Nick Kochan reports on the phenomenal growth of UCITS, a product of EU legislation that is going down a storm in Asia and Africa, and has US authorities looking on in envy.
They are advertised on the sides of buses in Hong Kong. They are widely promoted in the newspapers of Sao Paulo and Cape Town. Investment products described formally as undertakings for collective investment in transferable securities (UCITS) have become a global investment brand.
This is reflected in the growth of assets held by European fund managers, which last year rose to a record €7925bn. UCITS sales are growing at a rate approaching 100% a year, and investment houses say that the growth shows no sign of letting up.
This product of EU legislation has shown the capacity to cross borders outside its European homeland and win the hearts and pockets of wealthy mainland Chinese in Hong Kong, South African private investors and institutional fund managers based in Switzerland and London.
The European Fund and Asset Management Association (EFAMA) says 70% of all products sold in Hong Kong are UCITS. Asset managers say that UCITS has become the nearest thing in the financial sector to a global brand.
Growth potential
Although virtually every financial market now absorbs a growing number of UCITS, Asia is leading the field in growth potential. “The potential in Asia is absolutely huge,” says Guillaume Wehry, regional head of marketing and distribution at Société Générale Asset Management. “All Chinese people who get wealthy go on to open an account in Hong Kong. This gives them a window to any investment in the world. The market has a lot of growth potential. UCITS is the easiest way to invest.” SocGen says that during the past year it distributed $1bn-worth of UCITS funds to retail investors.
Steffen Matthias, senior adviser to EFAMA, says: “A significant part of Asian new money is entering Luxembourg funds. Asian investors find the products attractive. They are more short-termist investors and they use the product for speculation.”
Regulators in many key jurisdictions have ensured that UCITS has spread out of its European home base. Celeste Dias, head of product development at UK-based asset managers Threadneedle, says: “If you take UCITS to virtually every jurisdiction, they will open the door to you. The local regulator will take the fact that it has a UCITS certificate and put a cross in the box. UCITS has established itself as a strong global brand.”
Spin-offs
This ease of transferability across borders has produced considerable spin-offs for asset managers who can make economies of scale by selling the same product around the globe. Ms Dias says: “The fund manager team doesn’t have to manage several versions of the same thing. It can focus on the core product. In terms of economies of scale and efficiency from an investment perspective, it is ideal.”
This degree of acceptance followed a concerted push by European authorities to persuade regulators about the quality of the risk management facets built into the European UCITS legislation. The EFAMA’s Mr Matthias believes that the Hong Kong authorities were most concerned about risk management. He says: “We had to explain to the Hong Kong authorities about the structure of UCITS, what the eligible assets are and also how investor protection works. They always ask us about the structure for supervision and the risk management controls. The Asians have a lot of trust in European supervisors.”
Legal constraints
A series of regulatory and legal processes and controls underpin the creation of UCITS. It must first conform to Luxembourg or Dublin law. The product must also win the stamp of approval from a European regulator before it can describe itself as a UCITS.
| Simon Vernon, UCITS products manager at Schroders, explains: “Before we can sell the product, we need to get it authorised by the FSA [Financial Services Authority]. This is described as ‘specific product authorisation’. The FSA stamps a form which we can provide to a regulator. This is the so-called ‘UCITS passport’. We use that paper to show that the fund is a UCITS fund and that it testifies to the fact that our home state regulator is happy that the fund complies with the UCITS directive.” |
Regulator confidence
The confidence of the local regulator in the UCITS structure is critical to its success. Mr Vernon says: “Regulators have accepted the UCITS brand. They like the fact that it is an authorised product and all the safeguards that the UCTIS directive requires it to have, and they have allowed the product to be sold in their market.”
He points to a number of key regulatory safeguards. First, the investment manager is required to provide investors with a simplified prospectus giving the essential details of the fund before the sale of the product. This guards against mis-selling. Second, the price of each UCITS product is published daily, enabling the investor to follow their investment. They are also required to receive reports. Third, for security purposes, the asset manager must keep the UCITS funds in a separate place to its own assets. Specialist custodians are typically used to hold the funds and to provide prices.
Some regulators are so impressed by the UCITS product structure that they are preparing to create a similar investment regime. The Taipei regulator is understood to be preparing to go along this route. US authorities are also thought to be envious of the global acceptability of the investment product and are working on such a structure.
Third incarnation
Although regulators have given UCITS widespread entry to their jurisdictions, asset managers speak of some concern about the third and most recent incarnation of UCITS. This is called UCITS3 and it opens the way for a fund manager to use derivatives. There are certain constraints on this. Unlike a hedge fund manager, they are constrained from short-selling physical assets, but are allowed to short-sell derivatives. Ms Dias says: “UCITS3 products are Beta one and tend to be invested in equities. But the fund manager can short a part of the portfolio. This plays nicely to our skill set. The UCITS3 fund falls between hedge fund products and long-only products.”
Institutional investors constrained from investing in alternative products are attracted to UCITS3 vehicles because the hybrid structure is counted as a long-only investment. Ms Dias says that Threadneedle has developed a 130/30 structure, where the larger part counts as a long-only equity and the smaller part counts as a derivative. The complex structure of some UCITS3 products has given some regulators pause for thought.
Product flexibility
Mr Vernon says that not all UCITS3 fund providers put derivatives into their UCITS products. He says: “When you mention UCITS3, most people think derivatives. But that may not be why it has done so well in 2007. The fact that the product is more flexible doesn’t mean that we go right to the limit on derivatives.
“Far from it, in fact, it means we use derivatives in more interesting ways than we could have under the old rules. We don’t take it to the extreme. Some firms have very aggressive UCITS3 funds. We have found in the past year that our best-selling funds are not using derivatives in aggressive ways. Most managers aren’t using UCITS for leverage purposes. Most don’t see that as appropriate for retail purposes.”
SocGen’s Mr Wehry, based in Hong Kong, also detects some caution about the use of derivatives in the latest UCITS3 product. He says: “Regulators have understood more what is behind UCITS3 and they increasingly accept UCITS3 rules. This is being done step by step. Luxembourg funds and UCITS3 can more easily register in countries such as Hong Kong. The local authorities understand what is behind the rules and are quite comfortable with the seriousness of the Luxembourg regulators.”
Derivatives or no derivatives, the European Commission has done something right with its UCITS3 standard. The world would now seem to be the UCITS3’s oyster. The asset managers will have the opportunity to mop up that free liquidity with alacrity.
