally, even if it includes in its offer third-party funds, the distributor may have an interest (or be compelled) to suggest own funds to the client. Likewise, funds with a higher marketing budget may be easier to sell (independently of the fact that they are the suitable for the client). Finally, a common selling technique seems to be “new is best” which is used to gain clients for newly launched products in detriment of “old” ones with well established track records.
There are, on the other hand, distributors76 charging only fees which remunerate the advice itself (this being, thus, in principle more independent and objective). The BoNY study shows that 66% of respondents say that distributor remuneration based on fees for advice rather than commission (from fund producer) is an important factor in regaining trust by offering transparency on costs and fees. However, this business model may not yet be welcomed by investors even if it is translated into lower fund’s entry and management fees (which are often costs less visible for them).
Current trends in distribution may lead to higher aggregate charges for investors, particularly when the manufacturer is eager to increase its market share. It is reported that distribution cost make up to 70% of the total fund costs. Fund manufacturers wishing to enter a new market face high sales and marketing costs in order to gain room on the shelves of the local distributors. These costs are said to be four times bigger than the costs the industry pays on average on sales and marketing77.
76 Mainly, individual financial advisors in UK It should be noted that France recently implemented a “Conseillers en investissements financiers” (CIF) framework. 77 “High fund distribution costs exposed”, 2nd November 2004, FT
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3.2.2. Clarification of rules for new distribution channels
For marketing UCITS and non-UCITS by means of modern communication media (Internet, telephone, fax etc.), i.e. without simultaneous physical presence of the supplier and the investor the e-commerce Directive and the Distance Marketing Directive have to be applied.
E-commerce and distance marketing
Sale/offer of UCITS and non-UCITS when undertaken solely via internet is subject to the e-commerce Directive. This horizontal Directive is not specifically dedicated to financial services. It is applicable to services of any type and aims at removing obstacles to the free movement of services which are normally provided for against remuneration at a distance by electronic means (Information Society services). It therefore covers all fund-related services provided via internet. In contrast to the UCITS-Directive which requires a notification procedure for UCITS to be publicly marketed in another Member State and confers some residual competences to the Host Member State, the e-commerce Directive is based on a strict “country-of-origin” principle. According to the Directive, service providers are therefore entitled to provide their services by the means of Internet throughout the EU exclusively on the basis of the rules of the Home Member State without any further restriction. Ultimately, a strict application of the e-commerce Directive could lead to the consequence that UCITS where marketing and sales process is organised on Internet can be marketed in another Member State without any need to pass through a registration process.
In addition, the Directive captures not only UCITS but also non-UCITS. Therefore, even non-harmonised products could potentially be distributed in a Host Member State via Internet in case they comply with the rules in their country of origin without any further restriction, even if the public distribution of the product would be restricted or even prohibited in the Host Member State. Eventually, UCITS and non-UCITS could therefore theoretically be publicly marketed under the same conditions via Internet.
The Directive on distance marketing of consumer financial services is also applicable to the distribution of fund units on a remote basis. It applies in case funds are sold by the means of distance communication, i.e. those means which do not require the simultaneous physical presence of the supplier and the consumers such as fax, telephone and again Internet. In contrast to the e-commerce Directive and similarly to the UCITS-Directive the Distance Marketing Directive recognises certain residual competences of the Host Member State.
The Distance Marketing Directive also regulates the information which has to be provided to the investor. They are partly similar than those of the UCITS-Directive, however there are also some deviations: for instance, according to the Distance Marketing Directive the investor should be communicated the contractual terms and conditions before the contract is concluded whereas the UCITS-Directive only requires that the investor is informed about possibilities to consult the fund rules/instruments of incorporation.
Listing of investment funds
All type of investment funds, UCITS, non-UCITS and closed end funds can be admitted to trading on a regulated market; open-ended funds which are admitted to trading are usually designated as Exchange Traded Funds (ETF)78. By the end of 2003 assets under management under this vehicle in Europe have risen to over € 14 billion79.
78 The designation of ETF usually only refers to open-ended investment funds and unit trusts; it does normally not cover closed end funds admitted to trading. 79 Source: Morgan Stanley, PWM 11/2003.
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Most exchange traded funds pursue index tracking strategies; however, there are also actively managed investment funds which are traded. In case of the admission to trading investors can acquire fund units like any other security admitted to trading, i.e. by executing buy or sell orders through their bank or a broker. Whether end-investors have the additional possibility to subscribe or redeem the fund units with the fund management company varies from Member State to the other.
The admission to trading of funds is subject to the MiFID rules (Art. 40). Regarding the question whether the regulated market to which the funds shall be admitted to trading has to observe UCITS requirements (for instance, notification according to Art. 46 of the UCITS-Directive) or other local registration requirements in case of non-UCITS, Member States have developed different approaches: some Member States consider the admission to trading on a regulated market and the public marketing of units of the fund as two separate areas which are not interlinked; therefore in their view, there is no need to apply the requirements of the UCITS-Directive (notification requirements) or similar requirements in case of non-UCITS as a pre-condition to be admitted to trading. Some other Member States require the fund to be notified or to be compliant with the local registration provisions in the jurisdiction of the regulated market; these Member States are concerned that otherwise the provisions of the UCITS-Directive can be bypassed.
These issues reflect the difficulties to determine the relationship of public marketing as addressed by the UCITS-Directive with other ways of placing UCITS and other investment funds on the market.
3.2.3. Needs for clarification of private placement
Unlike UCITS (which are per definition publicly marketed), most non-harmonised funds (hedge funds, private equity funds, real-estate funds, etc.) are largely circulated by way the private placement. For instance, approximately 75% of private equity funds are marketed through private placement. In some Member States single hedge funds are also only allowed to be privately placed. However, even UCITS-like products which fulfil all the criteria of the Directive apart from being marketed to the public can potentially be privately placed.
There is no EU-legislative definition and framework applicable to the private placement of investment funds. Funds which are not publicly marketed are outside the scope of the UCITS-Directive. The Prospectus Directive provides for a definition of public offer. It further contains some provisions circumscribing situations in which no public offer takes place such as in case of an offer of securities addressed solely to qualified investors. The Prospectus Directive also defines the concept of qualified investors.
However, the Prospectus Directive only applies to closed end funds. Non-harmonised funds which are open-ended are excluded from its scope of application. Therefore, due to the absence of a harmonised approach to private placement for investment funds on the European level the relevant provisions in the Member States can vary considerably. In particular, Member States are not prevented from imposing local authorisation or registration requirements on funds which are not publicly marketed.
The absence of an EU-wide common set of rules for private placement applicable to investment funds might constitute a further hurdle to their cross-border marketing.
First, a privately placed fund has to face different regimes for private placement in the different Member States.
Second, there is also uncertainty as to what private placement for funds actually means and as how to draw a practicable border-line between public distribution and private placement. Questions to be answered are numerous: is a fund privately placed because there is no public distribution (no active promotion, no advertisement in communication media)? In this case the product will be also accessible for any retail investor who disposes of the necessary means and knowledge to acquire the product in question (e.g. high-net worth individuals). Or is the concept of private placement
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targeted to a specific group of investors fulfilling certain criteria such as “institutional” or “sophisticated”? How can these concepts be better defined?
3.3. Changing risk patterns
3.3.1. Potential conflicts of interest and fund governance
Investor confidence is a key issue in cross-border marketing of investment funds and is a prerequisite for a well functioning internal market. As mentioned earlier, the record so far in terms of investor protection has been broadly satisfactory. Fraud has been relatively rare and no evidence of widespread abuses linked to practises such as market timing and late trading has been found by European regulators.
However, recent investigations have pointed out some structural weaknesses in internal procedures of management companies when it comes to dealing with potential abuses “Improvements must be made to internal processes of the management companies and they must rise to the challenge”80: Furthermore, operational risks, such as breach of client guidelines, misdealing or failure to best execute are still the most significant source of risk for a management company. New risks of abuse might result from the development of open architecture (cf. section 3.3.3 below): retrocession fees may potentially prevail over fiduciary obligations; outsourcing could undermine, for instance, the control functions of the depositary.
Debate on fund governance and fund management oversight
In spite of a relatively good track record, the current EU fund governance81 agenda is undergoing external pressures.
First of all, the governance agenda is influenced by market developments, notably a deteriorating investor confidence in certain Member States in the context of bear markets and well publicized cases of product mis-selling82.It is also influenced by recent development in the United States, where the industry has undergone in 2003 and 2004 some of the most extensive reforms since WWII (improved disclosure, role of independent directors, compulsory compliance function and adherence to code of conduct, stricter trading rules…).
Numerous self regulation initiatives have resulted from the implementation of the new UCITS “III” Directive, regulators acting sometimes in cooperation with national industry representatives. Even if the industry often considers that the supervisors should focus in priority on competing products, that investment funds are already heavily regulated, and that they should not “foot the regulatory bill” for others. Nevertheless, fund managers seem ready in certain cases to anticipate possible regulatory initiatives in certain Member States by upgrading their rules of conducts and other professional standards, notably on disclosure and transparency. As noted by the AMWG, there is a longstanding tradition of self-regulatory action to deliver sound governance and high levels of investor protection. Self-regulatory Codes and Principles are developed by different bodies and fund governance is under examination in various fora (e.g. Investment Management Association in the UK, European Federation of Asset Management Associations). Codes of Conduct and Market Disciplines are also developed by management companies and funds themselves inter alia in the field of categorisation of
80 see CESR report on the investigations of mis-practises in the European fund industry, 4 November 2004, Ref: CESR / 04-407 81 Fund Governance refers to the rules, principles, practices and behaviour that affect the way in which powers are exercised by those who market and operate funds. Fund Governance, control and oversight are crucial to the maintenance and improvement of investor confidence in the asset management industry. 82 See “Restoring broken trust”, Bank of New York survey, July 2004
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funds, calculation of fund performance, and fund advertising. However, at European level, there is no widely-recognised industry or co-regulatory code which commands general compliance from the investment fund community. It should be mentioned that one broad issue arising from the AMWG report is the relative role of regulatory and self-regulatory instruments in defining conditions under which management companies behave. Questions of to what extent can self-regulation substitute fully or largely for regulatory prescriptions and of which are the main advantages and/or disadvantages of these instruments remain. The Expert Group’s conclusion on this last point is worth recalling: “Self regulation will only make sense if the industry itself is comprehensively and unconditionally adhering … If voluntary self-regulation by the industry does not live up to high expectations - and unless a mechanism is found to ensure that such self-regulatory rules are “enforceable” throughout the industry – appropriate regulatory intervention will be inevitable”.
One should also mention the new standards brought by the MiFID on organisational requirements and conduct of business which are directly applicable to management companies offering individual portfolio management services. Initiatives in this field also result from the progresses made in the corporate governance agenda: in this respect, the current work of IOSCO on fund governance is revealing83. However, it should be made clear that corporate governance initiatives cannot be extended to funds per se. Recent Community measures recommending solutions – independent boards - or creating obligations – audit committees - for all companies with a listing proved problematic for listed funds. The envisaged measures would have proved inappropriate or unhelpful for listed funds which are not trading companies and do not have a true corporate life which would warrant the imposition of some of the general corporate governance provisions. This is not to say that the governance or reporting requirements for listed funds do not warrant attention: on the contrary, they are crucial in maintaining investor confidence in the business. However, solutions which can be found should take account of the specificities of the fund industry as a whole and not impact on it via only one of its segments (i.e. listed funds).
What impact on the current governance framework?
Do emerging risks and the above debate make a convincing case for an extensive overhaul of the fund governance arrangements of the UCITS Directive? Probably not. The implementation of the UCITS III directive is still recent. However, this does not mean that the current framework should not be kept under review.
Ensuring that the right structures and tools to identify, manage and/or disclose conflicts of interest are in place is the crux of the matter. There is probably a need for a general understanding of where conflicts of interest arise in the European asset management business and how best to ensure that these do not compromise the asset manager’s obligation to put the unit-holder’s/investor’s interest first in all circumstances. In this respect, it is interesting to note that the AMWG identified the need to develop convergent approaches, as far as possible, on the following matters:
identification and management of possible conflicts of interests; high level principles of corporate governance for the industry; adequate disclosure of all information material to investor’s decisions; investor education and financial literacy; and cross-border redress.
It can be anticipated that the completion of IOSCO’s work on fund governance will provide a useful point of reference on the above issue.
83 See “Examination of governance for collective investment schemes”, Report of the Technical Committee of IOSCO February 2005, follow up report expected for Autumn 2005 following public consultation.
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3.3.2. Increasing operational risks
In the fund management industry, operational risk is the most significant source of risk in terms of potential losses for the management company, while credit or market risks are either inexistent or much less significant84.
The survey “Risks and Regulation in European Asset Management” 85 of January 2001, presented all the operational risks that may occur in asset management. They include:
Breach of client guidelines: this refers to a violation of the guidelines86 as set out by the client in their contract with the asset management company.
Misdealing: this refers to generally unintentional errors, for example in issuing orders to brokers (e.g. confusion between a buy-order and a sell-order).
Risks arising in the process of taking over new business: operational failures may occur when a client mandate has been acquired from another asset management company. The previous asset manager may not have maintained current records, which implies that there may be discrepancies between what is reported and what is actually held in the client’s account.
IT systems failure: this occurs as a result of a breakdown in the computer system. Failure to reconcile assets under custodianship and internal records: this may arise when
an asset manager is unable to reconcile the assets according to its own internal records with those according to the reports from the custodian. In order to minimise the probability of such a failure occurring, asset managers may conduct daily reconciliations of clients’ accounts.
Failure to best execute: this refers to a failure to obtain the best price for a client. Settlement problems: these may occur, for example, when the asset management
company has already paid the cost of purchasing stocks, but the broker, for some reason, is unable to deliver the stocks.
Failure to collect all income: an obvious example87 of this type of risk occurs in the event of a corporate action failure.
Fraud: this occurs as a result of dishonest behaviour conducted by employees or managers.
Regarding the efforts to increase the integration of the European investment funds markets, a lot of attention has been given to the product in order to create a simple investment vehicle for investors across the EU. Less has been, however, done to improve the working environment for key actors and functions of the AM business. Basic parts of the AM infrastructure have been so far rather neglected by the regulator. This has lead to a situation where the existence of different operational protocols and systems (sometimes even within the same country) by increasing operational risks88, costs and delays may hinder market integration.
84 Source: FEFSI “Operational Risk and Capital Requirements in the European Investment Fund Industry” Bruno Biais, Catherine Casamatta and Jean Charles Rochet IDEI Université de Toulouse; January 2003 85 “Risks and Regulation in European Asset Management: Is There a Role for Capital Requirements?” OXERA, in conjunction with Professors Julian Franks (London Business School) and Colin Mayer (University of Oxford) January 2001; Source: www.oxera.com. 86 For example, a client may specifically request that their portfolio does not contain any tobacco companies’ stocks. Inadvertently purchasing tobacco stocks for this client would therefore contravene the client’s guidelines. In order to reverse the transaction, the asset management company must sell the shares. In the meantime, the price of the share could have fallen, which could result in a loss for the asset manager. 87 For example, a client may hold stock in company A, which is being taken over by company B. Failure to complete the relevant documentation before a specified deadline may result in failure to transfer stock in company A into stock in company B. This could lead to losses, for example, in cases of depreciation of stock value. 88 Operational risk refers to the risk of losses incurred by the company, in the course of its business, because of inadequate or failed internal processes, people and systems.
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Some technological/organisational improvements can, however, reasonably be expected as an outcome of the action of market forces (e.g. outsourcing) and/or industry voluntary arrangements.
EU asset managers surveyed by OXERA ranked the potential (amount of possible losses) impact of risks in exactly the same order89 in 200190 as in 200491. The ranking of the frequency of occurrence92 has not change between 2001 and 2004. Thus, it appears that breach of client guidelines and misdealing are both the most frequent operational risks in asset management and, furthermore, the most costly in terms of induced losses. On the other end, settlement problems arise frequently, but their financial impact is small. Stock lending failures arise infrequently and their impact is the less important.
Nevertheless, the costs of operational failures have not, to date, been borne by investors. The 2001 OXERA study shows that the five most frequent risks93 reported from surveyed firms led to losses of 37.5% of the firm capital in one case and losses largely inferior to 5% of the firm capital in all other cases. Importantly, none of the losses was borne by clients; instead losses were covered by incomes or by capital. The 2003 survey seems to confirm this point. The five largest losses in 2003 in the surveyed firms94 ranged between 2.8% and 7.8% of the firm capital. However, one firm experienced a loss as high as 74% of its capital. In both surveys, respondents confirmed that the primary source of financing losses is profits. Regulatory capital95 has a secondary role. Both studies, therefore, suggest that although operational failures occur relatively frequently, losses tend to be small, and can in general be absorbed by the AM company (out of cash reserves). Naturally these results should be carefully considered because they are very dependent on the sample chosen and include an obvious self-reporting bias from surveyed firms96.
Operational risks and costs fall mainly at the level of the management companies. This may lead them to outsource administration functions to specialised and professionalized entities.
Is outsourcing a solution?
Back-office functions have been traditionally integrated with the other AM functions in the same structure (or within the same financial group). However, there are reasons why this may change. First, these functions are an important source of costs for the AM activity. They are sometimes low-margin, intensive in human capital and require important investments to keep the IT systems up-to-date. Additionally, outsourcing these functions to specialised Third Party Administrators (TPA) allows firms to concentrate in their core business, where they have a competitive advantage, and to “smooth” the costs related to them97. For some the growing complexity of transactions also makes the case for
89 From the most important potential impact to the less one : Breach of client guidelines, Misdealing, Unit trust mis-pricing, Risks from new business, Fraud, Failure to meet guarantees, IT systems failure, Failure to reconcile assets, Failure to best execute, Counterparty failure, Settlement problems, Failure to collect all income, Financial insolvency, Stock lending failures. 90 See above –mentioned study 91 Draft of final report on “description and assessment of the national investor compensation schemes in accordance with Directive 97/9/EC”, prepared for the European Commission by OXERA. October 2004. 92 Frequency of occurrence: Breach of client guidelines, Misdealing, Settlement problems, Unit trust mis-pricing, Failure to reconcile assets, Failure to collect all income, IT systems failure, Failure to best execute, Counterparty failure, Risks from new business, Fraud, Stock lending failures, Failure to meet guarantees, Financial insolvency. 93 1) misleading, 2) breach of client guidelines, 3) failure to collect income (including corporate action failure, 4) settlement problem, 5) mis-pricing 94 The sample is composed of 46 management companies. 95 Actually, capital exceeded even the largest losses in the two surveys. 96 For reputational reason, AM companies could not be keen to report the exact nature of their operational losses. 97 The fixed costs linked to an internal back-office are replaced by a variable regime which is more flexible and allows the firm to better plan its costs and to adapt quicker to changes in the business environment.
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outsourcing. Finally, the fact that most investment managers already operate front and back office activities separately make easier the replacement by a service provider98.
Outsourcing seems to be gathering pace in Europe with more firms seeking to outsource some of their operations and with an increasingly greater range of functions being the object of outsourcing99. This trend is expected to continue as Europe catches up with the US where nearly 80% of the fund managers’ back-offices are outsourced. The range of outsourcing possibilities for firms is, however, not large. The number of TPAs is rather limited with the bulk of the business concentrated in the hands of a few of them (State Street Bank, BNP Paribas, JP Morgan…).
EU firms generally outsource within the confines of the EU but the search for reducing costs may lead them to third countries. For instance, some UK firms have outsourced activities to India where the workforce is cheaper but skilled enough to take over those activities. However, there may be regulatory limits to this movement, such as data protection rules.
The market for fund administration outsourcing remains an area of strong potential growth. In 2001, according to responses to a survey questionnaire100, 59% of the surveyed firms had delegated functions within their group and 68% of companies had delegated some activities to parties outside their group. It should be noted that the functions that may be delegated in the survey included settlement, fund administration, and custody. In 2004, another survey101 asked surveyed firms whether they had completely outsourced the valuation, administration and accounting functions. Hence, this survey excluded custodian functions. Nevertheless, it worth to note that 53% of surveyed companies had not delegated such functions and handled those functions themselves, 25% had delegated those functions within their group and 17% to parties outside their group.
Institutional managers have been enjoying the benefits of outsourcing for some time. Retail fund managers, however, have been slower to relinquish control over their non-core operations. Primarily, they outsourced custody and fund accounting, for example. However, there has been a general reluctance to outsource other aspects of the business process. The coming months should see further activity around the outsourcing of retail fund administration102.
Outsourcing is, however, not necessarily a panacea. Asset managers who outsource key functions must maintain adequate oversight, as ultimate responsibility remains with the asset management firm. Furthermore, remains the question of the risk that raises growth in outsourcing. For instance, the UK FSA noted that the number of firms to whom substantial functions have been outsourced is not large. This concentration might create a wider/different type of risk.
By eliminating internal functions firms reduce their capability and skills to control the third-party administration services. Even if financial penalties are often negotiated in the contract with the TPA, the eagerness to outsource and the limited number of TPAs, does not provide high incentives to the TPA to respect its commitments. Some are concerned that TPAs are probably more interested in attracting new business than keeping current clients happy. Additionally, “one size fits all” solutions may not be the most efficient in the case of small boutiques or specialised managers which require specialised procedures.
98 “Edhec European Asset Management Practices Survey”, March 2003 99 These include, among others, unit dealing, calculation of net asset values, fund administration, pricing… 100 See above-mentioned OXERA 2001 survey 101 See above-mentioned «Edhec European Asset Management Practices Survey» 2003 EDHEC-RISK 102 Source: “Retail Fund Administration Outsourcing” PricewaterhouseCoopers Corporate Finance practice.
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Capital requirements
In view to ensure the stability of management companies the amended UCITS Directive has introduced requirements for the initial capital of a management company. Furthermore, an additional amount of own funds in relation to the portfolios under management has to be provided for by the management company.
The initial capital should be at least € 125,000; the additional amount should be equal to 0.02% of the amount by which the value of the portfolios exceeds € 250 million. This additional amount shall not exceed € 10 million. In any case, the own funds of the management company should never be less than one quarter of the management companies' preceding year's fixed overheads.
The Directive also contains capital requirements in case the management company carries out investment services. These requirements have to be reconciled with those for the collective investment management. Finally, for self-managed investment companies an initial capital of at least € 300,000 EUR is required.
The debate on capital requirements is going on within the AM industry. However, as a matter of fact, most of operational risks fall on AM companies which run more and more services. They cover operational losses first by profits and, then, by capital. In that view, the capital requirements should be assessed in order to know if they are suitable with the new AM company patterns and still protect adequately investors.
In conclusion of the third section, it seems that the AM industry calls for more single market freedoms:
Industry broadly supported the proposal for greater freedom to appoint depositary-custodian-administrator in another Member State as a way to increase competition in a fragmented market and lower costs for investors. Due to the current discrepancies in national regulations, progress on this front may require a clearer definition of the role, the missions and the liability of the depositary as regards oversight of the management company and safe-keeping of assets. It also may require a throughout assessment of the risks entailed by such approach and the means to address them, notably as to oversight.
The obstacles to asset pooling and cross-border fund mergers were highlighted by the Expert Group as important barriers hindering the efficient functioning of the market for investment funds. Nevertheless, there remain regulatory concerns associated with pooling and cross-border fund mergers and on whether these obstacles could be effectively tackled by EU level legislation.
Distribution structures are also changing. There is a slow but gradual move towards open architecture. However, open architecture is not always having a positive impact. Quite often, distributors are directly remunerated by fund manufacturers (typically via a “retrocession” of part of the entry or management fees). In view of these incentives it is unsure whether distributors’ advice is always in the best interest of the client. Thus, a greater disclosure of the total costs and information about particular manufacturer-distributor arrangements would help investors to make a more informed decision. Improved transparency is also a key in order to maintain investors’ confidence.
Finally, the risk patterns are changing. It is essential to ensure that the different links within the asset management value chain incorporate the right structures and tools to identify, manage and/or disclose changing conflicts of interest. In this respect, it is interesting to note that IOSCO working group on fund governance considers independent oversight as a starting point for considering these issues. Thus, views on the role of the depositary are currently the object of extensive discussion in the context of the ‘fund governance’ debate. The discussions are on whether it remains appropriate to conflate the two “core” functions of the UCITS depositary, i.e. asset safekeeping/custody and oversight of fund management, taking into account the capacity of many depositaries to perform the controls that would be needed to detect things going wrong.
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As regards to operational risks, although well known by the industry and unchanging in substance, they continue to affect AM companies. When operational risk occurs, generally, the involved AM company covers losses with its cash reserves or its capital, because of legal requirements or reputational concerns. Hence, although they have a cost in terms of fees for investors, operational risks have to date rarely led to losses for investors.
Outsourcing is a way to improve profitability of AM companies, by replacing a fixed cost by a negotiable cost. Yet, even when outsourcing administration functions or operational risk management, AM companies remain legally accountable if something goes wrong. Outsourcing, hence, could lead to new kind of “operational” risk in AM business. As in financial services industry, outsourcing of some activities may increase complexity of managing operational risks due to the loss of control and know-how over those activities and, hence, suppose to define at contractual level a clear relationship between the outsourcing company and the provider.
In order to better understand costs, trends and risks in the AM business, the Commission launched calls for tenders for two quantitative and qualitative studies, i.e. “Current trends in the European asset management industry”103” and “Ootential cost savings in a fully integrated European investment funds market104”.
4. OVERALL ASSET MANAGEMENT LANDSCAPE
UCITS do not exist in isolation. They compete with many other products for the private savings of European investors. Some of these other products may incorporate some additional service element resulting in them being subject to a very different regulatory or tax treatment. The creation of separate regulatory ‘boxes’ for different families of investment product may lead to arbitraging problems and distort investment decisions. It may also create regulatory hurdles for asset managers who seek to transfer their expertise across families of investment product.
4.1. Other collective investments: non-harmonised products
4.1.1. Development of non-harmonised products competing with UCITS
Collective investment products which do not meet the investment rules of the UCITS Directive currently account for around 25-30% of assets under management in the EU. Segments of the non-harmonised sector are amongst the fastest growing segments of the fund industry – in contrast to stagnation or even net outflows from some UCITS segments. Examples include: private equity funds105, hedge funds, structured and guaranteed106 funds and real estate funds.
Private equity funds107 invest in firms which are generally non-listed companies. Private equity
103 The purpose is to provide the Commission with a sound analysis of the degree of inefficiency in the European investment funds market. It will present a detailed comparative description of the main sources of cost in the EU investment fund value-chain. 104 The purpose is to achieve a better understanding of the functioning of the market for investment funds and of the current trends which could affect the future development of this market. 105 Private equity provides equity capital to enterprises not quoted on a stock market. Private equity encompasses both venture capital (Venture capital is a subset of private equity and refers to equity investments made for the launch, early development, or expansion of a business.) and investment in buyouts (Buyout investment refers to the acquisition of a company or business unit. It includes replacement capital, management buyouts (MBO), management buyins (MBI) and leveraged buyouts (LBO).). 106 It should be noted that the term “guaranteed funds” is used in a generic way since some Member-States deny the use of this term to structured funds which do not offer a guarantee on 100% of the initial capital (invested by the investor) or external guarantee. 107 Private equity funds managed roughly € 155 billion at the end of 2004 (from € 59 billion at the end of 1999).
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investments fund the targeted company and provide it with the help and expertise of a management team. They often use leverage (senior, junior, mezzanine debts). Since private equity funds are most often closed-end funds, they do not target individuals and concentrate on sophisticated investors (75% of funds raised).
Hedge Funds differentiate themselves from plain-vanilla collective investment schemes because they use of a wider range of instruments, techniques and strategies (such as derivatives, short-selling, arbitrage and leverage). They are, therefore, not only more flexible than other traditional investment vehicles but also offer investors the possibility to obtain investment returns which are in principle uncorrelated with the market.
Guaranteed Funds are products offering a protection against the full volatility of markets in the form of either a guarantee of capital or income. However, the investment techniques in guaranteed funds can be used in a way that complies fully with the UCITS directive. Therefore, guaranteed funds might be UCITS or non-UCITS, depending on the designer’s aim.
Real Estate Funds are a type of investment funds that allow investors to have an exposure to the property market without buying directly a property holding. Some of them are open-end with various redemption dates. In this case, they are often called quasi-UCITS, due to the similar features. According to the industry108, harmonisation of these funds would be feasible.
This description can be completed with ‘quasi-UCITS’. De facto, they comply with almost all of the requirements of UCITS law but they are nevertheless denied the benefits of recognition as a UCITS product. A widely documented example concerns (open-ended) real estate funds. These are authorised for offer to the public in several Member States. Due to the categorical prohibition of investment by UCITS in real estate, these funds cannot benefit from the UCITS passport.
UCITS legislation does not provide any solutions to the market access and regulatory issues presented by non-harmonised fund products. They have been omitted from the scope of the UCITS Directive because of (perceived) complexity or greater potential risk for investors.
Fund market consolidation seems to have been more intense for the non-harmonised funds segment whose average size has nearly doubled during the 1993-2003 period; probably reflecting the growing interest of investors (especially institutional entities) in diversifying their portfolios. Meanwhile, financial innovation continues to develop new products that fall outside the scope of the current EU framework.
While not subject to EU legislation, many of non-harmonised products will be subject to national regulatory regimes or divergent national rules on their offer/placement.
For example, in the private equity sector, although both funds’ raising109 and investments110 in private companies are made on a pan-European basis, fund promoters must set up legal structures according to the national legislation of the country in which the fund aims to invest (e.g. UK: limited partnership, France: FCPR/I , Belgium: PRICAF, Luxembourg: SICAR, etc.). The existence of 25 different legal structures and bilateral tax treaties prevents the private equity industry from achieving its full potential. Indeed, the complexity of the various vehicles and structures that are used increases the cost of setting up and operating private equity funds, notably on venture capital side (fragmented market). The different structures reduce the commercial transparency of these funds to investors, hence making them less able to compare funds and their performance. On the investment side, when considering the
108 Source: FEFSI (EFAMA) Real Estate Funds Workshop. December 2004 109 Between 1999 and 2003, 51.9% of these funds were raised on the domestic (where the fund is registered)
market, 16.3% on other European markets and 28.3% from non-EU countries (mainly USA). 110 For example, in 1999, the UK managed 45.8% of private equity funds and was the destination country for
36% of the investments (France: 8% and Germany: 10%). In 2003, UK managed 46.5% of private equity funds but was the destination country of 25.3% of the investments (France: 16.7% and Germany: 14.2%).
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country of destination, it seems that the cross-border aspect of this sector has increased, although the country where the funds were raised remains the first destination of investments in private companies. In addition, private equity and/or venture capital funds experience difficulties at the moment they exit the investee company. As the investment in a non-listed company is for a limited period only, they must divest all their investments. A financial return is only generated when a private equity fund can realise its gains – and distribute them to the investors – through an exit, either an IPO or by an acquisition by another firm. Currently, there is no liquid pan-European market adapted to young, growing companies to support secondary trading and easy divestment of such investments.
As regards to hedge funds, the EP report111 has called for the treatment of hedge funds from an EU regulatory perspective to be considered as part of the UCITS review. Indeed, the European market has not remained unaffected by the impressive growth of the Hedge Fund (HF) industry world-wide. Although the size of the European HF industry is still modest (only 3% of the EU assets under management (AuM), it continues to grow vigorously. Recent figures112 estimate at more than $256 billion (€ 187 billion at 31/12/2004) the size of European AuM at the end of 2004.
US$ billion in alternative management figures are estimated (source: www.hedgefundintelligence.com + Van Hedge Fund Advisors International + Hedge Fund Research)
125,00 $bn
216,32 $bn
480,00 $bn520,00 $bn
600,00 $bn650,00 $bn
820,00 $bn
972,00 $bn
20,50 $bn64,00 $bn
255,85 $bn
168,00 $bn
0
200
400
600
800
1000
1200
end 1999 end 2000 end 2001 end 2002 mi-2003 end 2003 mi-2004 end 2004
Europe Global
N.A.N.A.
In the EU, the development of HFs has not been homogeneous. As a result, the HFs business shows a rather concentrated picture. Two HF centres have clearly emerged: one for the fund management and another for fund administration. In the first case, the UK has an indisputable place in the European HF scene. At the end of 2004, 74% of the AuM of all European HFs are managed from the UK. As regards administration, Ireland is the leader with a not negligible percentage of HF global assets administered in Dublin. However, a strong competition from Luxembourg can be expected.
Fund managers are allowed to manage HFs in most EU countries. However, they have often to comply with minimum capital requirements (up to € 1 million in the case of Italy), in some cases demonstrate
111 (Rapporteur: John Purvis) on “the future of Hedge Funds and Derivatives” (2003/2082 (INI)) 112 Source: www.hedgefundintelligence.com
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that they have enough resources and competence and sometimes are allowed to manage only nationally domiciled HFs.
Distribution of offshore HFs may be completely prohibited, limited to certain types of investor (sophisticated, expert…) or in practice hindered by an unfavourable tax treatment.
Some countries have also allowed the creation of nationally-domiciled HFs although subject to restrictions regarding minimum subscription amounts, minimum fund sizes and portfolio investment.
The particular situation in some EU countries is described in more detail in annex B.
4.1.2. Policy issues regarding non-harmonised products
Market fragmentation and risk of regulatory arbitrage
From the point of view of a single market for funds in Europe, divergences of regulatory approaches, particularly with regard to HFs, could lead to higher market fragmentation and an increased risk of regulatory arbitrage. Substitute collective investment products, subject to less onerous regulatory requirements, may be able to compete to an extent that undermines investor protection or market functioning. Nevertheless, it should be further reflected whether these different products actually compete since they may have different investor bases.
Although examples of this form of arbitrage are evident in some Member States, the question remains whether this is a pan European issue calling for a common approach. Regulation at EU level could contribute to smooth regulatory divergences – but would only be justified if it can effectively enhance business efficiency or address demonstrable sources of risk having a cross-border dimension.
Retail investor protection
Traditionally sold to professional or qualified investors, the HFs base is now in a “retailisation” course in some Member-States. The development of funds of hedge funds (FoHFs), in particular, has made hedge funds more broadly available to investors. Some of them are listed on exchanges, further increasing their availability113 to investors. Furthermore, retail investors might get access to hedge fund exposure by means of structured bonds114. This may present some regulatory concerns for unqualified investors, typically in relation to diversification and disclosure: information on underlying funds may be less accessible for investors.
If HFs are being made available to retail investors, there may be a need to consider specific forms of protection for these less sophisticated investors. This protection should be assured, first, by the Member States supervisors/authorities, which are better positioned to understand and to take into account customs, preferences and other cultural aspects which influence investors’ decisions. Nevertheless, Member States protection may not be sufficient. Investors can have access nowadays to HFs and FoHFs even if they are not authorised to be distributed115 in their country of origin. In some jurisdictions, authorities consider that making investors responsible for their decisions is a medium-term strategy to protect them. However, investors are not always aware of what is in their portfolio
113 In February 2004, the estimated total of assets managed under exchange-listed funds of hedge funds was around $4 billion in the world. 114 Structured bonds enable investor to participate in the performance of a certain underlying without the need to invest directly into the underlying. 115 Listed funds, pension/insurance products or wrapper vehicles such as certificates are accessible to all investors.
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(e.g. if invested in a pension fund with x % in HFs or if badly advised by their bank or IFA). Additionally, financial literacy levels among EU investors are quite diverse and often rather low.
In relation to private equity funds, it should be noted that they may be listed as to offer investments more widely. A few funds are directed towards retail investors. Again, this would raise the question of the investor literacy regarding this often complex and technical product.
Financial stability concerns
Because of high degree of leverage borrowed from systemically relevant banks, HFs may represent a source of financial instability. In a rather integrated financial market the risk of contagion in the advent of a failure of a HF and its counterparties is higher.
To date, leverage in HFs is thought to be lower (3 times total assets116) than in 1998. Nevertheless, the growth of the business is prompting renewed concern as to whether HFs – and more particularly, lending by large banks to HFs – represents a source of potential financial instability. Typically recent years’ often mediocre HFs performances may push managers to increase leverage to maintain previous returns levels.
Around 15 hedge funds collapse per year out of a universe of 2,500 open to investment funds. This represents a high failure rate of 0.6%. According to one academic study117, collapses are related to investment risk in 38% of cases, to business risk in 6%, to operational risks in 50% and to multiple risks in 6%. That means that at least 56% of the hedge fund collapse due to operational processes, which adds a significant failure risk to the market risk.
Because of their role as prime broker providing leverage and credit lines, credit institutions are at risk in case of HF failure. Data points out a strong concentration of prime brokerage business with a limited set of global market players. It also seems that this business has become increasingly competitive over time, with a number of second-tier players aggressively trying to gain market share.
Furthermore, irrespective of whether they deal with onshore or offshore hedge funds, EU regulated counterparties are integrated in the EU-wide financial market (counterparties in OTC derivatives transactions, short-term lender of funds or securities, long-term lender or provider of capital, execution agent, responsible for buying or selling on behalf of a HF, clearing and settlement agents or prime brokers). However, data on EU-banks exposure to offshore funds are often not available. Hence, even if there is no conclusive evidence on the impact of HFs on financial markets, some risks may emerge. Finally, since most of the threats posed by HFs on financial stability would have a global dimension, the risks of an uncoordinated response by EU financial authorities may exacerbate its negative effects.
The ECB 2004 review highlighted the bank exposures towards hedge funds which are most likely to arise from their prime brokerage relationships. Direct credit exposures include loans, credit lines and trading exposures in OTC markets (including credit risk, derivatives markets and others).
According to the ECB, for some euro-zone banks, the income stream from prime brokerage services constitutes a very significant share of total trading and commission income, ranging between 25% and 40%. Increasingly banks are also investing in or setting up hedge funds. Prime brokerage is a rather concentrated industry and it is primarily dominated by US entities, although certain euro-zone banks are also among the established players. However, prime brokerage business is becoming more competitive as new banks enter the market. As hedge funds may use the services of several different prime brokers it is
116 Source: HFR and BIS Quarterly Review March 2005 – “International Banking and Financial Market Developments” 117 Source: Edhec Risk and Asset Management Research Centre, based on publicly available information only: “The Management of Hedge Funds’ Operational Risks” Jean-René Giraud; April 2004
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possible that a single bank lacks sufficient information on the full risk profile of its customer. In addition, the prime brokerage industry may become less resilient as a number of new entrants aggressively try to gain market share, which could also allow hedge funds to negotiate better access to credit. Indirect risks may also materialise, for example, through credit risk on counterparties that have large exposures to hedge funds. In addition, since hedge funds are active traders in financial markets, banks’ trading book positions could be exposed to market volatility, potentially caused by hedge funds realigning their positions.
Furthermore, market data show that a number of large EU-credit institutions are taking on more market risk and engaging in “hedge fund”-like strategies. Under these conditions, negative market events may not only have an impact on the direct relationship between credit institutions and hedge funds but may simultaneously affect the proprietary market positions of credit institutions. More detailed data, specifically on the value at risk (VaR) break-down, would be needed.
In its resolution on HFs and derivatives, the European Parliament (EP) considers, inter alia, that there is a risk of systemic damage to the global financial system if these investment vehicles proliferate without quantification or control. It also reckons that some hedge funds may be directly accessible anyway to retail investors without any specific protection, via European market listings or third country jurisdictions or indirectly via funds of funds or structured notes. Therefore, the EP recommends addressing the risks that represent HFs for financial stability and for investors. It suggests, hence, that a regulatory regime for sophisticated alternative investment vehicles be established in EU. Considering the fact that many hedge funds operate offshore and are not subject to Community regulation, the EP calls on the Commission to introduce EU-legislation in order to make the lending by EU financial institutions to offshore hedge funds more transparent. Last, that regulation should also concentrate on provision of information to investor.
Depositary role in respect of alternative investment strategies
Generally speaking, EU countries wishing to create hedge funds accessible “onshore” to local investors have opted for the depositary model on the basis of the UCITS Directive (France, Germany, Ireland, Italy, Luxembourg…). In contrast to the USA, administration of European HFs is undertaken by entity other than the HF manager. Due to the specificities of alternative investment management, additional missions for the depositary have been added to the traditional UCITS model. This is the case for funds of hedge funds: in France, for instance, the depositary shall check, inter alia, the eligibility of underlying funds and the quality of information provided to the public and of registrars, as well as the eligibility of the investors. This is also the case for hedge funds, where the depositary has been seen as a fundamental pillar for investor protection in the development of European-based hedge funds.
As opposed to UCITS, the picture is made more complex in the case of hedge funds by the existence of an additional actor, the prime broker. In the case of European-based hedge funds, it is generally provided that relations between the prime broker and the depositary must be formalised, including specific reporting and control mechanisms. The depositary is indeed given a supervision role over the prime broker, as the investor is to be protected by rules of conduct and risk spreading rules applicable to the prime broker as counterparty to the fund. In Ireland for instance, the depositary/custodian has a supervisory duty over the prime broker with regards to the assets held by the latter. The depositary/custodian is obliged to receive daily and monthly reports from the prime broker, to monitor them and to ensure that regulations are being complied with. The daily report must include the daily mark to market of the assets held by the prime broker as well as an evaluation of all outstanding liabilities of the hedge fund to the prime broker.
The role of depositaries when confronted with alternative investment strategies means more controls over the inner procedures of the fund and more supervision over underlying funds investments using more and more complex investment techniques. Hence there is a need for more sophisticated evaluation tools, more sophisticated reporting tools and new expertise within controlling teams of the depositary. Developing hedge funds capability is a costly exercise for depositaries. The new European
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regulatory regimes have thus not been exempt of criticisms in the current economic context, which remains difficult for depositaries.
The prime broker usually assumes clearing and settlement when processing an order. It is thus logical that it may be able to act as custodian. Furthermore, it is on the basis of the data collected as custodian that the prime broker is able to evaluate its risks when financing the fund’s positions. A difficulty created by the alternative management techniques is the potential overlap between the depositary and the prime broker in the field of custody. In some jurisdictions, the solution chosen is to provide for a sub-custody agreement between the depositary and the prime broker, ultimate legal liability remaining with the depositary, as under the UCITS model, and contractual liability being with the prime broker. Some regulators consider that the sub-custody agreement may create substantial operational risks for both parties in the case of hedge funds, even if this problematic already existed under the UCITS model. It must provide for adequate supervision tools from the depositary, where we encounter again the issue of the technical challenges. To meet this challenge, considerable resources are needed, and global players are best placed in this respect.
Thus, some players consider to merely merge o the depositary and of the prime brokerage activities. This could be technically possible on the custody side, but raises a lot of questions on the oversight side.
4.2. Level playing field with other financial products competing with funds
As frequently highlighted by the asset management industry, investment funds, in particular the highly regulated product of UCITS may be competing in certain cases with other types of financial savings products which appertain to a different regulatory environment such as investment certificates or some life-insurance products. They claim there is also a level-playing-field issue regarding occupational pension provisioning.
4.2.1. With pension funds (Fund schemes as occupational pension schemes)
This is one of the main issues put forward by the fund industry also outlined in the AMWG’s report. The institutions for occupational retirement provision (IORPs) Directive118 excludes institutions covered by Directive 85/611/EEC from the scope of application119. Thus, management companies under Directive 85/611/EEC are not “institutions for occupational retirement provision” and therefore cannot operate pension schemes.
Fund management companies are explicitly allowed by the Directive (Article 19) to manage IORPs assets. This can be done e.g. by :
Creation of funds (UCITS and Non-UCITS) to pool assets held by IORPs or Management of IORPs as external manager by the means of delegation (individual portfolio
management for an institutional client120).
The fund industry considers investment funds (UCITS) as an appropriate vehicle for occupational pensions because in their view they are “flexible, easily transferable and transparent”. Therefore, they highlight the necessity of a review of the IORP Directive as provided for by its Recital 12: “The Commission should carefully monitor the situation in the occupational pension market and assess the possibility of extending the optional application of this Directive to other regulated financial institutions”.
118 Directive 2003/41/EC of the European Parliament and of the Council of 3 June 2003 on the activities and supervision of institutions for occupational retirement provision (IORPs) 119 cf. explicitly Art. 2 paragraph 2 point b of Directive 2003/41/EC 120 Art. 5 paragraph 3 point a) of the UCITS-Directive
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It should, however, be noted that occupational retirement provisioning includes much more than just asset management. In particular the insurance elements in the pay-in phase (premiums), the pay-out phase (annuities) and the Asset Liability Management are part of the specific characteristics of IORPs.
Nevertheless, if investment funds were to be made fully suitable for pension provisioning further problems should also be resolved: for instance, the questions of how to ensure the protection of investor contributions and of appropriate capital adequacy rules, as well as compliance with social and labour law provisions aimed at protecting members of the pension scheme.
4.2.2. With life-insurance
Regarding disclosure requirements
UCITS are subject to a set of disclosure requirements such as two prospectuses, disclosure of TER and turnover rate, indication of fee-sharing agreements, disclosure of NAV etc. The disclosure requirements for all life-insurance contracts include information before concluding and during the contract121. In particular provisions apply concerning cooling-off periods, tax arrangements applicable, indication of surrender and paid-up values and the extent to which they guaranteed. For unit-linked policies, the definition of the units to which the benefits are linked and the nature of the underlying assets shall also be disclosed. Most of these requirements also apply in case of changing the policy. The insurer shall also provide information for handling complaints. For both, life insurance contracts and UCITS, different requirements demand administrative efforts which produce additional costs.In the view of the fund industry the requirements applicable to UCITS might entail the risk that UCITS are put in a competitive disadvantage with certain other products such life-insurance contracts. On the other hand, if UCITS are made a highly transparent financial product thanks to these requirements this might be possibly rewarded by investor choice so that the related cost might pay off in the long-term.
In particular: regarding unit-linked insurance products
The issue of transparency concerns particularly unit-linked insurance contracts122. According to European legislation on life assurance123 the benefits of an insurance contract are allowed either to be linked to UCITS or to internal funds held by the insurance undertaking.124 The disclosure requirements for this type of contract are fairly generic. In particular there are no detailed rules on the cost-transparency of the product, but some information requirements regarding the risk-profile and the investment policy of the underlying investment funds, although not as extensive as applicable to UCITS. UCITS disclosure requirements do not apply to internal insurance funds linked to unit-linked insurance contracts. For that reason life insurers can not sell these funds to the general public as it is possible for UCITS.
The management of internal funds by an insurer is an activity allowed by insurance legislation. It is similar to the management by the insurer of its assets covering technical provisions. Together with managing risks related to life and death, asset management is an important activity of a life insurer. Without this activity it would not be able to fulfil its commitments towards policyholders. In comparison with the management of UCITS, it may be regarded as less densely regulated. This might
121 Annex II of Directive 2002/83/EC 122 According to industry research investments in unit-linked products amounted to EUR 1020 Billion at the end of 2001, equivalent to about 20% of the assets under management at European life insurers. The most important markets are in the UK and NL, for instance the value of unit linked funds under management in UK was ca. £ 348 billion in 2002. 123 Directive 2002/83/EC concerning life assurance 124 Not all Member States’ legislation provide for the possibility of linking insurance contracts to internal funds. Insurance products linked to “Internal funds” are for instance rather common in NL or UK.
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make the management of internal funds by insurance companies less expensive than that of UCITS, but can also give rise to uncertainties since certain aspects such as regular NAV-calculation are neither regulated nor standardised. However, although internal funds may be less expensive, they do not provide insurers with the option to sell these internal investment funds directly to the general public as UCITS can.
It should be noted that an insurance contract (be it unit-linked or other) is first and foremost a contract that insures some unexpected events during a certain period. The assets are owned by the insurer. A unit-linked life insurance contract is not a pure investment product that can be sold at any time. From the perspective of a life insurer, unit-linked life insurance is just a better way of risk management concerning market risk and an instrument to provide optimal profit sharing with policyholders.
Regarding tax treatment
Tax treatment is another issue highlighted by the AMWG which might impact the competitive situation of investment funds in comparison with insurance and pension products. In this respect, the “Directive on taxation of savings income in the form of interest payments”125 has to be mentioned. The Directive aims at enabling savings income in the form of interest payments made in one Member State to beneficial owners who are individuals resident for tax purposes in another Member State to be made subject to effective taxation in that latter Member State. For this purpose a paying agent reports to his local tax authority payments of interest to individual investors. The local tax authority will pass this information to the country of residence of this individual. The Directive has explicitly extended the concept of interest payment to investment funds holding interest-bearing assets: distributions from and proceeds of sales or redemption of investment funds that hold interest-bearing investments above a certain threshold are subject to reporting or withholding. In contrast, insurance and pension benefits are expressly excluded from the scope of application of this Directive. The Directive will have significant implications for the administration of investment fund; it is expected that it will affect a large number of investment funds in Europe.126
4.2.3. With investment certificates
Investment certificates are structured bonds which enable investor to participate in the performance of a certain underlying without the need to invest directly into the underlying. Similarly to investment funds, in case they refer to a diversified pool of assets, they can enable investors to participate in the performance of a diversified range of assets and thus to spread their risks by acquiring one single security. Even if some certificates are exclusively designed for institutional investors as a response to their regulatory and/or tax needs, they are mainly marketed to retail clients and are becoming increasingly popular in some Member States. Most certificates are admitted to trading on a regulated market127. Certificates fall under the rules applicable to other bonds such as the Prospectus Directive and MiFID. They can therefore be bought and sold like any other bond admitted to trading. They are not subject to specific disclosure requirements as regards their cost-structure, their strategy or the risk-profile of the product. This issue not only raises concerns with the investment industry for competitive reasons but also regulators increasingly look at this issue as a matter of investor protection.
125 Directive 2003/48/EC 126 Ernst & Young, EU Savings Directive – An overview, 5/2004 127 By the end of 2003, 66% of the worldwide volume traded in certificates accounted for German stock-exchanges, 12% for Hong Kong, 7% for Switzerland 5% for Italy and 3% for the stock exchanges of Euronext. The turnover in certificates including warrants in 2003 was €154.77 billion at the stock exchanges in Germany whereas e.g. the turnover in Italy was only €10.83 billion and at the stock exchanges of Euronext €6.29 billion.
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In conclusion of the fourth section, it is worth to note that the cost/benefit associated with EU action aimed at developing a common regulatory treatment for non-harmonised funds should now be assessed. Actually, extending access to non-harmonised products and facilitating their distribution could achieve the following benefits:
increasing the options available to retail investors, enabling them to diversify their portfolios, whilst adding to the potential for investors to achieve positive returns in falling markets;
leveraging the level of innovation in the EU asset management sector, thereby enabling the market to fulfil its potential, and reducing operational costs; and
assisting the efficient operations of the EU markets, through increased capital available to exploit mis-pricing opportunities, in addition to increasing commercial transparency.
creating clearer distinctions between those investments that are packaged for institutional clients only, and those which could be suitable for retail consumption.
However, these benefits cannot be taken as given, and must be measured against the following risks:
maintaining an appropriate level of investor protection, especially considering that retail investors, even if denied access to HFs or FoHFs in their country of origin, may gain exposure through instruments offered in other EU jurisdictions; and
a potential threat to financial stability: failure of hedge funds could potentially give rise to difficulties for counterparties with significant exposures, including financial institutions in other EU countries.
Finally, UCITS are not only competing with non-harmonised funds but also, potentially with other financial products (e.g. life-insurance products, investment certificates, etc.). It should be considered to what extent there are level-playing field issues which might need to be addressed by action on a European level. . Nonetheless, such an action would only be justified if it can effectively enhance the efficiency of the business or to address demonstrable sources of risk having a cross-border dimension.
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Annex A: POOLING TECHNIQUES, ADVANTAGES, RISKS 1. Which are the two pooling techniques?
Virtual cross-border pooling
By the utilisation of information technology virtual pooling enables two or more funds (or sub-funds of an umbrella) to commingle their assets in investment pools. The investment pool has no legal personality. The participating funds retain the legal and beneficial ownership of their assets. The commingled assets are held in one account serviced by the custodian (omnibus account).
Contractual arrangements between the participating funds and the custodian ensure that the participating funds have the right to contribute/withdraw cash or assets to/from the account, to exclude other participating funds etc. These contractual arrangements ensure that the quality of the ownership of assets of the participating funds remains as if these assets were held in a separate account to the order of the respective participating fund. The holders of the account, i.e. the participating funds (or sub-funds) contractually appoint an investment manager. This investment manager executes the trades of the assets held in the account on behalf of the participating funds. The custodian and/or the administrator, which are usually but not necessarily the same entity, keep on the one hand the custody records of the pool in an omnibus account, but also on the other hand the ownership records of the participating funds with respect to the assets held in the omnibus account. 128
“Entity pooling” (“master-feeder” funds)
Entity pooling utilises legal entities to undertake pooling. There are two forms of pools which can be used for this purpose, “opaque” pools or “transparent pools”:
An opaque pool has a separate legal personality of its own. The participating funds are the owners of units in the pool which in turn is the legal and beneficial owner of an underlying portfolio of assets. Therefore, although the participating funds retain the same economic risks and benefits as if they had directly invested in that underlying portfolio, their legal entitlement is the units of the pool and not to the underlying portfolio itself. This structure is more or less equivalent to the master-feeder structures known in the USA, whereby the master fund holds the underlying portfolio of assets whilst the feeder funds exclusively invest in the units of the master fund. With respect to cross-border business two basic scenarios regarding these structures are conceivable:
The master-fund is domiciled in one jurisdiction, and the feeder funds which are exclusively invested in this master fund are domiciled in another jurisdiction
Both the master and the feeder funds are located in the same jurisdiction; the feeder funds are distributed on a cross-border basis.
A transparent pool has no legal personality of its own. The participating funds contract between one another for common ownership of an underlying portfolio which is managed through a partnership-type agreement. In certain respects (particularly for fiscal purposes) the participating funds are deemed to remain the legal and beneficial owners of the underlying portfolio of securities. An example for a transparent pool is the common contractual fund (CCF) Ireland has recently permitted by law for the area of pension pooling. Similar structures are apparently less common for the area of investment funds.129
128 Pooling, Report IMA December 2004 p. 8-9 (draft version only!). 129 Pooling, Report IMA December 2004 p. 2-8 (draft version only!).
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2. Potential advantages of pooling
Reduction of administrative costs
According to some industry research European investment fund managers are unable to enjoy significant economies of scale because small, local markets restrict the average size of investment funds. Pooling would help to realise those economies, since the average size of the pool would necessarily be larger than that of the participating funds. Those economies might be shown between fund managers and investors, provided that these benefits are passed on the investors. It should be noted that although pooling can approximate economies of scale, these are somewhat offset by diseconomies of administration.
Qualitative benefits
Some qualitative benefits from the investment management perspective are also cited which are, however, difficult to quantify. For instance, consistency of performance could be improved: the performance of the participating funds would vary; however, it would be clear that these differences arise because of local taxes or other local particularities, since the performance of the pool would be necessarily common to all the participating funds. Similar aspects would also apply regarding risk-management because the risks of the pool would be submitted to the same risk-management process independently of whether the assets belong to an Italian SICAV, a German Sondervermögen or a UK unit trust. Furthermore, the risks of volatile performance of smaller funds could be reduced since the pool, due its size, tends to be less volatile over time. 130
3. Risks related to these techniques
Operational risks:
Pooling mainly gives rise to operational risks. For instance, in case of virtual pooling there are risks related to a potential segregation of the pooled assets. Assets belonging to one participating fund or sub-fund are not segregated from the assets of the other funds or sub-funds participating in the same investment pool. In certain situations (e.g. in case of the liquidation of one of the participating funds) there is the requirement for the specific assets of the fund or sub-fund to be segregated into a designated account to the order of the respective fund or sub-fund. There is the risk that e.g. due to insufficient IT- and control system this segregation process is not properly carried out or delayed. For all types of pooling, risks related to the smooth and timely exchange of information and reporting between the participating funds and the pool are relevant.
Dilution risk and associated risks regarding allotment/re-allotment of assets and transaction costs
These risks are relevant for all types of pooling: pooling can result in a dilutive effect at the expense of existing shareholders and to the benefit of the incoming shareholders. Due to a subscription the share of the existing shareholders in the portfolio is temporarily diluted with cash until such time as the cash is invested. Though there is conceptually no difference to what happens within an existing fund it should also be taken into account in the case of pooling.
Furthermore, there is the need to carry out a double allotment process: one allotment process “distributes” the proceeds of the investment decisions taken by the investment manager amongst the participating funds; another allotment process adjusts the participating fund/sub-fund portfolios further to subscriptions, redemptions, conversions or distributions. Particularly in this latter case, there is the risk that undue transactions, costs or settlement expenses have to be borne by one or several of the participating funds/sub-funds through the acquisition or disposal of assets to meet a subscription or redemption in another participating fund/sub-fund.
130 Pooling, idem, p. 15-17 (draft version only!).
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Risk of circumvention of investment policy of the participating funds
There is the risk for all type of pooling that the investment restrictions imposed on the participating funds (by law and by sales documents) are circumvented by the management of the pooled assets.
Legal, regulatory and supervisory risks
Closely related to the risk of circumventing the investment policy of the participating funds are those risks which result from the fact that the pool of assets and the participating funds fall under different jurisdictions. This is particularly relevant in case of entity pooling, i.e. master-feeder structures. The master fund and the feeders might be supervised according to different regulatory and supervisory structures. This scenario also gives rise to the question of legal responsibility: the investment decisions are taken by the master fund which is located in one jurisdiction whilst the feeder funds which fully depend on these decisions fall under another jurisdiction. In case something goes wrong with the master fund there is the risk that the legal responsibilities remain unclear and that the investors of the feeder funds do not have the necessary protection because the national authorities of the feeder funds have no direct legal means to take necessary action against the master fund.
In addition there might be a need to consider the role of the joint-liability of the holders of the funds participating in a pool, i.e. whether investors in a given fund should be liable for the obligations of another fund. Such joint-liability seems to be problematic because the investor might be exposed to risks of funds which he has not selected for his investment. It should be clarified to what extent pooling techniques rely on the joint-liability of the investors of the participating funds and what practical safeguards could be applied in order to ensure adequate investor protection.
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ANNEX B: SOME NATIONAL FRAMEWORKS RELATED TO ALTERNATIVE FUNDS • UK
Despite being a key player in the HF arena131, there is no specific regulatory regime for the marketing of hedge fund products in the UK. As unregulated collective investment schemes they are, however not allowed to be freely offered to retail investors but to intermediate customers, market counterparties or to private customers where a firm has taken reasonable steps to ensure that the fund is suitable132. On the other hand, FoHFs that are officially listed are, therefore marketable to the general public.
Following a public consultation on the basis of a discussion paper on HFs133, the UK authorities noted that, there does not seem to be a significant demand from retail investors to access HFs and concluded that it was “not appropriate to change the regulatory regime to allow easier marketing of HFs to retail consumers”134.
More recently, the Qualified Investor Scheme has been introduced as an attempt to encourage the establishment onshore of HFs. This scheme, available only for sophisticated investors, permits managers to engage in many of the strategies which would be available for single HFs135.
Concerning HF managers, there is a continuous important growth in their number. In fact, according to the FSA, some two thirds of the request for authorisation received corresponds to HF managers.
• France
France has reviewed the framework for alternative investments (“gestion alternative”) in November 2004. There are now four kinds of new collective investment schemes (CIS): the funds ARIA (Agrées à Règles d’Investissement Allégées136), leveraged ARIA (ARIAEL), contractual funds and FCIMT (Fonds communs d’intervention sur les marchés à terme). Those funds can be offered to qualified investors (without any quantitative restriction) and to retail investors subject to investment thresholds which vary according to the perceived risk of the fund (€ 0 for guaranteed FoHFs, € 10.000 for FoHFs and FCIMT, € 125.000 for other ARIA funds, € 250.000 for contractual funds) and the net worth and experience of the investor.
• Germany
The entry into force on 1st January 2004 of the new Investment Act established a legal framework for HFs and FoHFs. For single HFs (domestic or foreign), distribution is only allowed via private placement but under certain conditions (e.g. that the offeree be able to fend themselves). Domestic domiciled HFs are permitted to use leveraging techniques and short selling. As regard to FoHFs, both domestic and foreign FoHFs can be distributed publicly. In the case of foreign ones, there are allowed to do so only if they are subject to public supervision in their home country and if the relevant regulatory authorities show willingness to collaborate with the German Financial Services Supervisory Authority. If this is not the case, foreign FoHFs can still be distributed in Germany but via private placement. Furthermore, both domestic and foreign FoHFs have to comply with investment limits137 and minimum disclosure requirements.
131 An estimated 15 to 20% of the global HFs assets is managed by firms authorised in the UK. 132 “Hedge Funds and the FSA”, UK Financial Services Authority, August 2002, p.13 133 “Hedge Funds and the FSA”, UK Financial Services Authority, Discussion Paper 16, August 2002, p.13 134 “Hedge Funds and the FSA: Feedback statement on DP16”, UK Financial Services Authority, March 2003, p.5 135 QIS investment powers are, however, limited. For instance, borrowing and the exposure to derivatives must not exceed the net asset value. 136 Registered funds with less stringent investment rules. These rules allow funds to use leverage (but limited in most cases) and more flexible investment ratios. 137 FoHFs should invest only in HFs, have no more than 20% of its assets in a single target fund, not use leveraging techniques or engage in short-shelling…
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• Luxembourg
The Grand Duchy is, behind Dublin, one of the first centres in terms of volume of HFs under administration. HFs assets serviced from Luxembourg are reported to amount to € 10 billion for single HFs and to be in excess of € 40 billion for FoHFs138. Part of the recent years’ rapid growth of the HFs industry in Luxembourg seems to have been supported by the issue of the Commission de Surveillance du Secteur Financier (CSSF) circular of 5th December 2002 on Alternative Investments (Circular 2002/80). This circular which set for the first time the regulatory framework for HFs in Luxembourg139, permits regulated HFs to engage in short selling, to borrow securities, to have a much greater flexibility in the use of derivative instruments and to use leverage. The Ministerial decree of 5th July 2004 and the CSSF Circular 04/151 will facilitate the listing of offshore funds on the Luxembourg Stock Exchange. This legislative change is believed to be an opportunity for Luxembourg to reduce the distance with its main competitor (Dublin).
• Ireland
Ireland is the leading European centre for HF administration. Estimates point to $200 billion of administered assets. The possibility to list HFs on the Dublin stock exchange is said to be one of the reasons for this.
Single manager HFs can be created as Professional Investor Funds (minimum investment amount is € 125.000; investment restrictions can be relaxed on a case by case basis) or Qualifying Investor Funds (€ 250.000 minimum investment amount; no restriction regarding the fund’s investment policy). Retail FoHFs are permitted as from December 2002. Their diversification requirements have been relaxed in June 2004 and their minimum investment requirement abolished. Current discussions between IFSRA and the HF industry aim to review the prime brokers’ regulatory environment and the access of retail investors to single HFs.
• Italy
The Ministerial Decree 228 of 24 May 1999 and the Bank of Italy decree of 20 September 1999 introduced a new type of funds, the “fondi speculativi”. Those funds can be single manager funds or FoHFs. In April 2003 the minimum investment amount for both types of fund was reduced from € 1 million to € 500.000 and the maximum number of investors per fund increased from 100 to 200.
• Spain
A draft Decree prepared by the Ministry of Economy is at present under consultation. If adopted, this new regulation will set the framework for the establishment and distribution of HFs in Spain. According to the draft, HFs which will be allowed to offer their parts only to institutional investors, will not be subject to the investment limits imposed to other collective investment schemes. They will have, however, to respect the principles of transparency liquidity and risk diversification. On the other hand, FoHFs seeking authorisation will have invest at least 60% of their assets in Spanish or non tax haven-based HFs and limit to a maximum of 5% their investment in an only HF. They will be available to retail investors. Both HFs and FoHFs should calculate the portfolio value daily and allow for at least monthly subscriptions/redemptions.
138 “Boom in Luxembourg HFs “, Association of the Luxembourg Fund Industry, Newsletter October 2004 139 Prior to the issue of this circular, HFs were authorised by the regulator on a case by case basis.
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Country Manager Capital Requirements1 Regulated Products Retail
Distribution? Threshold
Qualified Investor Scheme No None UK
€50.000 own funds + liquid capital of 3 months annualised
expenditure FoHFs Yes
Professional Investor Fund No € 125.000
Qualifying Investor Fund € 250.000 Ireland
€50.000 initial capital + 3 months annualised expenditure
FoHFs Yes None
HFs No € 500.000 Italy € 1.000.000
FoHFs
ARIA Yes € 125.0002
ARIAEL Yes € 250.0002 France € 125.000
FoHFs Yes € 10.0002
HFs Yes None Luxembourg € 125.000
FoHFs
HFs Yes, but only on a private placement basis None
Germany € 730.000 FoHFs Yes
HFs No None Spain3 € 300.000
FoHFs Yes 1 capital requirements for HFs managers are often the same as those for other asset managers. Capital requirements for some countries as at May 2003. 2 minimum investments is € 0 for qualified investors 3 draft regulation, not yet in force