The original 1985 UCITS Directive provided for investment into transferable securities. However, in the time since the first UCITS Directive (1985), innovations in financial markets meant that a range of financial products could arguably fall within the scope of “transferable securities” and hence be UCITS eligible assets.

Also, the UCITS III (Product) Directive opened up a wider range of eligible assets within the scope of regulated collective investment schemes, beyond investment into transferable securities. With this increased scope came greater uncertainty about the range of investments permitted.

Therefore, the Committee of European Securities Regulators (CESR, which is now ESMA) was mandated in 2005 by the European Commission to consult on the issue and to formulate Recommendations and Guidelines for the eligibility of assets for investment into by UCITS.

This CESR consultation process began in March 2005 and effectively ended in March 2007 with publication by the European Commission of the EAD to accompany the publication of CESR’s final guidelines on eligible assets

The aim of the EAD is, therefore, to achieve greater certainty and a more consistent implementation of the UCITS Directive as amended by the Product Directive.

The UCITS Directive

Article 1(2) of the UCITS Directive states that the sole object of a UCITS is collective investment in transferable securities and/or other liquid financial assets referred to in Article 50(1) .

Article 50(1) sets out eligible assets in which a UCITS scheme may invest. These assets, include:

The eligibility of each of the above assets type is subject to certain conditions being met. These conditions are set out in the UCITS Directive, and now additionally in the EAD and CESR’s Guidelines.

The EAD provides that, in order to be a transferable security:

Importantly, the issue of liquidity is to be understood in the context of the UCITS ability to redeem at the request of unitholders.

All transferable securities must be treated in the same way under Article 50(1) or Article 50(2) (max 10% in transferable securities not on an eligible market). However, it is recognized that unlisted or unadmitted securities cannot meet identical standards to those of listed or admitted securities elsewhere; in particular:

Structured Financial Instruments

The Directive and CESR’s Guidelines specifically confirm that “structured financial instruments”, such as asset backed securities, credit linked notes, similar forms of collateralised debt obligations (CDOs) or notes which are linked to the performance of a certain underlying will also be “transferable securities” so long as they meet the formal and general requirements for recognition as “transferable securities” as set-out above.

Also, there will be no requirement to perform any look-through to the underlying of those securities, unless there is an “embedded derivative” component. See later.

Closed-end funds

In some jurisdictions, such as the UK, investment into closed end funds such as investment trusts has traditionally been acceptable on the basis of their being within the scope of “transferable securities” under Article 1(8). The EAD confirms this by providing that the shares of closed-end funds are now included within the definition of transferable securities.

However, in addition to the requirements to be met by transferable securities, they need also comply with the appropriate safeguards in the draft regulation on corporate governance and national regulation of the management activity.

There is no need to perform a look through to the underlying assets of the closed-end fund.

Three types of money market instruments are defined under the Directive:

In general, Money Market Instruments (MMI) which are normally dealt on in the money markets dealt may be eligible investments for UCITS Schemes, provided that they are liquid and “have a value which can be accurately determined at any time” (Article 1(9)).

The EAD follows CESR’s Level 2 advice in that:

The Directive and CESR Guidelines also provide requirements and Guidelines to be met in respect of:

The EAD and CESR Guidelines clarify a number of issues in respect of FDI.

Eligible Underlyings

The UCITS Directive sets out the range of acceptable underlyings for Derivatives (such as transferable securities, CIS units, deposits and MMIs). The EAD clarifies that this also includes combinations of these assets, interest rates and of foreign exchange.

Credit derivatives

The Directive specifically acknowledges that credit derivatives are included within the definition of financial derivative instruments, although lays down some specific requirements, namely:

OTC derivatives

Article 50(1)(g) of the UCITS Directive provides that UCITS can invest in OTC derivatives’, provided that:

“The OTC derivatives are subject to reliable and verifiable valuation on a daily basis and can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS’ initiative.” Also, per Article 21.1 “[The management company] must employ a process for accurate and independent assessment of the value of OTC derivative instruments.”

The EAD provides that for these purposes “fair value” means the amount for which an asset could be exchanged or settled between knowledgeable, willing parties at arms length.

Accurate and independent assessment of the value of an OTC would be a process which enables the UCITS throughout the life of the derivative to define the investment reliably reflecting an up-to-date market value. If no reliable up-to-date market value is available, the value should be based on a pricing model which is, in turn, based on an adequate and accepted methodology.

Derivatives on financial indices

For the purposes of applying Article 1(2) UCITS Directive in conjunction with Article 50, derivative instruments on a financial index will be eligible if the reference index is one:

The Directive provides guidance on each of the above points. If the index is composed of eligible assets and complies with the diversification ratios in Article 22a(2) of the (original) Directive (now Article 53 in consolidated UCITS Directive) then it does not have to be combined with other assets to avoid the undue concentration rules. If the index is not composed of eligible assets, then to be acceptable, the index must be diversified in accordance with the ratios of Article 53.

Derivatives on hedge fund indices

As at March 2007, CESR was unable to conclude on whether hedge fund indices should constitute eligible underlyings for derivatives for UCITS’ investment. CESR undertook to perform additional work on this issue and in July 2007 published Guidelines aimed at addressing the perceived issues with hedge fund indices, including “back-filling” and “survivor bias.”

A transferable security or money market instrument will embed a derivative where it contains a component:

The importance of this is that the embedded derivative component must be held in accordance with the UCITS derivatives powers – e.g. need to look-through etc. to the underlying.

Under its Level 3 advice, CESR set out an “illustrative and non-exhaustive” list of structured financial instruments or ‘SFIs’ which could be assumed to embed derivatives. This list includes credit linked notes, convertible bonds and exchangeable bonds.

Article 1(2) states that UCITS can invest in transferable securities. Article 1(8) states that “techniques and instruments” referred to in Article 21 are excluded from the definition of “transferable securities.”

Article 21 provides that: “Member States may authorise UCITS to employ techniques and instruments relating to transferable securities and money market instruments under the conditions and within the limits which they lay down provided that such techniques and instruments are used for the purpose of efficient portfolio management.”

The Directive and CESR’s Guidelines provide clarity as regards what is meant by “Efficient portfolio management.” This is to be taken to mean (as under the original UCITS Directive) the making of investment decisions which involve transactions which are themselves:

Under CESR’s Level 3 guidance, collateral, repos, securities lending and securities borrowing would all qualify as potentially permitted transaction in transferable securities.

Article 53 of the consolidated UCITS Directive (Article 22 a in the original Directive) permits a UCITS to invest up to 20% of its assets in shares and/or debt securities issued by the same body where the stated aim of the scheme is to replicate the composition of a stock or debt securities index. In certain limited situations, this limit may be raised to 35%.

The index must:

These are the same criteria as seen with Derivatives on Financial Indices, but interestingly the conditions to be met for fulfillment of these criteria in this context differ somewhat, in particular that the provider of the index must be independent of the UCITS.

A UCITS is deemed to replicate the composition of a certain index if the only aim of UCITS is to replicate the composition of the underlying assets of the index. This can be achieved through the use of derivatives, sampling techniques etc.

Under the first indent of Article 1 (2) UCITS Directive, up to 30% NAV can be invested in non-UCITS schemes that meet certain criteria. These criteria, as set out in Article 50(1)(e), are:

This aspect is not included in the Directive although CESR’s sets out in the form of Level 3 Guidelines “indicators of equivalence” in regard to the above two criteria:

Supervision “equivalent to that laid down in community law”,

Investor protection “equivalent to that provided for unit holders in a UCITS