© Copyright 2015 by K&L Gates LLP. All rights reserved.

Session I: The Future of Retail Funds in the EU and U.S. Mark Amorosi, Partner, K&L Gates Washington. D.C. Sean Donovan-Smith, Partner, K&L Gates London Andrew Massey, Special Counsel, K&L Gates LondonRodney Smyth, Consultant, K&L Gates London

OVERVIEW Retail fund landscape Product developments Distribution issues Specific initiatives Future of the industry

3

European Retail Fund Landscape

4

European AUM in UCITS exceeding €9 trillion for first time everNet assets (EUR bn)

Category End 2014 March 2015 % change on previous month

UCITS 7,955 9,004 2.5%

Non-UCITS 3,347 3,547 2.3%

Total 11,302 12,551 2.4%

Source: EFAMA March 2015 Data

Breakdown of UCITS by Category

UCITS types

31/12/2014 Change from 31/12/2013

No. Share in % in No.

Equity 12,117 37% 0.0% 0

Balanced 8,740 27% 3.1% 265

Total Equity and Balanced 20,857 64% 1.3% 265

Bond 7,290 22% 1.8% 132

Money Market (MM) 1,037 3% -11.2% -131

Funds of funds 882 3% 0.8% 7

Other 2,517 8% -6.2% -165

TOTAL 36,148 1.2% 440

European Retail Fund Landscape

5

Location of Firm Headquarters

Top five countries

Source: Prequin Hedge Fund Analyst Source: EFAMA June 2015 Data

U.S. Mutual Fund Market

6

Closed-end Mutual funds funds ETFs UITs Total

1997 $4,468 $152 $7 $85 $4,7111998 5,525 156 16 94 5,7901999 6,846 147 34 92 7,1192000 6,965 143 66 74 7,2472001 6,975 141 83 49 7,2482002 6,383 159 102 36 6,6802003 7,402 214 151 36 7,8032004 8,096 253 228 37 8,6142005 8,891 276 301 41 9,5092006 10,398 297 423 50 11,1682007 12,000 312 608 53 12,9742008 9,603 184 531 29 10,3472009 11,113 223 777 38 12,1512010 11,833 238 992 51 13,1132011 11,632 242 1,048 60 12,9822012 13,052 264 1,337 72 14,7252013 15,035 279 1,675 87 17,0752014 15,852 289 1,974 101 18,217

Source: Investment Company Institute

Investment Company Total Net Assets by Type (1997 – 2014) (in billions)

Product Developments – Rise of Alternative Funds

8

Collective Investment Scheme (“CIS”)(UK definition)

Regulated CIS Unregulated CIS

Other AIFs

Alternative Investment Fund (“AIF”)(AIFMD definition)

NURS

Other recognised schemes(s.272 FSMA)

E.g. Limited partnerships, exempt unauthorised unit trusts

E.g. closed-ended investment companies

Regulated CIS

Recognised UCITS(s.264 FSMA)

UK UCITS

QIS

Convergence of Retail and Alternative Funds

NURS: Non-UCITS Retail SchemeQIS: Qualified Investor SchemePAIF: Property Authorised Investment Funds

FAIF PAIF

Glossary:ELTIF: European Long-Term Investment FundEuSEF: European Social Entrepreneurship FundEuVECA: European Venture Capital FundFAIF: Funds of Alternative Investment Funds

EuVECA, EuSEF

ELTIF

Rise of Alternative UCITS in Europe

2014 2013

9

Commodities

CTA

Emerging Markets

Equity Market Neutral

Event-Driven

Fixed Income

Index FX

Long/Short Equity

Macro

Multi-Strategy

Volatility

2014 Total Funds: 720 2014 Total AUM: €260.031 billion

2013 Total Funds: 724 2013 Total AUM: €190.071 billion

Source: UCITS Alternative Index

Can my hedge fund strategy be used in a UCITS?

Certain investment strategies can fit within a UCITS fund structure Traditional equity long/short or market neutral Absolute return Multi-strategy/multi-manager Merger arbitrage/event-driven/special situation Global tactical allocation Global macro strategies Credit strategies/convertible arbitrage/senior debt Managed futures

Some hedge fund strategies are not a fit for a UCITS fund Illiquid strategies Highly concentrated portfolios Nonfinancial investments

10

Growth of Alternative Funds in U.S.

11

Cumulative flows to alternative strategies mutual funds (2007 –2014) (in billions)

Source: Investment Company Institute

Total assets under management in alternative strategies funds were $311 billion at the end of 2014. (Source: Morningstar)

Alt Funds – Regulatory developments Intense SEC Focus on Liquidity, Valuation, Leverage and

Disclosure SEC Alt Funds Sweep Exams Derivatives Review Enforcement Activity

12

Product Developments – Rise of Exchange Traded Funds (ETFs)

The Rise of ETF UCITS in the UK

Why?

Pricing vs non-ETF UCITS (e.g. index funds)? Real-time – not forward Throughout the trading day – not just once a day

Cost vs non-ETF UCITS? Both have low annual charges – e.g. 0.30% p.a. S&P

500 and 0.50% p.a. FTSE-100 passive ETFs(including transaction costs) and 0.09% / 0.35% (excluding transaction costs)

14

Choice vs non-ETF UCITS? One ETF UCITS manager in the market offers single-

country funds for Brazil, Indonesia, Mexico, South Africa and Taiwan Although compare non-UCITS ETFs: – where another

manager offers funds for coal mining, coffee, lean hogs, live cattle and shipping indices – and spot palladium

“UCITS” label vs non-UCITS ETFs? – “UCITS” suggests the fund is a safe investment (fit for “widows and orphans”)

Transparency vs non-ETF UCITS? – not really, at least for passive stock market index ETFs – although most ETFUCITS disclose holdings daily (unlike other UCITS), the index is the index

15

Why not?

Brokers’ commission on all ETF sales and purchases – typically, £5/£12.50 flat fee per trade – vs £0 for non-ETF UCITS

Temptation to “day-trade” ETFs – because priced continuously

Flat brokerage fees and small day trades don’t mix!

European ETF statistics: 5.5% of total investment fund AUM = EU 362 billion (30 September 2014)

16

ETFs – Growing Popularity in U.S.

17

Source: Investment Company Institute

ETFs – Increasing Market Coveragepercent of US ETF Total Net Assets

18

Source: Investment Company Institute

ETFs — More Strategies

19

Source: Investment Company Institute

ETFs – Regulatory Developments

Less Transparent Actively Managed ETFs Systemic Regulatory Impact and SEC Request for

Comment Derivatives Review SEC ETF Rule Custom/Non-Pro Rata Creation and Redemption Baskets

20

Product Developments – European Long-Term Investment Fund (ELTIF)

ELTIFs Vehicle to encourage investment in long-term assets (energy,

infrastructure, education and research, etc.) European passport enabling retail investment Composite regulatory regime, including:

AIFMD ELTIF authorisation requirement and prescribed rules Prospectus Directive

ELTIF prescribed rules: Investment policy

At least 70% of capital in eligible assets Other investments limited

Closed-ended? Redemption restrictions… Transparency requirements

22

Distribution Issues

MiFID II – Investor Protection Provisions Execution-only exemption for noncomplex

instruments from appropriateness assessments Changes to list of exempt instruments Effect on distribution?

Product and distribution governance Manufacturers Distributors Extension to UCITS managers and AIFMs?

24

MiFID II – Intermediary Services and Payments

25

UK RetailDistribution Review (RDR)

MiFID II Investor Protection

Mandatory categorisation of advisory services

• Independent advice – based on comprehensive and fair analysis of relevant market

• Independent advice – assess a sufficient range of financial instruments available on the market that must be sufficiently diverse with regard to their type and issuers or product providers

• Restricted advice – not independent; subject to prescribed disclosures

• Restricted advice – not independent; subject to disclosure requirements

Scope of prohibition on inducements/commission payments

• Services:• Advice • Platform services

• Retail investment products• Limited to retail clients• For platform services, unit

rebates permitted

• Services:• Independent advice• Portfolio management

• MiFID financial instruments• Not limited to retail clients• No exception for unit rebates

SEC Focus on Distribution Payments SEC has attempted to adopt rule changes over the last 10 years to

enhance regulation of distribution payments with respect to funds, but has been largely unsuccessful (e.g. point of sale proposal in 2005 and Rule 12b-2 proposal in 2010)

2013 and 2014 OCIE Exam Priority: “The IA-IC Program is focusing on the wide variety of payments made by advisers and funds

to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same. These payments go by many names…most commonly revenue sharing, sub-TA, shareholder servicing, and conference support. The staff will assess whether such payments are made in compliance with….Rule 12b-1, or whether they are…payments for distribution and preferential treatment.”

OCIE Sweep Exams in 2014-2015 Speech by Julie Riewe, co-chief, Asset Management Unit on

February 26, 2015: “We…anticipate enforcement action from the Distribution in Guise Initiative, where we are

axamining, among other things, conflicts presented by registered fund advisers using the fund’s assets to grow the fund and, consequently, the adviser’s own fee.”

26

Some Specific Initiatives

UCITS V

28

Area UCITS V requirement AIFMRemuneration • Remuneration policies and practices promote sound and effective

risk management• Staff whose activities have material effect on risk profile of UCITS or

management company• Remuneration committee (if proportionate)• Fixed and variable remuneration appropriately balanced with fixed

component sufficient for variable component to be fully flexible• For variable component, at least 50% to consist of units of

UCITS/equivalent ownership interest; at least 40% to be deferred.• Disclosure in prospectus and annual report

(in part)

Depositary • Depositary eligibility• Single depositary expressly required• Written agreement with prescribed contents• Specification of functions:

• cash monitoring • custody • oversight

• Delegation restricted to custody function only• Strict liability for financial instruments held in custody

(in part)

Sanctions • Prescription of administrative sanctions and processes, categories of UCITS breaches, publication, and reporting to ESMA

-

Packaged Retail and Insurance-Based Investment Products – Key Investor Information

PRIIPs KID UCITS KIIDFor PRIIP available to retail investors For all UCITS

Pre-contractual; stand-alone Pre-contractual; stand-alone

Max three sides Max two sides (three for structured fund)

Prescribed statements and sections• What is this product?• Risk-reward profile• Compensation scheme• Costs• Term/minimum holding period• Complaints• Other relevant information

Prescribed statement and sections• Objectives and investment policy• Risk-reward profile

• Charges• Past performance

• Practical information29

PRIIPs Not PRIIPsInvestment funds (incl. UCITS) Shares and bonds held directly

Insurance investment products General insurance and life insurance

Structured products (deposits; securities) Pensions

EU Money Market Fund Reform – Current Proposals

Status: In “trilogue” – European Parliament, Commission and Council (i.e. Member States)

Latest published proposals Three types of MMF re. NAV CNAV (< 10% of CNAV and LVNAV) – divided into:

“retail” – but this means only charities, non-profit organisations, public authorities and public foundations

“public debt” – 99.5% invested in public debt instruments (i.e. sovereign debt) – so, no derivatives, securitisations or bank paper

30

LVNAV (> 90% of CNAV and LVNAV) May be redeemed at CNAV if actual NAV within 0.20% of CNAV

Authorisation for only five years at a time Neither CNAV nor LVNAV Two types of MMF re. residual maturity

Short-term – maximum 397 days Standard – maximum two years

Daily valuation No external support (such as guarantees) – to avoid investor uncertainty

and financial contagion Weekly investor reporting – liquidity, credit, portfolio, WAM (interest),

WAL (principal), proportion held by top five “investors” Will extend to EEA EU MMF statistics: c.15% of total investment fund AUM =

approximately EU 1 trillion (September 2013)

31

U.S. Money Market Fund Reform – Key Changes

Floating NAV Institutional MMFs will be required to price their shares based on a “floating” NAV Government and retail MMFs may continue to maintain a stable NAV of

$1.00/share Liquidity Fees and Gates

All MMFs will be permitted to impose liquidity fees and temporarily suspend redemptions (impose “redemption gates”) during periods of market stress

In certain cases, MMFs (except govt MMFs) will be required to impose liquidity fees Diversification: MMFs must meet enhanced diversification requirements

Stress Testing: MMFs must satisfy enhanced stress test requirements, including ability to maintain liquid assets of at least 10% and to “minimize principal volatility” in response to certain events

Disclosure: MMFs must satisfy new disclosure requirements, including new Form N-CR and website disclosure and amended registration statement and Form N-MFP disclosure

32

Pressure on Costs

FCA identified that UK fund charges higher than overseas equivalents

FCA thematic review (TR14/7): Findings (cause?): Investors lack of clarity regarding costs of

investment Solution: Consistent use of ongoing charges figure (“OCF”) in all

marketing materials

Investment Association paper on disclosure of costs and charges: Advocate consistent approach based on OCF But grappling with how to fairly represent funds that are expensive

to operate?

33

Mutual Fund Fee Litigation Developments

Extraordinary wave of Section 36(b) cases challenging mutual fund advisory, administration and other fees in the US

Common attribute of most of the cases is sub-advisory relationships Cases fall into two categories: defendants either employ a sub-adviser, or serve as

a sub-adviser to other funds employing a similar investment strategy Premise of the complaints is that sub-advisers ostensibly perform all

substantial services for a fraction of the advisory fees, assertedly rendering the advisory fees “excessive” in relation to the purportedly inconsequential additional services performed by advisers

Focus on sub-advisory relationships can be traced to Curran v. Principal Management Corp. (S.D. Iowa 2010), holding that allegations that an adviser charged far more in fees than it paid its sub-adviser gave rise to a reasonable inference that advisory fees were excessive

34

Future of the Industry

Future Legal Trends for European Fund Industry Continued product innovation fueled by investor demand Constraints on UCITS fracturing of AIF categories Enhancing liquidity toolkit Increased operation and compliance costs Increased market and regulator fee pressure More enforcement action; bigger penalties

36

Consolidation

Future Legal Trends for US Fund Industry Continued innovation and regulatory developments

impacting product development, including exchange-traded products and alternative and other specialized products

Increasing focus on risk management Challenging regulatory environment, with focus coming

from multiple regulators and from multiple areas within the SEC

37