The Rise of Liquid Alternatives

Options and considerations for UCITS with alternative strategies

Originally published in the April 2015 issue

The following article comprises extracts from the K&L Gates seminar, The Rise of Liquid Alternatives, hosted by K&L Gates partners Sean Donovan-Smith and Andrew Massey along with Hamlin Lovell, contributing editor of The Hedge Fund Journal. The session covered growth in the alternative investment funds sector and the advantages and disadvantages of alternative UCITS funds. The seminar addressed the strategies themselves in detail, and how to make them UCITS-compliant, and the key features of the UCITS rules in that regard. It also covered marketing and distribution, and looked towards future trends and developments.

Sean Donovan-Smith is a partner in the firm’s London office. He is a financial services lawyer with almost 20 years’ experience in the financial services industry, having acted for a range of clients including funds, managers, advisers, and institutional investors. Donovan-Smith focuses his practice on financial services and markets regulatory advice, regulatory enforcement and investigations, advising on regulated and unregulated funds and the international marketing of funds, and other financial products.

Andrew Massey is a special counsel in the firm’s London office, where he is a member of the financial services practice group. He provides advice on financial services law and regulation to a diverse range of financial services institutions. His practice encompasses advising on regulated and unregulated investment funds, the scope of regulation, and regulatory issues relevant to all aspects of a financial services business and its products and services.

Hamlin Lovell is contributing editor of The Hedge Fund Journal.


Sean Donovan-Smith: A little bit of brief background on UCITS: the UCITS regime came into being through a directive in 1985, and the first UCITS fund was established in 1989. So we have over a quarter of a century of experience of UCITS-compliant funds, and how they’re offered, and the wide distribution that they offer. In 2007 there was the Eligible Assets Directive, and that was really the turning point that introduced alternative strategies into the UCITS world, with numerous ones now being permitted in a UCITS fund context, to give investors more exposure to hedge-fund-like returns.

That has come under a fair bit of scrutiny in the seven or eight years since that point – some of those things we’ll touch upon, and some of them are related to future developments that are happening now in the UCITS space as well, and may or may not have an impact on the ability to use an alternative UCITS fund strategy going forward.

So just with that as the brief introduction, I’ll hand over to Hamlin, to speak to us about the growth in alternative UCITS funds. Hamlin – over to you.

Hamlin Lovell: UCITS assets are growing at a tremendous speed. In 2012, the Alix Capital UCITS database had about €140 billion of funds in it. As of last year, that had risen to €260 billion, so this is now roughly 10% of the global hedge fund industry, which is worth about $3 trillion. The biggest category is long/short equity, followed by fixed income, which includes various credit and commercial bond strategies, with other liquid strategies also featuring strongly. In this particular database, I think a lot of the CTAs come under the macro strategy, because they might just be tagged as a systematic macro. So that’s another important one as well.

So what is actually driving all this growth? Well, we think it’s pretty broad-based. UCITS can be distributed to retail investors just about anywhere, and although some UCITS may have a minimum of as high as €100,000, designed to attract the high-net-worth or institutional investor, there are plenty of other products which have a minimum of as low as €100, or €500, so almost anybody could be putting that into their personal pension plan, or tax-efficient savings accounts in any number of countries.

Private banks are believed to be particularly strong buyers of UCITS, especially Swiss private banks, in Europe, although in the US, there probably is a stronger preference for offshore Cayman funds. So UCITS can offer some of the return potential of hedge funds and other quant trading accounts strategies. In some cases the tracking error is virtually zero – in other cases, UCITS can be somewhat diluted for one or more reasons, whether it’s a VaR limit or leverage cap, or diversification, or eligible assets, or whatever else – but there are a growing number of UCITS products that have really a very marginal tracking error relative to the offshore sister funds. People are going for UCITS hedge funds because they are frustrated with the lack of diversification offered by traditional asset classes. Although commodities are held to be a useful diversifier, last year commodities were clearly not a particularly useful diversifier, or to the extent that they were uncorrelated, it’s only because they were actually losing quite a lot of money, so people realised they need the ability to actually go short of commodities, and profit from down-trends, and perhaps pursue alternative strategies, such as roll-yield strategies that could extract returns from commodities in a market-neutral kind of way.

Another driver for interest in alternatives is that clearly, trillions and trillions-worth of government bonds now have negative interest rates, so they are guaranteed to lose you money if you hold them to maturity – but they’re guaranteed to make you money if you actually short those contracts and hold them to maturity. So we think that the transformation of zero-interest-rate policy into negative-interest-rate policy should further drive more money into alternative strategies.

UCITS have other attractions: the minimum level of transparency they have to offer is greater than some other funds offer, in that twice a year you should be able to get a full viewof the holdings in the bi-annual reports. Liquidity of UCITS has to be at least twice a month, and it can sometimes be weekly, or even daily, but not intra-daily, unlike an exchange-traded fund – and people also perceive UCITS to offer more security and safety in terms of asset custody.

The strict depository liability which is going to be coming in for UCITS V is going to be pretty much non-negotiable, whereas an AIF can reduce its depository liability with the agreement of the governing body, and UCITS have other special attractions for some types of institutional investors. A non-transparent black-box hedge fund will typically attract a risk weighting of 49% under the Solvency II regulations, whereas a more transparent hedge fund, via managed account platform, or managed account, or risk aggregation methods – or indeed UCITS – can attract a much lower risk weighting, so that will allow insurance companies to allocate to a UCITS hedge fund without eating up too much of their regulatory and risk capital.

Andrew Massey: I’m going to be covering the advantages and disadvantages of alternative UCITS – looking firstly at the advantages of UCITS as a vehicle, secondly the increasingly level playing field for UCITS and AIFs, and then picking up on some of the challenges for alternative UCITS.

Distribution potential and opportunities
Hamlin has mentioned the breadth of distribution that is possible in terms of investor types, and range of jurisdictions. It is not just the advantage of increasing the possible target market; there are also opportunities to diversify the investors that are within an alternative UCITS, and hopefully attract investments that are stickier, or at least have a different likelihood of being redeemed.

Secondly, whilst we should generally be wary of Chancellors bearing gifts, pensions liberalisation and increased flexibility for ISAs also present opportunities for alternative UCITS, particularly as UCITS will remain a qualifying investment for a stocks and shares ISA.

But there is a note of caution. It is compulsory for seminars throughout 2015 to have multiple references to MiFID II, and here’s the first one: we need to be aware of the provisions regarding appropriateness, as there is the possibility that they’re going to make the distribution of certain alternative UCITS slightly less easy than it currently is for UCITS generally.

Key advantages for investors
Liquidity. There are two aspects to this – firstly, there must be at least two dealing days per month. Secondly, there are limitations on the hurdles to redemption that a manager can impose. The UCITS Directive requires that investors are able to redeem on request in accordance with the dealing arrangements as specified in the fund documents, and the only exception to that in the Directive is to suspend dealing, which can only take place in exceptional circumstances.

Strong governance. It’s fairly well accepted that UCITS have strong governance, through governing organs such as the independent board of directors for Luxembourg and Irish UCITS, and for UK ICVCs the authorised corporate director function. That is supplemented by the required functions for UCITS management companies, including the compliance function and risk management function, and further supported by the network of service providers which a UCITS will generally have in place, be it the administrator, the auditor, or registrar.

Depositary oversight. But the key service provider, or the Oscar for the best supporting service provider from an investor protection perspective, must go to the depositary, because of the depositary’s role in ensuring the security of assets through segregation and, in theory, preventing the misuse of the assets of the UCITS. And secondly, the depositary’s role as policemen over the UCITS management company – overseeing the management and operation of the UCITS to ensure it’s in compliance with the Directive, local law and the UCITS fund documents.

Regulated vehicle. It is also important for investors to have the quality stamp that a UCITS has as a regulated vehicle. Two practical consequences of note for UCITS managers are that the UCITS needs to have been approved by its regulator prior to launch with the due diligence that entails, and secondly, material changes to a UCITS will need to be approved by its regulator and may trigger a need for investor approval. So investors have certainty about the product which they are investing in – that it should not materially change without regulator involvement and the investor being aware, or possibly having some say.

Transparency. There are detailed transparency requirements. The extent to which these are beneficial to investors, particularly retail investors, is debatable, particularly the detailed exposure requirements and limitations required by ESMA and CESR guidelines – but they need to be in there, they are important to some institutional investors, and it is an important way for the management company to demonstrate and go through the process of ensuring it has the necessary control mechanisms in place.

Investment risk management. A UCITS is perceived to be a safe investment, and there are reasons for that. The requirements of the UCITS Directive should mean there is a prudent spread of risk achieved, through diversification, the concentration restrictions and the requirements to monitor and limit exposures.

The closing gulf between UCITS and AIFs with the introduction of AIFMD
Alternative UCITS have been possible for quite some time following the introduction of the UCITS III Directive, but it’s really with AIFMD that the other sister has become that much uglier, such that the regulatory regime for alternative UCITS looks that much better by comparison. The contrast between an alternative UCITS and alternative funds is not as stark as it used to be.

The transparency requirements: relevant to EU and non-EU AIFs marketed in the EU. Pre-investment disclosure is primarily related to the contents of the prospectus document, and the requirements are both highly prescribed for AIFs and UCITS, with arguably slightly greater detail for UCITS. But the interesting exercise undertaken last year for non-UCITS retail schemes – which are AIFs but being a UK authorised vehicle have a lot of similarities to UCITS – is that when reviewing the prospectus to see how we needed to amend it to comply with AIFMD, we weren’t taking away content; we were adding, revising, fleshing out various aspects of the prospectus.

Key areas related to conflicts of interest – AIFMD has some quite specific detailed requirements; we also needed to describe the depository function – something we’ll need to go through for UCITS upon the introduction of UCITS V; and we also needed to address the concept of the fair treatment of shareholders, and the AIFMD requirement that the possibility that certain investors may have preferential treatment be disclosed in prospectuses. It is possibly only a matter of time before those enhanced AIFMD disclosure requirements are also rolled out for UCITS.

Reporting requirements: relevant to EU and non-EU AIFs marketed in the EU. One other point I’d like to mention relates to reporting to regulatory authorities, which is undoubtedly more onerous for AIFs. I see this as the flip-side of the UCITS investment powers and restrictions. UCITS have prescribed investment powers and restrictions. By contrast, AIFs have much broader investment powers and restrictions, and therefore, reporting of the contents of the AIF portfolio is undertandably important.

Organisational systems and controls requirements: relevant to authorised alternative investment fund managers, and so at the moment, EU AIFMs. The general theme is that there is a lot of commonality between these requirements as they apply to UCITS management companies and alternative investment fund managers, but as always, the devil is in the detail. To pick a couple of examples where there is a disparity: in risk management, both an AIFM and a UCITS management company are required to have a permanent risk management function, but perhaps contrary to expectations, the requirement for a UCITS is subject to proportionality. Another point of difference relates to delegation. Both AIFMD and the UCITS Directive seek to achieve the same outcome: that delegates are only appointed where it is appropriate, and that there is monitoring and reviews of delegates – but there are additional requirements under AIFMD. For example, the delegation must be objectively justified, and there must be a review of the delegate to ensure it has sufficient resources, is of good repute and has relevant experience.

Level playing field for UCITS and AIFs? The UCITS Directive has had to pull up its socks in response to the ways in which AIFMD has introduced additional or more prescriptive requirements. Certain of these are going to be brought into force by UCITS V, primarily affecting the depository function and also remuneration.

Challenges for alternative UCITS
Moving to challenges for alternative UCITS, much as the German finance minister said recently in relation to Greece, “Reality is often not as nice as a dream”. And so it is that for alternative UCITS managers, it’s not necessarily as easy as packaging up an alternative strategy in a UCITS vehicle.

Liquidity. We mentioned liquidity as a major advantage for investors; it is also a major challenge for UCITS managers pursuing alternative strategies. The need to ensure there is sufficient liquidity to meet redemptions must go beyond simple cash monitoring, i.e., making sure there are sufficient holdings of deposits or deposit-like instruments within a portfolio. There needs to be a real assessment of the liquidity of the holdings of the UCITS, as a whole.

But if an issue does arise, what options are available to a UCITS manager? Suspension of dealing, which is the nuclear option, is permitted only in exceptional circumstances under the UCITS Directive. There is sometimes the possibility to defer redemptions – usually up to 10% of redemptions on a particular dealing day deferred to the next dealing day. UCITS VI may look at these issues and will hopefully harmonise provisions in the Member States. Gating is not going to be possible for a UCITS, unlike for offshore hedge funds. Side pockets are potentially possible, but the practical obstacles are so significant that it will rarely be viable.

Perhaps the most attractive way of managing liquidity, or managing redemptions, is to  introduce alternative fee structures, such as a redemption fee linked to the length of a particular investor’s holding in the UCITS which might tail-off over time. But the challenges here are for the manager to assess whether it is suitable if retail investors are going to be invested in the fund, and also whether it is administratively possible.

Investment parameters. Focusing on some of the more practical points on investment parameters, whatever is potentially permitted for a UCITS will be constrained by the particular fund’s investment objective, and so it is important to get the objective right. Managers increasingly want greater flexibility in terms of how they word their objectives; regulators want greater prescription. There’s always a tension here, and it’s important to get it right, because changes to an objective will require regulatory approval, and quite often will also require investor approval.

For alternative UCITS strategies, the ESMA guidelines on ETFs and other UCITS issues are going to be very relevant. They include requirements about efficient portfolio management techniques, and the need to ensure that all revenues that arise from EPM are credited to the UCITS net of fees and costs. There are also detailed requirements to impose a collateral management policy, so dealing with collateral that arises through the use of financial derivative instruments and EPM techniques. There is also a consequential point for managers to address relating to ESMA’s concern about the lack of transparency: that investors in a UCITS did not necessarily fully appreciate what EPM techniques are being used, and the possible consequence that may have on the risk profile of the UCITS.

Finally, on challenges for alternative UCITS, I want to focus on the issue of side-by-side management. If you are a manager that has an alternative UCITS and an alternative investment fund within your product range, how do you manage the potential conflicts of interest? How do you fairly allocate investment opportunities, and allocate specific transactions where you may be incentivised, be it due to the size of the funds, or the fee arrangements? You may be incentivised to favour one over the other – that’s an important point that managers need to address in their conflicts of interest policy.

Sean Donovan-Smith: Having gone through the general trends that are happening with alternative UCITS, and having an overview of some of the advantages and disadvantages, and some of the operational aspects, the real key is whether or not the strategy itself will fit within a UCITS vehicle, and so that’s what we’re going to turn to next. Andrew touched upon the need to spread risk and exposure, and Hamlin also talked about VaR limits, and leverage caps that could be imposed – and these are the topics that we want to get into now.

What I’ve chosen to start with is the core behind the UCITS risk spreading and concentration rules, which is generally referred to as the “5/10/40” rule. The 5/10/40 rule is what sets out the basic restrictions on concentration exposures that you can have to a particular issue or security and asset class, which says it’s generally 5% that you’re limited to, which can be expanded to 10%, but that 10% expansion is limited to 40% in aggregate of the assets within the UCITS fund – hence the 5/10/40. There are various exceptions; one of the main ones is exposures that are guaranteed by governments and local authorities – so you can turn off certain limitations there, and expand your exposure.

Similarly, there are different exposure limitations when you’re replicating an index. There is the concept of being able to invest in securities that are not listed in a recognised market, and there are some other detailed provisions that apply, but the main thing you have to keep in mind is this concept of the 5/10/40 rule. So most investments you’re making, you want to be limited to 5% but increase to 10%, but no more than aggregated of 40% in the fund. A related issue, which Andrew also touched upon, is around liquidity. If you have a portfolio structure that is loaded with illiquid investment types, it’s almost certain they’re going to be very difficult, if at all possible, to put it into a UCITS structure.

The reason I don’t knock it out of consideration entirely is because there are ways that you can use OTC derivative contracts, potentially, to replicate that type of exposure. Although the concept of having direct holdings in illiquid investments would not be permitted within a UCITS context.

Many alternative UCITS strategies rely upon the use of derivatives, or futures, to replicate their strategies, which require that the global exposure is calculated for the fund, and that includes the concept of value at risk. Here, you need to be evaluating the value at risk in the fund: if it’s a non-sophisticated strategy you can use the commitment method; more sophisticated strategies will use a VaR calculation (it can be absolute VaR) which is limited to 20% of asset value. If you do have a strategy that is comparing its relative performance to a benchmark, you can then use relative VaR. That’s limited to two times the benchmark’s value at risk itself, and it’s subject to the type of investment strategy.

On the concentration limits, one of the points we want to flag up is for counterparties: if you’re dealing with an approved bank, your exposure can be increased up to 10%. Other than that, it would be 5% – so if your counterparty is a MiFID investment firm, you’d be limited to 5%. One of the keys is that, whichever counterparty you’re dealing with, for an OTC contract, the counterparty has to be subject to prudential regulation in order to be permitted as a counterparty under the UCITS rules.

Where margin is subject to client asset protection, and segregated, it doesn’t have to be counted in your counterparty risk calculations, so you can exclude that. But if title was to be passed over, then you will have to take that additional exposure into consideration in the counterparty risk determination. Margin should be subject to daily calls, as well, in order to fall within the UCITS requirements on this. The last point is to consider at contract level where your exposure lies. It’s not necessarily by just contract type: it may be to the exchange as a whole; it may be to the clearing house as a whole – and that’s where some of the trickier analysis can happen.

So it’s not sufficient just to say that, “Well, I’m dealing in one FX currency pair, therefore if I have multiple pairs, they’re all different contract types, and then each one should have up to 5%.” It’s not quite that simple; you need to look at the correlations between them, and where the actual risk is, within the investment structure, to make that calculation.

One of the areas that we would typically start with in a discussion about alternative strategies for UCITS actually goes back to the eligible investments themselves. Because what you need to work out is, whether the investments that you would want to plug your fund into are eligible for UCITS? Not all of them are – I think many of you will be aware of this.

The key point is that investments in real property are not permitted, investments in physical commodities are not permitted – so agricultures, metals, gold, any precious metals will not be permitted – and also lending, as well, will not be permitted. In addition, investing in unregulated collective investment schemes is also not permitted, and I’ll come back to that, because there has been a clarification by ESMA on this: some funds were using what’s called “the trash bucket” to get exposure to unregulated schemes, but that opportunity has been closed down. Generally, the tests for UCITS-permitted investments is that losses should be limited to the amounts paid on them; there should be sufficient liquidity; there should be reliable valuations that apply to them; there should be appropriate information and transparency that’s provided on these; and they should be negotiable and transferable instruments. Investment types that don’t have those features are not going to fall within the permitted investments that a UCITS can get exposure to.

One aspect I touched upon a minute ago is eligible markets. All the investments need to be traded on an eligible market, which can be a regulated market or a market that operates regularly and is open to the public – depositories also have some discretion here, in conjunction with the authorised fund manager, to add to that list. A good example that we’ve come across recently is some funds deciding that certain MTFs can be included on that list – so you can get access to those investments. There’s a very heavy emphasis also, as Andrew touched upon, in terms of transparency and access to information, so that investors can actually make their own determinations of what the exposure is – and it’s all about that trade-off of getting the UCITS recognition as something that supposedly has less risk.

But the real secret, in my opinion, in terms of putting an alternative strategy into a UCITS fund, is around the use of derivatives and futures products. With many strategies, although you couldn’t replicate directly, you can replicate indirectly, by way of using a bilateral OTC contract. I query whether the European Markets Infrastructure Regulation (EMIR), that is pushing OTC contracts to be exchange-traded (which will happen under MIFID II) and centrally cleared (under EMIR), will mean that there are more product types out there, because I think one of the inhibitors in terms of using OTC contracts is that they tend to come with a higher cost than most other investment types. So, as various manufacturers of different types of futures contracts start to replicate OTC contracts as futures, that should make it a bit easier at a lower cost to gain access to them. But we’ll have to see how that transpires – a lot of people are talking about the futurisation of derivatives, because of EMIR and the equivalent Dodd Frank Act provisions in the United States. We need to see what happens with that as time passes.

The key with the use of a derivative product is that the underlying itself must fall within an eligible investment for a UCITS fund, and so that’s where the disconnect is. It’s not quite as simple as saying that you can just have an OTC contract, and therefore you’re okay, and you can now fit your strategy within a UCITS fund. By way of example, commodities is an area where there tends to be the tension with this concept, because exposure to a commodity directly is not permitted by a UCITS fund. Using an OTC contract in order to replicate that exposure is also not going to be permitted, because of that fact. So what you need to do if you want to get exposure to this is to do it either through exchange-traded commodity notes or look at using an index of some sort that can replicate that exposure. Those ways are permitted, and continue to be permitted.

One of the things I was hinting at before on indices is that ESMA introduced additional guidelines – these came into effect in February of 2013 – which severely restricted the ability to use proprietary indices in order to replicate managed futures strategies, which has had an impact on that sector. Those guidelines effectively, in addition to introducing additional disclosure requirements, said that if you’re going to have an index that’s eligible for use with a UCITS fund, its constituent parts have to be disclosed. It can’t be subject to anything more frequent than daily rebalancing, so intra-day rebalancing was taken away. And it also has to be such that another party can easily replicate the index. All of those reasons mean that you’re giving away the secret sauce for the strategy, which throws you back to those strategies that either look at using futures contracts that fall within the eligible investments definition for their underlying investments (because it’s not just that it’s the OTC contracts; it’s also futures – they have to be linked to an eligible investment under the UCITS regime) or look at using some sort of exchange-traded commodity, because that will be permitted, by virtue of the exchange listing, to continue to gain such an exposure.

Total return swaps are often used inalternative UCITS funds. You take a portion of the exposure through the total return swap, but again, it has to still be within the definition of a financial derivative instrument for UCITS purposes, so the underlyings still have to be linked back to eligible investments within the UCITS regime. So you do have to do the analysis, but the total return swap does feature in many of the replications of these types of strategies. Either that or a contract for difference (CFD) – that’s the other most common way of doing it. It has also always been permitted for UCITS funds, even before 2007, to use derivative contracts for efficient portfolio management purposes. When used for these purposes they need to be economically appropriate to the fund, consistent with that fund’s risk profile, and with an aim of reducing risk, or reducing cost in order to generate income or capital for the fund.

A very quick word on shorting – because many alternative funds use shorting as part of their strategy. You can get exposure within a UCITS fund, but you can’t exceed 100% of the fund’s NAV. You must use the commitment approach to calculate exposure, so that, together with the 10% leeway you get for borrowing purposes on a temporary basis, means you can go up to 210% in this category. You must have ownership of the assets or cash cover – so that doesn’t really get you that far. So how do you actually then replicate some of the long/short strategies?

What you do here goes back to total return swaps, and it’s one of the reasons I mentioned CFDs. The classic way of getting that is, you would use a CFD that synthetically shorts the position, and then you would secure the CFD using assets of the fund, that would be held as collateral against the contract. The fund would pay dividends on their securities to the OTC counterparty, who will exchange-pay any decrease in value on that contract back to the fund. That’s the classic way for 130-30 funds that some of you may have come across before. We don’t hear so much about them these days; they were very much in vogue in 2008 and 2009. Then the market crisis came and we had the great financial recession, but I think there’s still a future for 130-30 funds and similar types of funds going forward.

On cash and borrowing, because it’s related more to credit strategies, and also fixed income strategies, 20% of assets can be invested in cash deposits. You can also invest in approved money market instruments, and the borrowings themselves are limited to 10%. That could be for temporary purposes, but you can get leverage through the use of derivatives and futures products, because there’s functional leverage built onto the products, by paying margin, and then you’re exposed to a much greater increase on this contract. Within the credit strategies and fixed income strategies, you can also use a variety of bonds as well as debentures. Also there’s been a proliferation of exchange-traded products out there that can be used with different profiles and exposures, to replicate a strategy. Interest rate and FX futures have as their underlying eligible assets under the UCITS Directive, so they can be used quite readily.

Moving forward I wanted to touch upon, very briefly, a growing trend of UCITS funds of hedge funds. The concept of having funds of funds has been permitted since the inception of the UCITS regime – so this isn’t anything particularly new. The general rule is to limit exposure to 20% in any one collective investment scheme, but they do need to be regulated investment schemes. One thing that you may find of interest, because I don’t think it’s that well known, is that you can establish your own fund of funds, and each of the underlying funds within it can be managed by the same manager. So that potentially opens up a few more opportunities.

So can a hedge fund strategy be used? We talked about a number of features, with the keys being the risk spreading with the 5/10/40 rule, and monitoring those exposures, and also ensuring that the investments themselves are eligible in the UCITS regime. But applying that to many of the alternative fund strategies out there, you’ll be able to get a traditional equity long/short or market-neutral strategy into a UCITS. You can use it with multi-strategy funds. You can set up a multi-manager platform in a UCITS context. You can use it for merger arbitrage, special situation funds and you can use it for credit strategies. Managed futures funds are more tricky, but depending on the strategy, you can fit into this as well. We’ve just helped one particular managed futures CTA that wanted to just deal with FX and interest rates, so that was relatively easy. We have helped another that did rely upon indices prior to the ESMA guidelines changing the environment in 2013, and we were able to successfully help them in adjusting their strategy to that. It did mean some adjustments, but they were able to do it in a way that was acceptable to them.

So the key if you’re looking at putting an alternative strategy into a UCITS fund is to do some analysis as to whether you have investment types that can fit in. If you don’t, are there alternatives that are suitable for you? Do they allow you to replicate something close to that strategy that you think is going to be attractive to the investors that you’re targeting? Then look through at the risk spreading and concentration rules, because you need to understand those, and your depositories need understanding as well, for monitoring purposes. That also links back to the risk management process (RMP). So for all of these strategies we would expect to see one of these RMP documents in place that is appropriate for the type of strategy being used.

Andrew Massey: One of the key advantages is the ability to utilise the UCITS passport within the European Union. The process for exercising the passport compares very favourably with the AIFMD private placement regime. But the hope is that eventually we may end up with an AIFM passport regime that operates equally as well.

Relating to the exercise of the UCITS passport, although it is a harmonised regime, there are inevitably differences between Member States, so it is always necessary to begin the process by checking the requirements to exercise a UCITS passport in the particular Member State. Differences may include the disclosures that need to go in prospectuses, whether the distributors appointed in the jurisdiction need to be listed in the notification, and the fees payable. A UCITS manager must then update its documents as necessary. A point of interest here: the only document you need to translate is the key investor document (KID); other fund documents can be updated at the manager’s discretion.

You then submit your notification to your home state regulator, plus supporting documents. The home state regulator has 10 business days to review it and by the end of the 10-day period (or earlier if it’s unusual) it transmits it to the regulators of the Member States where the passport is seeking to be exercised. At that point the manager is able to market the UCITS in those jurisdictions. Simple; straightforward.

Where it actually gets slightly more complicated is in maintaining your passport, or the ongoing requirements. It’s necessary to maintain a paying agent in the jurisdiction. It’s also necessary to ensure that changes to the manager and updates to fund documents are provided to all the jurisdictions where the UCITS has exercised its passport, but this does not operate in the same way as for the notifications – you do not send updates to your home-state regulator who kindly forwards it on. Instead you have to contact the overseas regulators individually. So it’s important to be aware of that, and make sure you’re set up to deal with it.

The ability to register or recognise a UCITS outside of Europe is also an advantage of UCITS. There are fast-track approvals available in certain jurisdictions – but note that fast has a special meaning in this context, which is closer to slow, unfortunately. The point to note is that as UCITS become increasingly sophisticated, regulators are increasingly questioning applications, and not necessarily waving through funds simply because they are UCITS. They are looking more closely at investment strategies, so it is important to address this. Contact local counsel in the relevant jurisdiction to identify if there are any red flags.

We shouldn’t be surprised that jurisdictions outside the EU are taking this approach, because that looks to be where we may end up under MiFID II, particularly with the changes to appropriateness. At the moment, the requirement to assess appropriateness is disapplied for UCITS schemes. That’s going to change. It will not be possible to disapply the appropriateness requirement if the product you’re dealing with is complex, and structured UCITS will automatically be regarded as complex products. The grey area is whether there will come a point in time – perhaps beyond MiFID II – when other types of UCITS, in particular alternative UCITS, may be regarded as complex, and if so, what attributes will shift a UCITS into that complex category. But if it is necessary to assess appropriateness in relation to alternative UCITS, that will then have implications for distribution, because of the need to request information from potential investors and to make sure the appropriateness assessment is fulfilled, and not all intermediaries, particularly platforms, will be geared up or willing to do that.

Another general theme relevant to marketing and distribution is the need for product providers, the UCITS manager, to be cognisant of what’s happening down the distribution chain. This was apparent in FCA guidance issued a couple of years ago, emphasising the responsibilities of product providers in relation to the activities of distributors. It was also apparent in FCA enforcement action taken against Credit Suisse and Yorkshire Bank in relation to the distribution of structured deposits, so there are real consequences. It is also a theme that is picked up in MIFID II. We expect to see detailed provisions about where you draw the line, if indeed there is a line, between the responsibilities of product providers and distributors regarding the distribution of products.

Future developments
We’ve covered a number of these throughout this seminar, so just to pick up on a few points.

For UCITS V, the main changes here relate to upgrading the depository function for UCITS to broadly match that which has been introduced for AIFMD. The practical point to note is that if you’re a UCITS manager, you will shortly be receiving telephone calls, emails, people knocking on your door from depositories, to talk about upgrading or replacing the depository agreement, and maybe even talk about fees.

UCITS V will also affect the remuneration of personnel within UCITS management companies. We have the Directive provisions. We are currently waiting for the ESMA guidelines to work out whether there are going to be aspects that may differ from those which were introduced for AIFMD – so here it’s a case of watch this space.

UCITS VI so far has just taken the form of a very, very high-level consultation paper where possible ideas for future reform were mentioned. No firm proposals were set, and indeed some of the topics raised have been addressed by other means – for example, the reform of money-market funds set up as UCITS willbe subject to a separate regulation, as is the proposal for European Long-Term Investment Funds (ELTIFs). Originally it was proposed that this brand of fund (for the purposes of facilitating retail investment in infrastructure products) should piggy-back off the UCITS regime, i.e., be put through a UCITS vehicle. There was a strong reaction against that, with the result that ELTIFs are going to be a type of AIF, but with the unusual aspect that they will be intended for retail investors. At the moment, the promotion of AIFs to retail investors is subject to a Member State discretion.

The final point to note is the introduction of the Packaged Retail and insurance-based Investment Product Key Investor Documents – happily abbreviated to “PRIIPs KIDs”. This is important for UCITS because it will level the playing field for point-of-sale disclosure, and for similar, roughly equivalent products. It will apply to insurance contracts that are used for investment purposes, structured deposits, and similar instruments from next year. There is a transitional period for UCITS – three years, towards the end of which there will be a review. We’ll discover whether the KIID in its current form for UCITS will remain, or whether there’ll be changes which will bring it more into line with PRIIPs KIDs.