One of the cornerstones of the European Union’s UCITS (Undertaking in Collective Investments in Transferable Securities) directives governing investment funds suitable for sale to the general public is the concept of investor protection. Built up by a series of laws that have come into effect between 1988 and July 2011, the UCITS regime aims to provide individuals with a secure environment for fund investing. It sets out universal rules on how these funds should be structured, managed and governed, and how their assets should be safeguarded.
The current UCITS rules were introduced in Luxembourg through the law of December 17, 2010, supplemented by circulars and guidance from the country’s financial industry regulator, the Commission de Surveillance du Secteur Financier (Financial Sector Supervisory Authority, or CSSF for short).
Funds that meet these criteria can be sold freely to the public in any EU country, provided that they meet the standard UCITS notification requirements. Arguably the UCITS standards of investor protection are the most important factor in their development over two decades into a trusted brand not just in Europe but worldwide. Therefore it’s worth taking a closer look at various important aspects of investor protection contained in the UCITS framework:
UCITS funds are subject to rules on what kind of assets they are allowed to invest in (eligible assets), which you will find in the investment policy section of a fund’s prospectus. Generally they must invest in transferable securities or in other liquid financial assets – for example, money-market instruments, bonds, shares and any other instruments offering the right to acquire these securities through subscription or exchange, as well as other funds and bank deposits.
Under certain conditions they may also use financial derivative instruments, such as futures, options or swaps based on an eligible UCITS asset or an approved financial index – either for investment or hedging purposes (to reduce the risk of the portfolio). Since the UCITS directive defines eligible assets in general terms, European regulators have issued additional guidelines to ensure there is a common understanding of what kind of assets may be acquired by a UCITS fund.
Diversification is a vital means of reducing risk for investors of all kinds, from the biggest pension schemes to individuals putting their savings into funds. Different types of fund give investors access to asset classes and strategies whose performance may vary according to the market and economic conditions. The vast range of UCITS funds on the market offers investors diversification in terms of the assets in which funds invest, the economic or business sectors they cover, and the countries or regions where investments are located.
Since UCITS funds are designed to be suitable to the retail investors, their rules build in certain levels of diversification with the aim of reducing their vulnerability to the performance of a small number of assets. In general, the more different assets a fund holds, the less the risk to investors of losing a substantial portion of their portfolio if one particular asset falls in value.
The most commonly known restriction is the so-called 5/10/40 rule. This says that a maximum of 10 per cent of a fund’s net assets may be invested in securities from a single issuer, and that investments of more than 5 per cent with a single issuer may not make up more than 40 per cent of the whole portfolio.
There are some exceptions to this rule. For example, where the fund is replicating a stock market or other index, the maximum limit per issuer is 20 per cent of net assets (or 35 per cent in exceptional circumstances).
An individual investment in another fund must not exceed 20 per cent of assets, while no more than 30 per cent of the UCITS fund’s portfolio can be invested in non-UCITS funds. In addition, UCITS funds may not make an investment in another fund that amounts to more than 25 per cent of the other fund’s total assets.
In accordance with the principle of risk-spreading, the regulator of a UCITS may authorise it to invest up to 100 per cent of its assets in securities and money-market instruments issued or guaranteed by EU member states or local authorities. In this case the fund should hold securities from at least six different issuers, and securities from a single issuer should not account for more than 30 per cent of its total assets.
There are a range of further limits, all designed not to eliminate all risk but to keep it within bounds suitable for ordinary investors. These rules cover investment in assets that are not listed or traded on a recognised exchange, the use of derivative instruments such as futures and options, and counterparty risks (the risk of default by the other party to a fund’s transaction)
The UCITS fund’s prospectus should contain detailed information in the prospectus and indicate in which categories of assets the fund in question is authorised to invest. It should also mention whether transactions in financial derivative instruments are authorised. If so, the prospectus should state prominently whether the derivatives transactions are for the purpose of hedging, or to meet investment goals, and how the use of derivatives may affect the fund’s risk profile.
One of the most important characteristics of UCITS is the ease of buying or selling a fund’s shares or units. This means that investors wishing to sell their holdings in a fund, whether because they believe the value may fall or for any other reason, can do so without delay. As a general rule investors may buy or sell UCITS shares or units at least twice a month, subject to limited exceptions, but in fact the vast majority of UCITS funds offer daily liquidity.
The sale or purchase price is determined by the Net Asset Value per share or NAV. NAV is equal to the net assets of the fund divided by the number of shares or units held by investors. In most cases sales and purchases are subject to fees and commission charges. Exchange-traded funds (ETFs) that are UCITS, which are themselves listed and traded on public markets, may enable investors to buy and sell shares at any time those markets are open. However, their ability to trade and the price offered will depend on the availability of other buyers or sellers.
For investors to have confidence in a UCITS fund, they must be able to trust the valuations it uses for individual assets and for the NAV. Investors buy shares or units in a UCITS without knowing the exact price, which is only established after the deal has been placed. As a rule, the latest official market closing prices must be used to value publicly-traded securities, otherwise a ‘fair market value’ must be provided. This is designed to offer protection against late trading, market timing and other practices that can affect the value of a fund.
There are also prescribed rules for valuing certain assets such as short-term commercial debt and OTC derivative instruments (short for over the counter) that are not listed or traded on public exchanges. The management company of a UCITS fund must put in place valuation procedures for derivatives that are appropriate to their level of complexity, and details of the process must be disclosed to investors. The manager may appoint an outside firm to carry out such valuations. If it does so in-house, the process must be independent of the portfolio management to avoid conflicts of interest.
All investments involve at least some risk. What is important is that a UCITS fund adheres to the level of risk it has told investors it will take. Managers must have procedures to measure the risk of a fund’s investments at all times, and the risk management function must be independent of the portfolio management activity, to minimise the possibility of conflicts of interest. The manager may hire an outside firm to provide risk monitoring and measurement if necessary.
The risk management procedure for a UCITS fund must be appropriate, fulfil specific requirements, be described in detail, and approved by the CSSF. One of the best-known approaches to measure the risk of loss of the fund’s investments is value at risk or VaR, but others may be used as long as the regulator agrees that this is appropriate for the fund’s risk profile. The use of an advanced risk methodology is required where the fund is following a complex investment strategy or where it invests significantly in derivatives.
The investment compliance function, which in some companies is a part of the risk management function, must monitor compliance with the fund’s policy and procedures and with the UCITS investment and diversification rules; it reports to the fund’s board of directors on its activities, including details of any remedial action taken to correct deficiencies. It will also alert the fund manager’s executives to actual or potential breaches of limits, and should oversee valuation procedures for OTC derivatives.
Oversight and safekeeping
There is broad range of supervision, checks and balances at different levels to ensure that the interests of investors are protected.
First, management and investment companies of UCITS are responsible for the oversight of the fund’s activities and the safeguarding of investors’ interests. They must have a supervisory and governance framework for taking decisions, hold regular board meetings, and appoint officers responsible for operation of the fund. They must have and employ efficiently the resources and procedures necessary for the proper conduct of its activities. The fund must be managed in accordance with the management regulations and in the exclusive interests of the investors. It also should be noted that a management company is liable to the fund’s investors for any loss resulting from failure to carry out its obligations.
An important role belongs to the depositary, which under Luxembourg law must be a bank approved by the CSSF and must be registered in Luxembourg or have a branch there if based in another EU country. The assets of the fund must be entrusted to a depositary for safekeeping.
The depositary must at all times keep the assets of a UCITS fund segregated from its own and the manager’s assets. The strict separation of the management company and the depository bank and their obligation ensures, for example, that the fund’s assets – which belong to its investors – cannot be seized to pay creditors should the management company run into financial difficulty.
The depositary has additional important monitoring functions. It must ensure that the sale, issue, repurchase and cancellation of fund units or shares are carried out in accordance with the law or the management regulations. It oversees the collection and deployment of the fund’s income from investments such as dividends. Finally, it ensures that the NAV calculation is carried out according to the fund’s own rules.
The depositary is also liable to the management company and the fund’s investors for any loss suffered as a result of its unjustifiable failure to perform its obligations or negligent performance of them.
One of the foundations of the UCITS investor protection principles is that the depositary and the management company – in the context of their respective roles - must act independent and solely in the interest of investors.
To ensure compliance with all the rules, Luxembourg-based managers and providers of certain services to UCITS funds as well as funds themselves and their depositaries are licensed and supervised by their home regulator, the CSSF, and must provide information to the regulator regularly. In addition they are subject to internal and external audits, whose reports are made available to the regulator.
Readily accessible, comprehensible and up-to-date information is one of the best kinds of protection for investors. It can prevent them buying a fund that is not appropriate for their needs or risk profile, and alert them if the fund is not being run in the way its promoter has promised.
According to the UCITS rules, the fund must publish a prospectus, annual and semi-annual reports, and a Key Investor Information Document, or KIID. The KIID replaces another document known as the simplified prospectus, and all UCITS funds must have them at the latest by July 1, 2012.
The fund prospectus provides comprehensive details of the fund’s investment goals and strategies, and of the inherent risks, and may contain past performance information if applicable. It will also state how the fund is valued and the terms and conditions for buying or selling shares or units. However, the prospectus can be hard to read and understand for non-experts. The KIID has been created to fill the gap as a concise but full overview of the fund’s main features, written in plain language and produced in a standard format (mostly on two A4 pages).
The KIID informs ordinary investors about how a fund operates, what it invests in, the level of risk of its investments, a history of its performance, and details of the regular costs that will be deducted from the fund’s assets. Fund managers must produce a KIID for every UCITS fund they market (in appropriate languages for each country) and for each distinct class of shares or units. New ones must be produced in the event of significant changes to the fund, and at least every year.
The KIID should provide enough information for an investor to understand whether or not the fund in question is suitable for them. It uses a measure known as the Synthetic Risk and Reward Indicator to show its targeted risk/reward profile on a scale between 1 (the lowest level of risk and potential reward) and 7 (the highest level). The KIID should also discuss non-performance risks such as exchange rate fluctuations that might affect investor returns.
A fund’s annual report provides details of its investments and performance and includes commentary from the fund’s manager about developments over the financial year. The annual report (and a semi-annual report) provide investors with the information to help them judge whether the fund is being managed in the way they have been promised and whether it is still appropriate for their investment needs. An independent audit of the accounts provides the assurance that the published numbers are accurate.