Samuel Sender, of Edhec-Risk Institute, looks at the issue of eligible assets in Ucits funds and the problems of misselling
Ucits regulation was originally constructed from country regulations when funds invested mainly in domestic-listed securities, and when depositaries could hold all assets in custody. With the increasing sophistication of fund management techniques and the number of asset classes, investment fund managers started to invest in derivatives and extended their holdings of securities to geographies that required local custody.
The legislative framework was unsuited to managing the risks arising from industry change. After all, the continuous evolution of funds makes non-financial losses all the more likely.
In recent research conducted as part of the Risk and Regulation in the European Fund Management Industry research chair, supported by Caceis, Edhec-Risk Institute has looked at how non-financial risks and failures have impacted the regulatory agenda in Europe.
The evolution of financial techniques used in Ucits funds was acknowledged in the Committee of European Securities Regulators’ (Cesr) advice on eligible assets in 2007 and in the resulting Eligible Assets Directive (EAD). These made tentative clarifications of the use of these new assets, and there was also clarification of the very vague Article 21 in Ucits III that allows EU member states and Ucits some leeway in calculating global exposure when investments in derivatives are made.
Access to the ineligible
The EAD has allowed investment in indices representative of such ineligible assets as commodities and hedge funds, in non-leveraged collateralised debt obligations, and even in real estate and private equity, if the indices comply with liquidity and diversification requirements of Ucits.
Derivatives on ineligible assets must naturally be settled in cash, otherwise the fund would receive ineligible assets directly. In theory, exposure to precious metals is not allowed, but this Ucits requirement is being discussed, if not challenged, by some country regulators.
Cesr has also exempted Ucits funds from incorporating the underlying positions of their investments in financial indices for the calculation of the quantitative restrictions – such as the limitation of concentration risk – of their funds.
Along with these increased possibilities for investing, funds have ever more means of investing in other geographies. Some exotic geographies usually require sub-custody, so restitution risk increases. In such locations, restitution risk is similar to default risk as it is closely linked to the choice of investment and cannot be fully mitigated by European regulations to which the sub-custodians are not subject.
Second, the Ucits framework allows higher leverage for sophisticated Ucits as a result of the authorisation to use value at risk (Var) to measure leverage. Cesr’s advice in 2009 on sophisticated funds requires that monthly Var be limited to 20%, a fairly lenient figure, which has made possible a wave of such funds. Conventional Ucits, not subject to Var rules, can be riskier than sophisticated Ucits.
Leverage is usually achieved with derivatives, since cash borrowings by a Ucits are limited to ten per cent of its net asset value.
On the whole, the pursuit of returns outside the traditional investment scope, naturally increases non-financial risks, as losses in the fund management industry have illustrated. But the duties of depositories with respect to bookkeeping for derivatives and sub-custody have never been defined with precision at the European level.
The EU recommendation that defines sophisticated funds as well as the extension of eligible assets has not been preceded by an impact assessment on back-office and middle-office functions or by reflection on the greater transparency needed by investors. In general, Ucits funds have been able to gather more risks without proper information and monitoring by parties: new instruments such as derivatives or funds of funds give access to risks that investors are unaware of because the true nature of risk is hidden.
Adverse selection and misselling
Regulatory certification based on inadequate rules contributed to the rise of adverse selection and misselling and, in the end, to an increase in risk. After all, the publicised objective of regulations to create a safe environment for investors and thus to protect unit holders from non-financial risks leads investors to trust that certified funds will be free of non-financial risks.
Adverse selection and misselling are especially worrying in the retail landscape because investors are often unable to make informed decisions, perhaps because they lack the relevant knowledge or because regulators have not required of investment professionals the necessary transparency.
Adverse selection may arise when certification can be obtained by complying with the letter of the law, but without truly restricting the fund’s investment strategy or protecting investors.
Ucits money market funds, supposedly the most liquid, have been able to invest in illiquid assets, such as sub-prime securities, which only seemed liquid, as trading volumes were very thin relative to the size of the underlying assets.
Investment in structured products can provide the same illusion of liquidity. For such funds, the requirement to have bi-weekly calculation does not mean that fund liquidity will be available when needed by investors, and it creates a false sense of security, especially since regulators and supervisors authorised suspensions in Ucits funds and side pockets typical of illiquid hedge fund strategies.
Inadequate prescriptions and misleading certifications also contribute to misselling as well as poor risk management when regulators state that risks can be neglected. By certifying funds with illiquid assets as very liquid, Ucits money market funds, regulators misled end-investors.
Distributors and parent companies, which relied on such certifications, were also deceived. Because distributors are responsible for marketing and distributing products that conform to the investor’s profile, they have been sued by retail investors when commercial documents failed to mention the risks embedded in funds.
In some cases, as with the Bernie Madoff scandal, the simplified prospectus of Ucits funds failed to mention large concentration or sub-custody risks. Structured products and other complex financial products sold by banking networks to retail clients outside the Ucits scope raised numerous complaints. In many cases, structured products offered capital protection but no real guarantee, since stock market falls of more than 20% wiped out any possible protection.
Distributors have also been held liable for giving advice at odds with the fundamentals of financial theory. In France, distributors recently made good on investor losses in cash+ funds, as the risk of these money market funds going illiquid had not been clearly disclosed to investors.
On the whole, no certification at all would have been better, as misleading certification also limits the incentives to transparency and risk management. If the fund is certified as a money market fund by the regulator and perceived as low-risk by the market, what are the incentives to disclose the nature of the risks to investors, or to the shareholder of the investment firm?
In the absence of a clear definition of responsibilities for the management of non-financial risks and of clear communication of non-financial risks, the full Ucits universe is at risk of the same adverse selection and misselling practices, which mean, in the end, higher non-financial risks for end investors.
Distributor bears risk
It is clear that, in the responsibility of fund-industry professionals for the non-financial risks of products sold to investors, a subsidiarity principle should prevail. In this framework, it is logical for the distributor that ultimately sells the products to bear the primary responsibility for disclosing the financial and non-financial risks of the financial instruments it sells. As such, the distributor should ensure that the products offered the client are in keeping with the client’s risk profile and wealth; it should also make every effort to provide the investor the clearest, most accurate, and least misleading information possible.
It is, first of all, the distributor that is liable for poor investment choices or for misinforming the client. Of course, if the distributor can prove that the fund manager or the depository has provided erroneous information or failed to respect contractual or legal terms, the burden of this liability can be shifted or financial compensation for damages can be awarded.
It is, as it happens, one of the reasons for which, in application of the Markets in Financial Instruments Directive (MiFID), some country regulations defined the relationship between distributor and manager and made it possible for the distributor to have its promotional documents for a product approved by the manager of the product. The Ucits IV directive seeks to harmonise country regulations as well as the distribution of funds in Europe, so the ties between distributors and managers, currently a matter of national law, could be formalised in EU regulations, too.
Country competition in implementation
The Ucits regulation has inherited from country and European retail regulations the objective to protect unit holders of regulated investment funds. It relies on requirements on eligible assets (definition of eligible assets and diversification requirements) and on the enforcement of risk management practices.
Article 19(1) of the Ucits Directive defined eligible assets. In the main, these are transferable securities, units of other investment funds, deposits and money-market instruments, and financial derivative instruments. The Ucits Directive gives countries leeway in the choice of authorised instruments and techniques.
The definition of eligible assets in the Ucits regulation is sometimes vague. The French regulator has defined a list of eligible assets; other countries have not.
According to Article 19, Ucits can invest in “units of Ucits authorised according to this Directive and/or other collective investment undertakings within the meaning of the first and second indent of Article 1(2), should they be situated in a member state or not”.
In such countries as France, target funds must be Ucits, whereas in others, such as Luxembourg, they must be
equivalent to Ucits.
A more widely discussed issue has been that, although Ucits regulation stipulates that “a Ucits may not acquire either precious metals or certificates representing them”, this clause has not been transposed equally in all countries. France has been the most faithful to the Ucits directive, and thus the most restrictive, by forbidding investments in precious metals.
Luxembourg and the UK have allowed investments in gold bullion securities (as long as there is no physical delivery, in compliance with the Ucits requirement for derivatives on commodities), and the UK has allowed investments in other precious metals. Ireland has not transposed the article on precious metals at all, and thus authorises investments in securities with precious metals as the underlying asset.
These differences are disappearing with the development of exchange-traded funds (ETFs) on precious metals. After all, ETFs are listed regulated funds and as such are usually eligible for Ucits, even when they have precious metals as underlying assets.
Country competition: from Level 3 to effective supervision
Legislative proposals in 2009 address weaknesses in macro- and micro-prudential supervision by creating two different systems of supervision – the European Systemic Risk Board, in charge of macro-supervision, and the European System of Financial Supervisors (ESFS), for the supervision of individual financial institutions. The ESFS will include the European Securities and Markets Authority (Esma), whose role will involve contributing to consistent application of technical Community rules, direct supervisory powers for credit rating agencies, coordination in emergencies, and the creation of a common supervisory culture in European countries.
Even supposing that Level 1 and Level 2 of European regulations are made clear and that the Esma ensures a homogeneous implementation of EU regulations, the supervision of funds and investment firms will be a country prerogative, and country competition will still be possible.
In Ucits IV, the simplified prospectus is to be replaced by the key investor information document (Kiid). This is a crucial document, as it alone, a homogeneous European document, needs be translated into the language of the target country in the accelerated notification procedure that automatically authorises the distribution of funds in target countries. Since the domestic supervisor opens the European market by validating the prospectus or the Kiid, countries may try to attract funds by facilitating validation. And supervisors in target countries will have reduced means of controlling the distribution of foreign funds.
So we argue that the Esma should be responsible for the direct supervision of funds or at least have very clear direct authority over country supervisors.
Samuel Sender is applied research manager at the Edhec-Risk Institute