Luxembourg is a stronger domicile for the challenges it faced over the last 18 months. But perhaps more needs to be done at an industry level to convey Lux's successes as a fund haven throughout the financial crisis. Senior figures from the industry consider this point and talk about their experiences of working in the second largest fund domicile in the world. (part 2)
Bob Kneip (CEO, Kneip)
Noel Fessey (head of European fund services, Schroders)
Martyn Cuff (Managing director, Allianz GI)
Michael Ferguson (head of asset management practice, Ernst & Young)
Charles Müller (deputy director general, Alfi)
Funds Europe: You mentioned that funds are safer than bank deposits. Do you think people, retail and professional buyers, are as aware of the benefits of funds as they should be?
Fessey: Generally not. By putting money into a bank account you are taking risk on the bank’s balance sheet. The difference between a deposit account and a fund when a bank fails is that cash on deposit is potentially lost in the bankruptcy whereas the fund’s investments in securities – which already reduce risk considerably because they are diversified across many issuers – are protected from the bank’s failure. In that sense, during 2008 when many banks were at risk of bankruptcy, a Ucits fund offered much lower counterparty risk than a bank deposit account.
It took the extraordinary events of 2008 and the failure of banks such as IceSave to remind investors that a bank deposit is only as good as the bank, and that it is not risk free. However, while investors intuitively grasp the concept of a fund’s market risk, they can sometimes become fixed on the downside, which was understandably daunting in 2008. That helps to explain why so many preferred bank deposit accounts and why some of them unwittingly increased their risk considerably by placing money with banks who were offering unusually high interest rates because they were in such need of deposits to sustain their balance sheets.
Funds Europe: How will Luxembourg make Ucits IV work? And what about the management company passport aspect to it, where a fund and the management company behind it no longer have to be in the same country? How will Luxembourg continue to distinguish itself as a major domicile in this new regime?
Müller: The Luxembourg funds industry never opposed the management company passport. We have said there are a lot of complicated issues linked to it and in light of this we would have preferred the Ucits IV proposals to have emerged without
the management company passport issue within it.
These issues are mainly regulatory- and tax-based. For example: who is going to supervise what in the fund, and who is going to supervise what in the management company if they are in different jurisdictions? How will the two supervisors work together?
These questions are important in the context of investor protection. The investor needs to be confident that the fund is properly supervised and there will not be gaps in the supervision because each supervisor believes that the other one is responsible for picking up on certain points.
The tax difficulties are also important. We were told by our colleagues in Efama and by certain regulators that we were exaggerating the problem. But now that we have a management company passport all these issues are in fact coming back to the surface. We talk to asset managers who say they will not use the passport immediately because they want the regulatory and tax issues, which are still relevant within it, to be resolved first.
Ucits IV is very much about giving options to fund managers that they can use if they wish to. Ucits IV was not meant to revolutionise the world; it was meant to fix what wasn’t working and make the Ucits landscape as optimal as it should be.
So how are we preparing ourselves in Luxembourg?
Alfi has six working groups, one per topic [topics relating to the proposals contained within Ucits IV, such as the master company passport and the merging of any master feeder structures with Ucits IV funds], and for the moment we are analysing the provisions to see how we will recommend that these be implemented in Luxembourg law in an efficient and business-friendly manner.
Ferguson: We as a firm have done a lot of work in this area with asset managers and have held a series of discussions with many around their Ucits IV intentions. In our recent survey of over a hundred global investors, the initial view that has been expressed to us is that nobody is going to go for a major ‘big bang’ approach – it will be a slow lift-off.
With regards to the domicile of management companies and to the master feeder fund, without exception they see Luxembourg as continuing to be the dominant player in the international global distribution space, both from the point of view of putting the master fund here along with the management company.
Many felt initially that Ucits IV was going to reduce costs, but the view now, I think, is changing. The current view is much more about consolidating corporate governance and creating operational efficiencies. Of course there is the open question around whether any reduction in costs at the management company level will flow through to the underlying investment fund products.
When you look at the key decision about where to put the management company, cost is obviously one issue, but costs can be very broadly defined including costs of changing the infrastructure, etc, of what you have already got in place.
However, another area, that requires serious consideration, is the potential impact on the fund’s distribution – not just in the EU but probably even more importantly in the key Asian markets. Given Luxembourg’s lead as a cross-border fund distribution centre not just within the EU, but also outside of the EU and especially in Asia, I believe Luxembourg-branded domiciled Ucits will continue to play a very prominent role post Ucits IV.
As regards the product provisions of Ucits IV, such as the cross-border fund merger provision, its unlikely to bring any substantial value until the related open tax issues are sorted out and this will, in my view, take three to five years at a minimum.
The product provision of Ucits IV that I see as being of the most interest is the master/feeder element. From speaking to asset managers, there is a desire to manage greater consolidated pots of assets and at the same time enhance cross-border distribution. The master/feeder element does go some way to facilitate this. Overall as far as Ucits IV is concerned, I believe the two existing international fund centres will continue to dominate this space.
Cuff: The other centre being Ireland?
Ferguson: Ireland, yes of course – however, it’s no secret that France has also a strong desire to break into this space. For example, the AMF has recently announced that English documentation will be permitted for certain filings, etc. There is certainly a strong political push to try to create what I would describe as an international cross-border investment fund industry in France.
I would say Luxembourg and Ireland should welcome this – it keeps us both on our toes!
Funds Europe: Do you think that recent economic difficulties in Ireland have affected its standing as a fund centre?
Ferguson: I don’t believe there is any evidence to indicate it has.
The issue for Ireland at the moment is the challenge around reducing its current budget deficit – the recent budget in December ‘09 went for primarily expenditure cuts rather than tax increases. It goes almost without saying that the potential for tax increases whether personal or corporate in any jurisdiction would, for example, influence decisions where to place Ucits IV management companies, etc. For example, when I speak to some UK managers, they talk about the great uncertainty around UK tax after their next general election which is expected to be in May of this year.
As regards Luxembourg, the authorities do not tend to make wild changes from day to day on any of these issues, tax or otherwise. There’s a great level of certainty, meaning that if you want to set up your business here in Luxembourg today, the laws, the regulations, whether it’s actually to do with Ucits investment funds, or whether it’s about tax, are not going to be dramatically different in two or three years time.
Cuff: As an industry it doesn’t help our cause to focus on competition between domicile A and domicile B. It is better to pull together and promote the funds industry as a whole.
Within Allianz Global Investors we have funds domiciled in a number of European locations and we would expect Ucits IV to help us optimise our current set-up
Funds Europe: Everything relating to Ucits IV is a step towards more efficiency in the European cross-border funds market. There is surely little question about that. But how big of a revolution is Ucits IV really for the funds industry?
How much closer is the industry to a single market for funds as a result of it?
Ferguson: Ucits IV should be viewed as a step in the right direction rather than a huge leap, it will hopefully further reinforce the Ucits brand. Obviously, the danger is that brands and reputations take years to build up and then can disappear in the snap of a finger. All the debate around the Ucits brand and Ucits IV may be very boring and unnecessary, but if it reinforces the brand – then that has to be good.
Kneip: In theory, as open architecture takes over from proprietary sales, opportunities increase for overseas asset managers to gain market share over local players. However, there seem to be hurdles in the way. A roundtable discussion we recently conducted with CEOs from major European fund management houses revealed that most of them think it might be more than five years before there is a fully functioning single market. They said that a lack of distribution partners and disparity in regulation and tax legislation between individual member states are the main obstacles.
While Ucits IV is a step in the right direction, one has to remember that facilitating fund registration across European markets might also create new difficulties, including reporting challenges for fund managers.
In my opinion, having a single jurisdiction for funds makes the most sense, as it is more efficient and poses less questions about compliance over multiple jurisdictions.
Funds Europe: If we do arrive at a point where we have cross-border management companies and master feeders – basically all these wonderful things – will it work? Without wanting to sound rather cynical here, given some of the experiences seen in the banking crisis, it’s an open question.
Fessey: Depending on which jurisdictions are cooperating, I think cross-border management companies and master-feeder structures can work. However, I think that Ucits IV will take time to develop in practice and I think that is a good thing. Ucits III was adopted very rapidly in respect of certain changes to product rules and that created some stresses operationally, particularly as portfolio managers started to exercise their new investment powers. I’m more comfortable with a steady development of Ucits IV, which I see as an evolution of the regulatory foundation of retail products in Europe, and which is a long-term project.
I think that the UK and Luxembourg would probably work quite well together as two jurisdictions cooperating on a cross-border basis, but at the moment Schroders is not contemplating a cross-border management company because we don’t see that the reward for doing so is sufficient to overcome the challenges that we anticipate. We haven’t yet identified any particular benefit, whether regulatory or financial, marketing or anything else that creates the compelling case to make it happen. Even the amount of capital released by merging management companies is too small to make it a worthwhile prospect, and there are few cost savings to be made in operations that are already tuned to be as efficient as possible.
When it comes to cross-border management companies involving jurisdictions that Luxembourg does not have such a good relationship with, I think that it is unlikely that anything will happen any time soon.
Looking at the broader fund industry from a post-crisis perspective, I feel that some of the jurisdictions that led the call for cross-border management companies are likely to be those that are least likely to facilitate it in practice, probably citing Luxembourg’s original concerns about supervisory gaps and shareholder protection as the reason why they’re not willing to permit the import of management company services. That would be ironic.
Müller: I agree with the point about the slow take-up, but how will Ucits IV shape the service provider industry here?
Ferguson: The Luxembourg asset servicing landscape has changed quite a lot over the years. Many of the detailed processes are not necessarily performed here in Luxembourg any longer, but the client relationship and risk management oversight over the processes remain here. The open question is whether Ucits IV will speed up the reshaping of the Luxembourg asset servicing landscape? I believe it will.
Fessey: I don’t see Ucits IV as a revolution – it’s just not going to happen that way. I think that the things that will shape the industry in the longer term will be environmental circumstances that always would have shaped it anyway.
To some degree, yes, people relocate services to other jurisdictions in pursuit of labour arbitrage opportunities. We have considered that and we have decided that our cost of production and the quality of service that we have here in Luxembourg means that this is where we want it to be.
Given the size of my firm – which is a reasonably sized enterprise – the cost of pursuing an offshoring strategy simply does not pay back in the medium term. And it comes back to questions like, why are we in Luxembourg and why are we so successful here?
Well, the time zone means we can service Asia and the Americas as well as Europe, and we can find the specialist fund service skills that we need. The international employment pool also means that we can often service clients in their own language, often reflecting their own culture, and we think that’s important.
People talk about Luxembourg being expensive, but I’ve done the maths and it’s not expensive when you take proper account of the cost of moving offshore. The cost of production in Luxembourg is actually reasonable. It’s certainly a good deal cheaper than London although the fall in the value of the pound has to some degree reduced that advantage. Luxembourg understands the funds business; it’s technically literate; there’s a know-how here that you cannot acquire easily elsewhere. And also it has an ability to improve efficiency progressively. In Schroders Luxembourg, we are much more operationally geared now than we were seven years ago and our unit cost of production is therefore much lower than it was then. Overall, we’ve had almost zero real cost increase and yet we’re supporting a much larger business.
Cuff: One thing I would add because I fundamentally agree with that point, is that I don’t see Ucits IV as fundamentally changing the service providers’ world. The only clear implication is, if you go down the master-feeder route, then clearly that is going to have an impact. If a manager has assets in domicile A and in domicile B, but domicile B is the master fund, B is going to have all of the assets while the feeder in domicile A is just a fund of funds. The logical next step in thinking is whether you have the same service provider for the master fund and for the feeder fund.
If you keep them separate, how attractive is a feeder business to a third-party service provider when actually all they’re doing is administration for one bit of a fund of funds?
If I were in charge of a service provider and I were looking at a fund manager who was in a number of jurisdictions I’d put a priority on securing their Luxembourg and Ireland business above their mutual fund business in other domiciles because of the reasons we’ve said before now.
LUXEMBOURG BEYOND EUROPE
Funds Europe: Where is Luxembourg going next in terms of growth markets in the Far East, the Middle East and elsewhere?
Kneip: We are essentially an outsourcing company and we plan to open an office in Hong Kong. This is being done because for us, like for asset managers, one of the aspects that came out of the crisis was the need to understand and be closer to clients and, in the case of fund managers, to be close to their distribution networks.
We looked at the main distribution markets for Luxembourg, at least for certain funds, and found that a lot of this activity can be done out of Luxembourg on an international level. However, it’s quite difficult to argue that we would know anything about the UK without being in the UK. The same applies to France, Germany and to the Far East.
In 2009 a lot of influence came from those countries and it seems right to support that and support our clients in their efforts to do the same. It’s totally out of the question that we should not be there, not so much to sell to locals than to support the Luxembourg funds industry in their distribution efforts throughout Asia.
Müller: Alfi is looking at different avenues for the future success of the Luxembourg fund industry. One avenue is to make the most of European regulations like Ucits IV and the Alternative Investment Fund Managers’ Directive. I think that’s a very important new piece of legislation.
For us the important point there, is that there will be a passport for those products that will comply with the alternatives directive. The prime location for people who want to use the passport is Luxembourg so we see this as an opportunity.
The second avenue is found among other products that are not really linked to any European regulation. An example is Islamic finance. The tax authorities in Luxembourg recently issued a new circular which will make Islamic finance in Luxembourg easier.
Microfinance is an area we are looking at too, and green funds. ETFs is certainly a sector where we have to work in order to be competitive and attract ETFs to Luxembourg, so that’s another avenue of interest.
Then the third is global distribution, especially new markets. Luxembourg distributes already in many markets but there are still a lot of spots where there are opportunities. Think about China, of course. There is a memorandum of understanding between the supervisors in China and Luxembourg, and it means Chinese QDIIs can invest into Luxembourg funds. Alsot, there is a growing opportunity in Latin America. A lot of Latin American countries were influenced by Spain. In Spain we were not blacklisted, but sort of greylisted due to the fact that there was no exchange of information on demand in the double tax treaty. The double tax treaty has now been altered and the Spanish authorities have announced that they will take us off their list and this obviously has a positive impact on views of us in Latin American countries.
We already distribute to pension funds in Chile, Peru and Colombia and there are other countries that could be interested as well.
Fessey: By and large Schroders has already expanded to cover most of the markets that we think are important for cross-border fund sales, so I think that the future for us is a question of confirming our long-term success in those markets.
I think Luxembourg will continue to strive to be more efficient. This is a natural response to the offshoring threat that we perceive here, but it is something that we need to do anyway because I think that revenues in the asset management industry in the future will be lower than they were in the past; that much is clear. Cost pressure will also probably lead to consolidation – though I hesitate to make any prediction about how and when, because not a great deal of consolidation happened in the last 18 months, or less than we might have expected. But I think that there probably will be fewer funds, promoters and service companies in the future.
Most of all Luxembourg must be ready for whatever comes next. It is important for those of us that work in Luxembourg to ensure that our fund complexes remain stable, that they are well governed, that they do what they have been established to do in terms of supporting their shareholders’ investment objectives, and that they are as safe as they possibly can be, no matter what the world and the markets throw at us. I do not think that this crisis is over yet.
Ferguson: I can only repeat pretty much of what has already been said. I also think we need to be very conscious about the convergence going on between so-called alternative and traditional investments.
We have seen, for example, how all of the big institutional hedge fund managers have set up Ucits funds and that is an area and space that we need to ensure we are supporting.
When we look at the proposed Alternative Investment Fund Managers Directive – which will cover the three main sub-sectors of alternatives, being real estate, private equity and hedge funds – I think we must make sure we focus carefully on that, not just in the sense of having the appropriate legislation here, but we must also focus on the operational challenges for service providers. This will enable Luxembourg to take its fair share of the opportunities created.
Ucits has served Luxembourg very well, but we need to ensure that there is also a healthy alternative investment fund industry here. Great strides have been made in this area over the last five years. There needs to be continued focus on this given the proposed Alternative Investment Fund Managers Directive.
Fessey: Property is already well developed here and I think it has good prospects for growing stronger. I would like to sound a word of caution on Ucits hedge fund strategies, however.
As a fund centre, Luxembourg should be careful to ensure that new concepts such as Ucits hedge fund strategies are developed responsibly, with proper consideration for shareholder protection and the reputation of the Luxembourg and Ucits brands. Luxembourg should aim to develop good reputable business here, not any business at any price, and I think our regulator will be an important gatekeeper in that test of quality and reputation in the future as we expand that particular product sector.
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