The regulatory road to efficiency

The Ucits legislative framework has shaped the ETF industry within Europe and beyond. With the next phase of Ucits on the horizon, the market is set to become even more efficient, as Helen Fowler reports

European legislation might not sound like much to set the average investor’s pulse racing, but without the European Parliament’s ground-breaking series of legislation on Undertakings for Collective Investments in Transferable Securities (Ucits), the ETF industry in Europe today would be almost unrecognisable. 

The series of directives, designed to safeguard investors and increase market confidence, is widely seen as responsible for making the $192bn European ETF market what it is today. “The current form of the ETF industry is based around Ucits,” said Michael John Lytle, marketing director at ETF provider Source. 

Ucits is a stamp of EU regulatory approval for standard funds and ETFs across all 27 member states. Leading ETF providers recognise it as the mark of a stable, well-regulated investment product. Jean-Michel Loehr, chief industry and government relations officer at RBC Dexia, said: “Since their founding directive was launched in 1985, Ucits funds have won a huge and appreciative audience among global investors.”

It has become accepted practice for almost every ETF in Europe to have the hallmark of Ucits status. Deborah Fuhr, global head of ETF research at Barclays Global Investors (BGI), said: “Ucits is a recognised brand everywhere outside the US and that has done the ETF industry a lot of good. Ucits is a set of regulations that people know and understand.”

So successful is the Ucits hallmark that its influence has spread outside of Europe. Over 40% of net new Ucits sales are outside the EU, notably in Switzerland, South America and Asia. 

Manooj Mistry, head of db x-trackers UK, said people take Ucits status now as a given. He added: “If anyone wants to launch an ETF business in Europe, it has to be Ucits-compliant. It gives you the ability to passport and list your funds in different jurisdictions.”

Ucits III – the rise of swap-based ETFs

The 2001 directive known as Ucits III, an addition to earlier regulations, is credited with the inexorable rise of swap-based ETFs, many of them provided by newer market entrants such as banks and brokers, which are challenging the traditional dominance of passive asset managers. The latter group of ETFs typically hold physical assets rather than derivatives to underpin their products.

“Prior to Ucits III, funds could only use derivatives for efficient portfolio management,” said db x-trackers’ Mistry. By allowing funds a maximum 10% exposure to derivative counterparty risk, Ucits III effectively ushered in a new type of ETF provider and opened the door to different industry participants. 

Lyxor Asset Management and db x-trackers are respectively the second and third largest ETF providers in Europe, with a joint 37% market share, according to BGI. Both run exclusively swaps-based ETFs. “The banks and brokers who have entered the market recently using swap-based ETFs could not have done products in that way prior to Ucits III,” said BGI’s Fuhr. Lyxor is owned by French bank Société Générale and db x-trackers by Deutsche Bank.

Demand for swap-based ETFs is high, as seen by the growth in assets among swap-based providers entering the market. For example, assets at db x-trackers have mushroomed to £22bn in less than three years since the firm’s launch. Since Source, the joint venture founded by Morgan Stanley, Goldman Sachs and Bank of America Merrill Lynch, launched its first swap-based ETFs in April, its assets have grown to $1.8bn. 

The 2001 directive also made an important change in how much a fund may invest in other investment vehicles, a development that has made it easier for standard funds to invest in ETFs. Until eight years ago, a Ucits fund could only invest up to 5% of its assets in other funds, which hampered investment in ETFs. Now funds may invest up to 20% of their assets in other funds, provided they do not own more than 25% of the fund in which they are investing. “That change has meant that people are using ETFs in their portfolios much more,” said BGI’s Fuhr.

Ucits III also differs from earlier Ucits legislation by allowing investment in a much wider range of underlying asset classes, although certain restrictions still exist. Chief among these is the ‘5/10/40’ rule, under which no single security may exceed 10% of the ETF’s net asset value and the total number of holdings exceeding 5% may not cumulatively exceed 40%. In addition, a fund – or ETF – may not hold more than 10% of the issued debt securities of a single issuer, though experts say this rule is rarely problematic in practice. 

Non-compliance

When it comes to commodities, an ETC or ETN cannot have Ucits status, as both are securities and so do not qualify as collective investment schemes under the Ucits umbrella. However, ETCs and ETNs may count as a permitted or ‘eligible’ investment for other Ucits funds to purchase. 

Most leading commodity indices do not conform to the permitted Ucits weightings, but this has not stopped firms from building ETFs around them. John Davies, senior director at Standard & Poor’s Index Services, said his firm has gained significant amounts of new business from clients asking for customised commodities indices, so they have weightings on which they can build Ucits-compliant ETFs. Davies said: “We are building new versions of existing indices that meet these parameters, so clients can launch Ucits-compliant funds.” 

However, leading ETF providers say they are happy with the degree of investment flexibility allowed under Ucits. “We have been able to do a lot of product innovation within Ucits,” said db x-trackers’ Mistry. “In the two and a half years since we launched, we have developed ETFs on hedge funds, currency strategies, commodities and credit indices.” 

In February last year, db x-trackers became the first firm to launch a Ucits-compliant ETF based on the Vietnamese stock market. Mistry said: “We made sure the index satisfied Ucits requirements, which meant the components were diversified, liquid and tradeable. It was a challenge but we made sure everything was compliant.” Andrew O’Callaghan, advisory leader for PricewaterhouseCoopers’ asset management practice in Dublin, said the Vietnam ETF was an example of what can be achieved under Ucits regulation, provided the right risk control is put in place.

Mistry said Ucits regulation had not hampered his firm’s investment plans. The Middle East and Africa for example are two places where db x-trackers has not yet launched ETFs. He said: “It’s not Ucits regulations holding us back. It’s a function of the practicality of running an efficient product on something not very liquid.” He added this reflects the difficulty in hedging and getting liquidity in those markets. 

The Ucits hallmark is expected to play a part in developing the fledgling European retail market for ETFs, currently estimated to be only around 10% of the client base, according to Mistry at db x-trackers. As recommendations of the Financial Service Authority’s Retail Distribution Review take effect in the UK from 2012, increasing numbers of private investors look set to invest in ETFs, encouraged by the safety net of Ucits protection. Mistry estimated: “Within five or six years’ time we will see that retail investors could account for 40% or 50% of ETF assets. And that is in a growing market, without taking market share away from institutional clients.”

Ucits IV – a new hope

Ucits regulations already allow ETF providers to ‘passport’ an ETF registered in one country into another one. Under Ucits IV legislation, due to be adopted by EU member states by July 2011, distribution is set to become even easier. PwC’s O’Callaghan said: “Ucits IV is designed to make it easier to sell funds cross-border and should facilitate the effective selling of ETFs.” Key Ucits IV goals include reducing providers’ cost bases, rationalising fund ranges, streamlining market entry and simplifying documentation.

Ucits IV will make it easier to merge funds, including ETFs, into one another, potentially creating cost efficiencies. Another measure aimed at reducing costs is a structure called the master-feeder, which will allow for greater economies of scale. One effect of the initiative, O’Callaghan predicts, is that cost ratios for non-ETF funds may decline, although he does not envisage they will narrow to the point where costs are the same as for ETFs.

Under Ucits IV, ETF providers will be able to provide key investor information via websites for the first time, rather than the present paper-only format. Documentation approval will depend solely on the home member state authority, not, as is currently the case, on both home and host states. The host regulator will no longer be permitted to alter the investor information and official documents will no longer all be translated into host language. 

Under the current Ucits regime, passporting ETFs into other countries can take up to two months. PwC’s O’Callaghan said: “Ucits IV should facilitate faster market entry”. Under Ucits IV, a provider should in theory be able to start marketing a fund as soon as the home authority confirms it has sent through the relevant material. 

The move is designed to address issues of protectionism in some markets. O’Callaghan said that it is possible to complain if it takes longer than a month to passport a fund, and the local regulator is “dragging its heels,” although in practice this does not occur. He added: “This change in the notification process is very relevant for ETFs and, if it works, should assist in the effective distribution of ETFs across Europe.” Providers say they are hoping that Ucits IV will do for ETF distribution what its earlier incarnations have already done for investment strategy, taking fund distribution to another level by further opening up the European market and reducing remnants of protectionism.