A practical guide to UCITS funds and their risk management - Alain Ruttiens - ebook

A practical guide to UCITS funds and their risk management ebook

Alain Ruttiens

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Opis

A must-have book about investments !UCITS funds today represent a major share of European funds. The European directives started with UCITS I in the mids 1980s, and have been amended up to UCITS IV in 2009, to be followed soon by a UCITS V package. In its first part, this book is summarizing the evolution and features of these successive sets of European regulations. Among others, it covers the UCITS eligible assets, the key parties involved in UCITS funds operations, their reporting and information requirements, taxation and many other useful related subjects, to give a short but useful understanding of the UCITS world.Beside the UCITS IV directive is entering into the risk management fiel, wich is materialized by the issue of a key document entitled Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (the famous ref. 10-788 Guidelines of the Committee of the European Securities Regulators "CESR"). The Guidelines require some technical skills: the second part pf this book reproduces the CESR's Guidelines, punctuated with comments and prerequisites of quantitative finance, to help for a better understanding of the content and significance of this UCITS IV objective.This book will give you the best keys to invest, avoiding many financial risks.

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About the Book

UCITS funds today represent a major share of European funds. The European directives started with UCITS I in the mid 1980s, and have been amended up to UCITS IV in 2009, to be followed soon by a UCITS V package. In its first part, this book is summarizing the evolution and features of these successive sets of European regulations. Among others, it covers the UCITS eligible assets, the key parties involved in UCITS funds operations, their reporting and information requirements, taxation and many other useful related subjects, to give a short but useful understanding of the UCITS world.

Besides, the UCITS IV directive is entering into the risk management field, which is materialized by the issue of a key document entitled Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (the famous ref. 10-788 Guidelines of the Committee of the European Securities Regulators “CESR”). These Guidelines require some technical skills: the second part of this book reproduces the CESR’s Guidelines, punctuated with comments and prerequisites of quantitative finance, to help for a better understanding of the content and significance of this UCITS IV objective.

About the Authors

After studying law in Paris and London Charles MULLER became a Luxembourg barrister. In 1994 ne joined Banque Générale du Luxembourg, then, in 2003, the Association of the Luxembourg Fund Industry (ALFI) where he held the position of Deputy Director Gênerai. He was also a Board member of the world-wide federation of investment fund associations (IIFA) and a member of the Management Committee of the European Fund and Asset Management Association (EFAMA). Since December 2011, Charles Muller is a partner with KPMG Luxembourg, in charge of the Investment Management arm of the EMEA Financial Services Regulatory Centre of Excellence.

Alain RUTTIENS holds a master’s degree in Chemical Engineering (Faculté Polytechnique de Mons, Belgium). After about a 20-years experience in financial markets (mainly Indosuez bank), he started his own business as a partner of NEURON sàrl, providing services related to financial markets and products. He is professeur affilié at ESCP Europe (Paris), also teaching in several universities and institutions, a.o. HEC Paris, the Sorbonne University of Paris I, the Institut d’Etudes Politiques (Paris). He is also the author of several books, among others, Futures, swaps & options, Edipro (4th ed., spring 2012), and Mathematics ofthe financial markets, John Wiley & sons, March 2013.

Contents

INTRODUCTION

FIRST partThe UCITS directives

CHAPTER I. UCITS – a short history

CHAPTER II. Key Statistics

II.1 Global and European key figures

II.2 Luxembourg key figures

CHAPTER III. The legal set-up

III.1 Law-making process (EU Directives and national implementation)

III.2 Legal types of funds

III.3 Permitted activities

III.4 Structuring

III.5 Key parties involved in the operations of UCITS funds

CHAPTER IV. Investor information and protection

IV.1 The KIID

IV.2 Annual report and semi-annual report

CHAPTER V. Confidentiality and anti-money laundering

CHAPTER VI. Taxation

VI.1 Financial Transaction Tax (FTT)

VI.2 FATCA

CHAPTER VII. Non-UCITS funds and level playing field

VII.1 AIFMD

VII.2 Venture Capital Funds and Social Entrepreneurship Funds

GLOSSARY

LITERATURE

SECOND partUCITS risk measurement guidelines

CHAPTER I. General

I.1 Market risk

I.2 Credit risk

I.3 Liquidity risk

I.4 Operational risk

CHAPTER II. Comments on the CESR guidelines

BIBLIOGRAPHY

Copyright

Introduction

The fund industry general, and the UCITS world in particular, occupies a specific and often underestimated role in the fund industry. Asset managers and investment bankers consider it boring, full of rules limiting creativity and “real” money-making and full of administrative and legal constraints. Regulators see it as a receptacle of savings that needs to be particularly heavily regulated to protect retail customers from losing money.

In fact funds are vehicles that help connect people that have money with people that need money. On the contrary to banks and insurances, funds don’t operate their own balance sheets and don’t make profits. All the added value that is generated (minus cost of service providers) goes directly back to investors. On the contrary to direct investments, funds provide investors with certain safety measures, “airbags” that cost money but will reduce risk and increase certainty. The assertion that funds would in addition provide an increased return compared to corresponding direct investments has been questioned over the last years, even if it remains an important selling arguments for fund promoters.

The EU has enacted directives governing UCITS (Undertakings for Collective Investment in Transferable Securities) since 1985. Today, UCITS IV is implemented, with a further UCITS V already in preparation. It seems useful to us to take stock of this growing set of regulations, and present the salient facts of the UCITS funds, which today represent a major share of European funds. This constitutes the first part of the present book.

Besides, a significant feature of the UCITS IV directive relates to risk management, which has become a major concern for the funds industry, particularly in the wake of the credit crisis of 2007, since then having spread to a broader financial crisis. To that extent, the Committee of European Securities Regulators (“CESR”) has issued Guidelines on Risk Management that makes this concern concrete. Although clearly presented and exemplified, these Guidelines refer to several aspects of quantitative finance, which may not be sufficiently familiar to the average people confronted with UCITS IV. Hence the second part of this bookreproduces the CESR’s Guidelines, punctuated with comments and prerequisites of quantitative finance, to help for a better understanding of the content and significance of this UCITS IV objective.

The authors would like to thank the KPMG Centre of Excellence team for its support and contribution to the regulatory part of this publication and especially Dee Ruddy, Gabrielle Jaminon, Dorothea Mevissen, Thomas Ertl, Kian Navid and Ludivine Zanetti.

Charles Muller, [email protected]

Alain Ruttiens, [email protected]

FIRST Part

The UCITS directives

Chapter I. UCITS – a short history

Investment fund structures already existed in Europe at the end of the 19th century, but their development at a larger scale really only occurred after the second world war. At that time, investment funds were regulated according to largely differing national laws. The first attempt to regulate investment funds at the European level dates back to the mid 1980s, when Directive 1985/611/EEC was adopted and the “UCITS” (Undertaking for Collective Investment in Transferable Securities) label created.

The main focus of this first Directive, now referred to as UCITS I, was the establishment of a common set of rules to facilitate the distribution of UCITS across Member States while ensuring a consistent level of protection to investors. The aim was to allow a UCITS authorized in one Member State to be authorized for sale in other Member States without additional authorization requirements from national authorities. However, reality did not meet expectations. On the one hand, distribution was hampered by specific local marketing rules introduced by individual Member States and on the other hand, investment possibilities were considered too restrictive, providing only limited scope in terms of the range of products that could be offered. These difficulties called for a revision of the rules in the early ‘90s, and an amended version of the Directive under the name of “UCITS II” was put on the table. As the Council of Ministers of the European Union failed to find an agreement, the revision was finally abandoned.

It took almost 10 years before a new, amended version of UCITS was finally approved. Directives 2001/107/EC and 2001/108/EC represent what is commonly known as “UCITS III”, a package of new rules that were respectively focused on Management Companies and simplified prospectuses on one hand, and investments of UCITS on the other hand, all aiming at wider consumer choice and improved investor protection.

Directive 2001/107/EC sought to provide Management Companies with an European Passport to operate throughout the European Union, with a tightening of the risk management framework and substance requirements. The Directive also introduced the “simplified” prospectus in order to ease public comprehension of financial information, using a simplified format that, it was hoped, would be understandable across different European jurisdictions.

Directive 2001/108/EC expanded the type and range of investments a UCITS may hold to money market instruments, deposits, other UCITS and derivatives under certain conditions. The evolution of the UCITS framework under UCITS III however fell short in tackling industry consolidation and efficiency constraints. In addition, the hope of a fully functioning Management Company Passport did not materialize. Having recognized these shortcomings, the European Commission initiated a new wave of amendments - the “UCITS IV package” that was adopted in 2009 (Directive 2009/65/EC).

The main amendments to the legal regime introduced by UCITS IV relate to:

a full Management Company Passport allowing a UCITS to be managed by a Management Company authorized in another Member State;

a framework for cross-border UCITS mergers and for master-feeder structures allowing industry consolidation;

replacement of the simplified prospectus by the Key Investor Information Document (KIID), bearing in mind the inefficiencies of the former simplified prospectus and harmonizing the structure of these publications on all European markets;

design of a new regulator-to-regulator notification procedure with a view to reducing the time to market in the other Member States;

enhanced regulator cooperation.

Though the implementation of UCITS IV is recent and all the opportunities offered by the new framework have not yet been exploited, the European Commission is already discussing future changes to the UCITS rules.

A “UCITS V” draft directive from the European Commission is currently being discussed at the level of the EU Parliament and Council of Ministers. It focuses on harmonizing the role and liability of the UCITS depositaries, introduces remuneration policies for UCITS managers and a catalogue of sanctions that national competent authorities must apply in the event of a breach of the UCITS regulation. It could be adopted in the course of 2013.

The European Commission also issued a consultation paper in July 2012 seeking the views of the market on, among other things, the definition of additional rules concerning risk management within UCITS, the scope of eligible assets and the depositary passport. These changes to the UCITS framework might materialize in a new set of rules already commonly referred to as “UCITS VI”.

Chapter II. Key Statistics

Statistics are fluctuating animals. Assets under management and market shares can vary depending on what you consider a fund (regulated, unregulated), a mutual fund (UCITS, non-UCITS…), and depending if you can eliminate double counting in fund of funds.

II.1 Global and European key figures

The following international figures are based on reports from the ICI in the US and EFAMA in Europe, collecting data on regulated funds from 45 jurisdictions. This means that funds domiciled in non-reporting jurisdictions (mostly alternative funds in offshore locations) are not included.

At a global level UCITS funds are considered as a major investment product. While the US still lead the way with almost 50% of total assets in worldwide mutual funds, Europe has a market share of roughly 30%.

Source: EFAMA Factbook 2012

However, the average size of a European fund is still much smaller than in the US, a fact that has drawn the attention of EU regulators who have tried to encourage cross-border fund mergers in Europe.

Source: ICI/EFAMA (31/03/2012)

UCITS is a pure European “invention” that dates from the middle of the 1980s, and its evolution can undoubtedly be considered as an unparalleled success story, as statistics show. Today UCITS funds have become the standard in Europe, since over 70% of all assets in regulated European funds are invested in UCITS products. Between 2000 and 2012 net assets in UCITS funds increased from 3.5 to more than 6 billion EUR.

Source: EFAMA Fact Sheet December 2012

The six top investment fund domiciles in Europe in terms of assets have historically been Luxembourg, France, Germany, Ireland, United Kingdom and Switzerland; amongst the EU markets, Luxembourg, Ireland and the United Kingdom have always been benefiting from a higher equity exposure of fund assets compared to France and Germany, and this has contributed to the rapid post-crisis growth of those markets in the past few years.

Market share of European Fund Domiciles as at 31/12/2012

Source: EFAMA Quarterly Statistical Release Q4/2012

European markets tend to differ based on the assets preferred by local investors.

Equities tend to be the most popular kind of assets in Europe, due to the higher return they can provide, especially in times of low interest rate; but equities also potentially embed higher risks compared to other kinds of securities, and this is reflected in the tendency that markets have to divest from equities during a financial crisis.

Bonds represent a relatively stable type of assets. They are considered as one of the safest investments, as they grant a return of capital plus interest at the end of a fixed period.

Asset allocation by UCITS type (%) as at 31/12/2012

Source: EFAMA Factbook 2012 & Quarterly Statistical Release Q4/2012

Investment funds should therefore been considered as tools to help finance the “real” economy: governments, local public entities and enterprises. The source of money is diverse but mostly comes from retail customers and long-term saving, pension and insurance vehicles.

Investment Fund Asset Ownership (%) as at 31/12/2012

Source: EFAMA Factbook 2011 & 2012

Even excluding insurance and banking products, the retail segments represents, directly and indirectly through pension funds, roughly 40% of total savings in funds.

Main financial Assets of Households (%) as at 31/12/2012

Source: EFAMA Factbook 2012

II.2 Luxembourg key figures

The evolution of assets under management in Luxembourg domiciled funds derives from the widening of the Single European Market (growth in the number of EU countries), the increase in promoters and funds, the developments on financial markets and, last but not least, the distribution of UCITS funds outside the EU. The beginnings were rather slow: it took the fund industry from the late 1980s to 1999 to reach 500 billion Euros in assets under management. AUM then doubled between 1999 and 2004, and doubled again within 3 years (benefiting from the various enhancements of the UCITS regulation) to reach the 2 trillion threshold in May 2007. Due to the crisis, AUM fell back to 1.5 trillion in March 2009 and it took the industry until the beginning of 2010 to reach pre-crisis levels.

In Luxembourg, the main categories of funds are UCITS (i.e. Part I funds), other UCI (i.e. Part II funds) and SIF (i.e. specialized investment funds). Whereas UCITS and other UCI are regulated in the Law of 17 December 2010 on undertakings for collective investment, SIF are regulated in a separate Law of 13 February 2007 on specialized investment funds.

Fund promoters in Luxembourg by Country of origin (as at 31/12/2011)

Source: CSSF Annual Report 2011 & Newsletter 02/2013

Net assets in Luxembourg funds (in bn EUR)

Source: CSSF Annual Report 2011 & Newsletter 02/2013

Except for the crisis year 2008, net sales in Luxembourg have remained positive and the number of funds has continued to increase (3,867 funds representing 13,407 sub-funds at the end of June 2012). While less than half of the funds are UCITS, they represent almost 80% of assets under management.

Breakdown of funds by legal form and net assets

Source: CSSF Monthly Statistics as at 31/01/2013

Luxembourg law recognizes three different legal forms to the funds: Fonds Commun de Placement (FCP), Societé d’Investissement à Capital Variable (SICAV) and Societé d’Investissement à Capital Fixe (SICAF). The FCP is the most common legal form used for funds in Luxembourg, followed by the SICAV. The SICAF, a fixed capital structure, is less popular and its use has been decreasing to 33 units only as at the end of 2011. The preference for FCP in Luxembourg is confirmed by the figures provided by the market at the end of 2011:

Number of UCIs according to their legal form

Source: CSSF Annual Report 2011

The most popular types of assets traded by the above mentioned funds are represented in the chart below; the figures are split between UCITS – Part I, UCI – Part II and SIF, as these are the three main categories of funds we can find on the market of Luxembourg:

Investments of Luxembourg funds per asset type (in bn EUR)

Source: CSSF Annual Report 2011

Not included in the figures for UCI – Part II are those UCITS excluded from Part I of the Law of 17 December 2010 closed for redemptions, not promoted in the EU or only sold to individuals in countries outside the EU, as well as UCITS excluded from Part I of the 2010 Law under one of the categories laid down by CSSF Circular 03/88 owing to their investment and loan policy.

Chapter III. The legal set-up

The principles governing UCITS funds are laid down in an European Directive that was first adopted in 1985 with the objective of creating a retail collective investment fund that could be freely sold across the EU, subject to common rules on authorization, supervision, structure, portfolio and the information to be provided to investors. In the intervening years the UCITS Directive has undergone multiple amendments (see history of UCITS above) to modernize the regime and the latest changes were formally adopted in 2009 (Directive 2009/65/EC). In July 2012 in line with their investor protection agenda the Commission issued a new proposal (UCITS V) to amend the UCITS framework which is expected to be voted before the end of 2012.

In the same month the Commission launched a wide-ranging consultation (UCITS VI) covering new areas where the framework could be further enhanced.

This section will give you an overview of EU regulation with, as a special focus and case study, the regulation in Luxembourg as the leading European fund domicile.

III.1 Law-making process (EU Directives and national implementation)

At EU level, only the European Commission has currently the right of initiative (right to propose new pieces of regulation) and the Commission generally proposes “Directives” or “Regulations”. UCITS takes the form of a directive and accordingly must be implemented by EU Member States, which may require new national legislation or amendments to existing legislative provisions. The implementation process is called “transposition”, and Member States are normally required to comply within a specific deadline that is set in the Directive. In contrast, “regulations” are directly binding as soon as they are passed and do not need further legislation at a national level.

As part of its preparatory work prior to drafting a legislative proposal, the Commission normally launches a consultation seeking feedback from the various stakeholders, although this phase is not compulsory. After the consultation phase the Commission adopts a draft legislative proposal which is submitted to the European Parliament and Council for evaluation, comments and amendments, and then for approval or rejection.

The “co-decision process” is the EU’s standard decision-making process in which the European Parliament and Council of the European Union examine the Commission’s legislative proposals, suggest amendments, agree on the wording and vote to pass or reject the legislation. Once the legislation is passed into law it needs to be implemented by national parliaments.

If a Member States misses the implementation deadline this might trigger actions taken by the European Commission before the European Court of Justice. In order to reduce the number of actions taken by the European Commission, the European Court of Justice has developed the doctrine of direct effect in circumstances where non-implemented (or wrongly implemented) Directives can have direct legal force due to the specificity of their contents.

Luxembourg transposed the first UCITS Directive in 1988 well ahead of many other countries and gave the country first mover advantage which helped to attract many international fund promoters to the country to set up their cross-border UCITS range. Luxembourg has continued this momentum and was also the first country to transpose the UCITS III and UCITS IV updates of the Directive. The current framework for UCITS in Luxembourg is provided by Part 1 of the Law of 17 December 2010 on Undertakings for Collective Investment and all Luxembourg UCITS are subject to the full UCITS IV regime. At present, not all Member States have fully transposed the UCITS IV amendments and in some 13 Member States UCITS are still governed by the UCITS III regime.

III.2 Legal types of funds

According to the UCITS Directive there are several legal structures available to UCITS, including structures constituted under contract law (common fund managed by a Management Company), trust law (unit trust) or statute (investment companies). Investors in different countries may have a preference for a specific legal structure. UCITS are permitted to take the form of either a contractual fund or a corporate fund under Luxembourg law.

Contractual UCITS

: a ‘

Fond Commun de Placement

’ (FCP) is any undivided co-ownership of securities and/or other liquid financial assets, managed by a UCITS licensed Management Company (subject to chapter 15 of the law of 2010) in accordance with the principle of risk spreading, on behalf of joint owners who are liable only up to the amount contributed by them and whose rights are represented by units. FCPs do not have legal status and are a tax transparent structure. The governance body is the Board of Directors of the Management Company. The net assets must not be less than EUR 1,250,000 which must be reached within six months of authorization.

Corporate UCITS

: a corporate UCITS can either take the form of ‘

Societé d’Investissement à Capital Variable

’ (SICAV) or a ‘

Societé d’Investissement à Capital Fixe

’ (SICAF). The SICAV is a public limited company with variable share capital, whose sole object is to invest in transferable securities in order to spread investment risks, whose units will be placed with the public by means of a public or private offer. The nominal value of the capital of a SICAF does not change. A SICAV/F can either appoint a Management Company or designate itself as ‘self-managed’. The governance body is the Board of Directors of the SICAV/F. The minimum capital of a self-managed SICAV is EUR 300,000 upon authorization and must reach EUR 1,250,000 within six months of authorization, being the same amount required for a SICAV managed by a Management Company.

A UCITS must be open-ended. UCITS may be set up as a single fund or as an umbrella fund that is comprised of several ring-fenced sub-funds, each with a different investment objective and policy. Each sub-fund is treated as a separate entity, with segregation of assets and liabilities. The investment management can be performed by a different investment manager for each sub-fund. The umbrella structure is very popular in Luxembourg, particularly among the larger promoters of UCITS. Sub-funds are permitted to invest in each other, subject to certain investment restrictions. A Luxembourg UCITS may also issue multiple share classes to cater for different investor segments, currencies or fee structures. The number of share classes is unlimited.

The UCITS IV reforms introduced the concept of Master-Feeder UCITS whereby a feeder UCITS is required to invest at least 85% of its assets in one master UCITS. This structure offers some portfolio management efficiencies for promoters that are keen to maintain a local UCITS in certain countries.

III.3 Permitted activities

III.3.1 Eligible assets

The UCITS Directive contains provisions on the categories of assets that may be held in the portfolio and sets out detailed rules and criteria on how to assess whether an asset may be eligible for investment as well as detailing a list of portfolio risk diversification and liquidity requirements. One of the core concepts of a UCITS fund is that it is a liquid investment and that investors can redeem their holdings at any time on request. This obliges the investment manager to construct a liquid portfolio of investments that they can sell off easily for cash to satisfy redemption requests from investors.

The broad categories of eligible investments are:

Transferable securities listed or dealt in on a regulated market. This category broadly includes equities, bonds, structured financial instruments, depositary receipts and closed ended funds that are negotiable, subject to reliable valuation and where the maximum loss is limited to the cost. The risks inherent to these instruments must be properly captured by the risk management process. In addition closed ended funds must be managed by a regulated asset manager and be subject to robust corporate governance requirements.