The Ucits fund is likely to be the main fund of choice for many years, despite tighter regulation and competition from Asia, according to our panel of experts. Among other issues, it looks at the route to market for alternative funds.
Rafael Aguilera (executive director, advisory services, EY)
Chris Edge (managing director, HSBC Securities Services Luxembourg)
Jon Griffin (managing director, JP Morgan Asset Management)
Claude Niedner (partner, investment management, private equity and real estate, Arendt & Medernach)
Funds Europe: Considering the stricter rules under the Ucits V directive and competition from Asian domiciles, will Ucits survive as the investment wrapper of choice for fund managers?
Chris Edge, HSBC: It is odd that the focus is still on the negative side of regulation when it should be focused on the positive aspects.
Regulation has made Ucits the safest product in the world, and that’s what we should be making a virtue of, and we should be focused on that aspect, not the onerous regulatory wrapper that goes with it. We’ve all had to deal with that, but now it’s time to market the virtues of Ucits.
As for competition from Asia, I don’t think it should be a competitive landscape; I think it should be a complementary landscape. The developments in Asia around mutual recognition of funds and passporting schemes have many years to go before they are scalable and operating on a par with Ucits.
And even when the passport schemes do become relatively at par, then there’s enough investor demand in Asia to make room for both sets of products.
Rafael Aguilera, EY: Ucits is a global brand at this point in time and having new regulations may make it stronger. Ucits remains a wrapper of choice for global distribution.
Asian competition might be a feature in the future, but not yet. Even when Asia starts its own cross-border project, it would still have to then prove itself as a feasible alternative for distribution in other continents, such as in Europe. So for the time being, there is no real alternative to Ucits from a regulatory point of view.
Jon Griffin, JP Morgan: Ucits V is a necessary alignment with the investor protections – such as depositary rules – that exist under AIFMD [Alternative Investment Fund Managers Directive]. At the Alfi December roadshow in Asia, there was quite a lot of interest from the audience in terms of what Ucits V means and they clearly understood that much of it was about enhanced investor protection.
There will always be room for a number of different product offerings. But at present, the mutual recognition scheme requires Hong Kong funds to have a certain track record in order to be eligible for approval in the first wave for distribution into mainland China.
For us [JP Morgan] as a global player, that is interesting. We recently received authorisation for one of our Hong Kong funds and we’ll see how that particular opportunity grows.
Likewise, with the proposed wider Asian passports, if at the end of the day our clients need to have a domestic product in a particular market, then we will seriously consider doing that.
For the moment, though, I would say there’s increased interest and need for our Luxembourg products that meet the needs of Asia, and the voice of Asia and indeed Latin America is much greater around our product development process.
Claude Niedner, Arendt: Ucits V does not impact the way investment strategies and policies are structured and this means it is regarded more as a positive development, from an investor perspective, rather than a negative one.
Maybe some markets where passporting schemes are proposed, such as New Zealand and Australia, are difficult or out of reach for European Ucits. Therefore their own local passporting rules may be more suitable for asset managers. However, as a global brand Ucits is not under threat.
Edge: Use of the word ‘competition’ doesn’t help and the industry across the globe should have more of a visionary approach to this. The more Asian funds look like Ucits, the better. In a perverse kind of way, we should be encouraging Asia passporting of products that look remarkably similar to Ucits, because that opens up the notion of regional reciprocity. It’s a scale business. Fund firms have to sell a single product range in as many countries as possible. And why shouldn’t an Asian product with scale be sold in Europe if it has equivalency?
We have to stop talking about competition and talk about co-operation if we are pursuing a long-term vision for the industry, for the benefit of investors.
Funds Europe: What do funds have to do to bring down their costs and become more aligned with the costs of funds domiciled in the US? Or are fund costs already as cheap as they can possibly get?
Griffin: The US has an incredibly large domestic mutual fund industry and gains efficiencies with that domestic scale and market standardisation, which aren’t replicated in a cross-border market model. For both Ireland and Luxembourg as the principal cross- border distribution domiciles, there is a lot of natural and inherent complexity in order to ensure that Ucits products work locally for investors, such as tax reporting requirements and some aspects of product design.
There are clear headwinds for the industry to bring down costs and one way to do that is to operate at decent scale and be able to pass that benefit on. That said, one cannot ignore the increasing costs of compliance with regulatory change in our industry.
Edge: The key word is ‘scale’. It’s not a question of cutting costs as much as gaining scale.
Too often in an attempt to cut costs, it’s the service provider that’s squeezed. We represent about one-twentieth of the cost of a fund. It always surprises me that not enough focus is given to the cost of distribution, which typically represents half the cost of a fund. If you’re going to cut costs, that’s got to be the place to focus.
As a scale business, even big fund houses will more and more have to focus on a much more select range of products and on supersizing those, cutting out ‘hobbies’ which too often fail to achieve scale.
Aguilera: When you compare US products with European Ucits in a market such as Asia or Latin America, the majority of funds that are sold are European products, not American. So, cost is not everything. Were cost the main issue for these investors, we would find it harder.
However, we may see in the next five years, potentially, US-domiciled products become available for some European investors. Then we’ll see how these products are priced and how European products react.
Where I particularly agree with Chris is on the marketing cost. If Europe eased marketing rules and created more harmonisation, costs would be downsized a lot.
Neidner: The MiFID II prohibition on inducements is likely to also reduce the management fees on share classes. Efama [the European Fund and Asset Management Association] made a study of US fund TERs [total expense ratios] and found 50% of US fund assets were based on the advisory model. Those who went into these funds were advised and paid an additional advisory fee of between 1% and 1.5% upfront. MiFID II could bring down the management fees of investment funds since investment advisers distributing funds are currently paid on an inducement basis by the asset manager rather than directly by the investor.
Griffin: Another big difference in the US is the important impact of the well-developed 401k market, which drives predictable waves of regular subscription flows. That does not exist in Europe; we are still fragmented with individual national markets having differing forms of third-pillar pension schemes.
Dialogue is increasing on the need and reality for a pan-European pension product similar to a 401k, which is actually part of the Capital Markets Union (CMU) ambition.
Funds Europe: Amid a myriad of changes that tend to favour large asset managers in the business environment – such as brand preference by fund selectors, and economies of scale – is there any hope for smaller players?
Niedner: I think there is. MiFID II will change the way products are brought to market. Distribution models will move more towards digital, and the way branding works and the way performance is disclosed will change the way products are bought. Smaller boutiques will be able to think differently about how to reach the market – something we already see in banking. But small boutiques will have to run through a regulatory exercise which is becoming increasingly burdensome.
Edge: Boutiques will live or die based on performance; with brand-building by the larger players, automated filters on new platform channels, and the inability to ‘buy’ distribution via commission, boutiques will have to market on the basis of superior performance.
Aguilera: Regulation is pushing advisers into offering fewer funds, because product governance and information disclosures mean advisers will have to manage this in a way that is easily understandable for clients and reduces risks of missing key information.
So, on the one hand, the adviser will have too much data; on the other hand, the investor – who may use more than one adviser – will want to differentiate offerings between advisers, else they will question whether there is added value.
Griffin: MiFID II is bringing in a new intensity to the kind of exchange of information that will need to occur between distributor and manufacturer, which is why ‘target market’ is such an important topic for industry. It’s really important not to have different interpretations of target market in each of the European countries. It could make cross-border extremely difficult if there’s no harmonised view, which would be an obvious backward step and counter to the goals of a single market for Europe.
Aguilera: It needs to be on Esma’s [the pan-European financial regulator] agenda. Each regulator will find different levels of understanding among their country’s investors.
Niedner: In all consultations from Esma, we saw that they stopped short of defining a target market. Esma does not want to take any risk for defining something that applies to retail investors across 28 member states. That’s a very tricky exercise.
Aguilera: It is really a very tricky exercise to define this in a way that matches different needs from different countries. It’s something that could harm asset managers, not only for distributing Ucits on a large scale, but also by supporting insurers.
Funds Europe: In light of the G20 focus on systemic risk in asset management, to what extent do you think funds or fund activities present a potential systemic risk?
Niedner: I think there is no justification for this view. Regulators are sometimes seeing systemic risk everywhere.
Supposedly, the larger a fund is, the more systemic risk it has. This approach doesn’t take into account that banks, by reinvesting the money they receive from clients, are leveraged, yet many large funds have virtually no leverage.
This mix-up is also something we see in other areas, such as remuneration rules. Remuneration issues of credit institutions and remuneration issues of asset managers are totally different.
Edge: Yes, policymakers can’t have it both ways. With the Capital Markets Union (CMU), there’s a massive shift towards funds as being almost a replacement for the reduced capacity of banks to lend money. Funds are being seen as an investment vehicle to promote economic growth. So don’t encourage funds through CMU, while at the same time calling them systemically risky.
Funds are heavily regulated now. Funds can only invest in what product regulation allows. Those regulations have been designed for a purpose. Retail funds don’t have leverage, and they have diversity and liquidity at their core. What more can they do to avoid being systemically risky?
Griffin: My understanding is that the Financial Stability Board (FSB) has shifted from funds specifically as being systemically important and is now looking at the role of asset managers and at regulating activities. I think FSB is due to come out with recommendations in the first half of this year, so we’ll see where that’s going, but I understand that they are examining liquidity mismatch.
A question that is getting asked more frequently is whether it is really necessary for Ucits funds to continue to give daily liquidity. Is it needed? However, for internationally distributed retail products, it is hard to imagine any practical alternative to daily dealing.
Edge: Seventy per cent of the investors are institutions that demand it, yet the product was designed for long-term retail savings. The profile of investors doesn’t align with the level of liquidity offered.
Niedner: There is daily liquidity – except in a crisis, the point when investors want to get out. Funds will have to deal with this issue and can use several mechanisms such as ‘swing pricing’, ‘gating’, dilution levy and perhaps by saying that Ucits have daily liquidity only in normal market situations, that daily liquidity cannot be promised. What is important in all situations is to treat investors fairly.
Aguilera: A diversified fund should not cause systemic issues. Risk is not at the portfolio level. The risk is of the investor using different products to create a similar exposure.
Under AIFMD reporting, it isn’t known how investors actually invest in their products and if it isn’t possible to tell how an investor is actually behaving, the question is about if systemic risk can be created at that level.
A bank or a large institutional investor might create systemic risk, but not the products. These are diversified and liquid. So I think that the topic of systemic risk is not discussed on the right level.
Griffin: Diversification of the shareholder base has clearly demonstrated its value from an asset stability perspective. We have observed times when Europe was a net seller, with Asia being a net buyer. Over the period of the recent financial crisis, this was evident when in Luxembourg, funds didn’t decline tremendously, whereas domestic fund markets saw outflows. Proves the point that investors do different things at different times, for different reasons. A fund with a diversified shareholder base is inherently a lot more stable and can achieve scale in size.
Aguilera: A recent example is of South American pension funds. One of the requirements they have for a fund to be eligible is diversification goals at shareholder level, so there is liquidity and protection for investment values. It is way more important to look at the shareholders’ behaviour, the shareholder base, rather than the portfolio itself.
Edge: It’s unclear what the policymakers have in mind. If they do seriously regard funds as systemically risky instruments, what is their remedy? They’ve either overseen the introduction of required regulations that govern the product itself correctly, or they have failed!
I just don’t understand the thinking. Any further ‘remedy’ would either reduce the scale of a fund or increase the cost of a fund. Neither would be in the best interests of the investor.
Funds Europe: Is national private placement to remain a feature of a hedge fund’s route to market? How is hedge fund distribution and fund set-up evolving?
Griffin: Our experience in the marketing of AIFs [alternative investment funds] from the JP Morgan stable – be they European or US-based – has been to follow the AIFMD. In other words, we have gone through market registration and performed the required regulatory reporting requirements.
Aguilera: Nowadays there are three ways to market, depending on the fund, so for European AIFs, there is a market notification process; then, for non-European AIFs, there is still private placement where possible; and then for funds which are below AIF thresholds, again private placement.
From 2018 onwards, there will be market registration for European AIFs and non-European AIFs, and funds below thresholds have to hope that there will still be private placement regimes.
This is a major challenge for those players.
As I see it, private placement may be something that will be restructured because there are still products that fall out of AIFMD as it currently stands, and this would put them back into member states’ scope of regulation.
Niedner: I’m surprised how the European Commission, on the one hand, wants to export the AIFMD regime, saying, ‘This is good for Europe, so it’s good for the rest of the world,’ but at the same time it kind of creates a number of rules that put European asset managers at a disadvantage compared to third-country managers.
Remuneration, clearly, is one. Without any legal basis, Esma is considering making delegated portfolio managers follow similar remuneration practices than the AIFMs. This is not helping make the European passport attractive. For example, a US manager who might only manage a small amount of European money would have to change their remuneration practice, deferring some of their variable compensation over some years, to be in line with AIFMD.
I’m not surprised that hedge fund managers today are using national private placement regimes in order to distribute.
Another point that I’m also surprised about is how Europe approaches the third-country passport and private placement component. The passport will be introduced and then private placement will fade out about three years afterwards. There will be a lot of uncertainty about how that will happen, because a third-country passport will not be introduced for all countries at the same time.
This means that European managers with European products will have to go for the passport. Meanwhile, third-country managers will have the option, theoretically, during a certain period of time, of going for the passport or doing private placement.
If the European alternative asset management industry is to be on a level playing-field compared to managers in third countries, there needs to be much more consideration about factors like these.
Edge: I stood up in front of a roomful of asset managers in the US, many of them alternative managers, about a year ago and defended remuneration rules in Europe. I thought I was going to get thrown out of the room – but in fact, I was reassured by how many said they already operated according to those rules. So I’m not sure how big a deal it is, and any portfolio manager that objects to the notion of remuneration being aligned to the best interests of investors perhaps should not be managing regulated products.
I think most managers now, with the social conscience that financial services has now embraced quite rightly, are moving more and more towards long-term rewards for long-term performance.
Niedner: I have not seen a single US manager for whom some sort of deferral of the variable remuneration will not be somehow an issue.
Aguilera: They still have two choices at this point. US managers who want European investors will have to comply with those rules. And Asia is also looking at AIFMD now.
At the end of the day, investors will have the final say about what type of fund they want – and if managers don’t do this, they will simply not have a competitive product.
Edge: I agree. For me there are three points emerging from this debate.
Firstly, the new Reserved Alternative Investment Fund (Raif) in Luxembourg has huge potential as an attractive asset-gathering vehicle for EU and non-EU managers to access European investors, because it addresses the concern that Luxembourg is seen as being slow to approve the set-up of alternative funds.
Why would you set up a Cayman fund when you can set up a European fund with all the benefits of investor protection and passporting? The Raif has this, and has the equivalent approval timeframe.
Secondly, more and more big institutional investors are self-imposing what they can buy and focusing very much on investor protection aspects of a European fund.
Thirdly, again, it’s about long-term vision. If we really want regional reciprocity in our retail products, let’s not hold up reciprocity for alternative funds.
So, whichever way you look at it, accessing European investors is increasingly achieved through products with inherent investor protection, so compliance with sensible remuneration rules appears a small price to pay.
Funds Europe: What are the greatest opportunities for fund managers in the next few years and what role will Luxembourg play?
Niedner: The Raif will internationalise the way alternative funds are set up in Luxembourg. But also, Luxembourg has adopted a number of other measures, particularly the creation of the Luxembourg Limited Partnership, which has been a great success.
We have 900 of those partnerships already. They are non-regulated structures and, along with the Raif, will make Luxembourg a very attractive place for setting up alternative investment funds – and alternative asset classes will play an increasing role in investment going forward.
Griffin: It’s clear that retail savers need to save more and take better care of their financial futures. Ucits funds represent a safe, trusted wrapper for those savings. Cross-border distribution clearly can deliver scale, which should pass down reduced costs of those investments to those investors at a point in time. Luxembourg’s is the centre of both Ucits and cross-border fund distribution overall.
So if Luxembourg can continue to promote a secure and trusted fund centre, be flexible, be faster in around the time to market, then it’s got all to play for in terms of continuing to be the leading domicile in the world for the cross-border funds.
Edge: It is time for bold thinking for the next wave of Luxembourg growth, in two areas in particular.
A European portable pension scheme, where Luxembourg is the natural domicile for those vehicles, should be actively promoted and lobbied for. We must create the framework and the desire and the hunger amongst policymakers to make this a reality, and encourage the free movement of labour, which is a fundamental pillar of the EU.
Secondly, as I’ve said, is regional reciprocity. This is a crucially important opportunity for us where, again, we can encourage the growth of Asia in passporting, using products remarkably similar to Ucits, if not plagiarising Ucits.
A healthy disregard for the impossible is the way I’d put it, and bold thinking can really leapfrog Luxembourg ahead again in the next wave of growth.
Aguilera: We need to provide AIFs with a sound distribution support like we do for Ucits. However, AIFs will need something different, because the type of product is different, the type of demand from investors is different. Luxembourg will have a role to play in this.
As distribution rules change, we need to have answers about how products will be sold in the next decade and how to address investor demand when it comes to product disclosure and regulation.
©2016 funds europe
