The MiFID review proposes a change in the classification of more sophisticated Ucits funds that could threaten the growth of these new products. Nicholas Pratt investigates.
When the Markets in Financial Instruments Directive (MiFID) was introduced in 2007, it was heralded by exchanges, brokers and investment banks as the most important piece of legislation since the “big bang” (the deregulation of stock markets, not the creation of the Earth). The aim of MiFID was to create a competitive and harmonised, pan-European securities market that would deliver better value and greater protection for the end investors. But for most fund promoters and distributors, MiFID barely registered.
This could change once the current MiFID review is complete and new legislation is introduced, particularly for those distributors and promoters that are invested in the rapidly growing alternative Ucits, or “newcits” market. Up till now, all Ucits funds have been classified as non-complex products under MiFID, meaning that they can be freely sold directly to retail investors without the need for certain appropriateness or suitability tests. Under the proposed review, however, some of the more sophisticated Ucits products may no longer be seen as non-complex products and this change of classification will require more work from promoters and distributors before the products can be sold to an investor.
Industry concerns
Luxembourg, along with Dublin, lies at the heart of the Ucits market, and the MiFID review is causing some concern, as seen by the strong opposition expressed in the various responses to the MiFID consultation paper. The Association of the Luxembourg Fund Industry (Alfi) stands at the forefront of this opposition. “The commission would say that the MiFID review is in the interests of the investor and will address the concern that an investor may not know what they are buying,” says Alfi’s deputy director general Charles Muller. “At Alfi, we support any proposal that improves things for the investor, but we do not think this is the right way to go.”
Muller’s two major problems relate to the issue of defining and categorising different Ucits funds and the inference that complexity equals greater risk. “Every Ucits follows the Ucits rules but once you start making categories, you are splitting up the system.” And then there is the correlation between complexity and exposure. “Just because one fund is more sophisticated, does not make it more risky or necessarily unsuitable for a retail investor. Classic long-only, simple products like Greek bonds, for example, are very risky right now. So not only will it be difficult to find common ground on the definitions, you could also end up with sophisticated products that are ‘complex’, but not risky and vice versa,” says Muller.
Alfi is not alone in its stance towards the MiFID review. “Responses to the MiFID consultation seem to be universal in disagreeing with the need to introduce a new sub-category for Ucits such as complex or non-complex,” says Jon Griffin, managing director of JP Morgan Asset Management in Luxembourg. “If the complex category came in, I don’t think it would do anything to damage the Ucits brand, but it could create some distribution issues in terms of who the funds are offered to which in turn could create capacity constraints and a shortage of liquidity in certain strategies.”
Currently under Ucits III rules, the fund board has to decide if a product is “sophisticated” which is normally based on whether derivatives are used for more than just hedging, says Griffin. “Such funds are then subjected to value at risk monitoring. Certainly in Luxembourg the local regulator pays a lot of attention to each firm’s risk-management process to ensure that they are satisfied with how the fund is controlled. If the complex category came in, I assume this would mean that distributors would have to perform suitability checks.”
Protecting the investor
It is difficult to find anyone within Luxembourg’s funds industry who agrees with the MiFID review’s proposals. Even the service providers who would profit from the greater administrative burden placed on fund promoters and distributors don’t agree. “As a service provider, I’m generally happy with more complexity and more data,” says Bob Kneip, the founder of Kneip, which provides data management services to Luxembourg’s asset managers. “But I believe the MiFID review would be bad for the industry and that would be bad for me.”
Kneip also believes that the MiFID regulators are now aware that its review proposals might be bad for the industry. “I think regulators always begin the consultation process by overstating their case and I think that is the case with the MiFID review. The first draft is disproportionate. The number of sophisticated Ucits funds in the Luxembourg market is very small, but the measures from the MiFID review would penalise the whole industry – investors and asset managers alike.
“Asset managers would face a huge burden in testing the appropriateness of potential investors and the definitions involved would be open to interpretation which would create more discomfort for investors.
“Regulators are primarily concerned with protecting the investor but increasing disclosure is not always the best solution,” says Kneip. “They need to work out exactly how much investors need to know about a product because there is a cost involved on both sides – for the asset managers that have to produce the reports and the investors that need to go through them all. I think the Kiid [key investor information document] does this better than the MiFID review proposes to. But I think the regulators are beginning to recognise this and are likely to soften their stance once all of the industry’s responses are received and the next draft is produced.”
The commission may also recognise that the funds industry has done a pretty good job at policing itself when it comes to Ucits products, even the sophisticated ones. There is already a requirement under Ucits III to monitor the delegates of a Ucits fund as part of the board of directors’ responsibility, and new guidelines for Ucits IV will further strengthen the regulatory safeguards that exist. For example, Ucits IV includes the Kiid rules, which require specification on the risk factors within each product – something which Kneip thinks provides more assurance for investors than the MiFID review proposes to.
Extra requirements
At best, the MiFID review will serve to underline these existing safeguards. Antonio Thomas, managing director at RBS Luxembourg, says: “MiFID, as with Ucits IV, will encourage Ucits boards to further review the information and reporting they are receiving from their service providers to ensure that they can continue to comply with regulatory requirements and execute their oversight obligations.“
Boards will need to ensure that the promoter of the collective investment scheme reports back to them on how they are ensuring compliance with MiFID both at their level and at the level of any sub distributors they may engage to distribute the fund. Some of this reporting may also satisfy any additional reporting boards to in respect of conflicts and inducements under Ucits IV.”
But Thomas does not believe these extra requirements will be so onerous as to create any issues in the distribution and growth of the alternative Ucits market in Luxembourg. “I don’t see any immediate reversal of the trend,” says Thomas, not least because the growth has come from investors outside the remit of MiFID in that they are neither retail nor European.
“The investors in these products have typically been sophisticated players from the alternatives world, often from the US, Asia and the Brics, who are already invested in other non-Ucits, non-European funds managed by an alternative investment manager. The managers from these regions often engage services like our own to help support them when dealing with new regulatory environments. So given further regulatory changes and increasing governance requirements which will be implemented over the next few years, it is not unreasonable to expect this trend to continue.”
In fact, the MiFID review may even help to highlight the efforts made by the Luxembourg funds industry in recent years, supported by the local regulator, in respect of further enhancing governance and oversight of Ucits in the traditional and alternative space, says Thomas. But in Luxembourg, the preference is for any further safeguards on Ucits to come from the industry rather than the commission. “In Luxembourg, we recognise that the issue of safeguarding the Ucits brand exists and that it has intensified since hedge fund managers have begun launching Ucits funds,” says Michèle Eisenhuth, partner in the regulated investment funds practice at Luxembourg-based law firm Arendt & Medernach. “However, we think that it is better for the industry to address this rather than have regulations imposed. It is not the purpose of MiFID to define what is complex and non-complex within Ucits and there is no need to add further obligations on distributors and promoters.”
Eisenhuth is right to recognise that this issue over what is complex and what isn’t within the Ucits framework is unlikely to go away and that the highly regarded Ucits brand will need to be protected. Consequently, Luxembourg and the likes of Efama are attempting to pre-empt any further commission-led reviews and be pro-active in persuading other jurisdictions, such as France and Germany, that all that money being sent out of the country via Ucits investments is adequately protected.
“We would like to see some guidelines that would be used by all parts of the industry – promoters, distributors, lawyers, auditors and administrators – to ensure that they are fully able to service these funds before launching them,” says Eisenhuth. “The guidelines could also be used by investors to ensure that the right questions are raised before they invest in a newly launched Ucits fund.”
©2011 funds europe
