In March 2007, The European Commission published the Eligible Assets Directive (EAD) clarifying the eligibility of assets as investments for a UCITS scheme.
This was accompanied by the publication by the European Committee of Securities Regulators (CESR) of its Final Guidelines in respect of UCITS Eligible Assets. In July 2007, CESR also published final Guidelines on the eligibility of Hedge Fund Indices.
Introduction
BACKGROUND
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:
Transferable securities and money market instruments;
Units of UCITS and/or other (open ended) collective investment undertakings;
Deposits;
Financial derivative instruments dealt in on a regulated market or over the counter; and
Warrants.
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.
DEFINITION OF "TRANSFERABLE SECURITIES"
The EAD provides that, in order to be a transferable security:
The security must not expose the UCITS to loss beyond the amount paid for it;
Liquidity must not compromise the ability of the UCITS to redeem the security;
There must be accurate, reliable and regular prices; and
There must be regular, accurate and comprehensive information available to the market.
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:
Valuation of an unlisted security must be available on a periodic basis derived from information from issues of security or from competent investment research; and
Regular and accurate (but not comprehensive) information must be available to the UCITS regarding security.
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.
MONEY MARKET INSTRUMENTS
Three types of money market instruments are defined under the Directive:
Those dealt in on a regulated market in accordance with Articles 1 9(1 )(a)-(d);
MMI other than those dealt in on a regulated market which meet the criteria in Article 50(1); and
MMI not falling into one of these two categories are eligible assets, subject to the 10% limit.
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:
To meet the criterion of “liquidity”, the MMI must be capable of being sold at limited cost in an adequately short time frame;
The criterion of its “value which can be accurately determined at any time” should mean that accurate and reliable valuation systems should be available to calculate a net asset value in accordance with the value at which MMIs held in the portfolio could be exchanged between knowledgeable willing parties at arms length; and
The expression “normally dealt in on the money market” will include instruments with a maturity of less than 397 days or a residual maturity of up to and including 397 days.
The Directive and CESR Guidelines also provide requirements and Guidelines to be met in respect of:
MMI other than those dealt in on a regulated market which meet the criteria in Article 50(1); and
MMI not falling into one of these two categories are eligible assets, subject to the 10% limit
FINANCIAL DERIVATIVE INSTRUMENTS (FDI)
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:
The credit derivative complies with the conditions of eligibility of derivative instruments;
The end of the transaction can only result in the delivery or transfer of assets (including in the form of cash) which are themselves eligible for the UCITS;
The risk management process should be the same as for OTC derivatives; and
The risks of “asymmetry of information” between the issuers/banks and the UCITS must be taken into account.
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:
Whose composition is sufficiently diversified;
Which represents an adequate benchmark to the market to which it refers; and
Which is published in an appropriate manner.
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.”
TRANSFERABLE SECURITIES AND MMI EMBEDDING DERIVATIVES
A transferable security or money market instrument will embed a derivative where it contains a component:
By virtue of which some or all of the cash flows of the host contract can be modified;
Whose economic characteristics and risk are not closely related to the economic characteristics and risk of the host contract; and
Which has a significant impact on the risk profile and pricing of the host contract.
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.
TECHNIQUES AND INSTRUMENTS FOR THE PURPOSES OF EFFICIENT PORTFOLIO MANAGEMENT
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:
Economically appropriate;
Entered into for reasons of reduction of risk, reduction of cost or the generation of additional capital or income with an appropriate level of risk; and
Whose risks are adequately captured by the risk management of the UCITS.
Under CESR’s Level 3 guidance, collateral, repos, securities lending and securities borrowing would all qualify as potentially permitted transaction in transferable securities.
TRACKER / INDEX FUNDS
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:
Be sufficiently diversified;
Represent an adequate benchmark for the market to which it refers; and
Be published in an appropriate manner.
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.
OTHER COLLECTIVE INVESTMENT UNDERTAKINGS (NON-UCITS)
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:
The scheme must be subject to supervision equivalent to that laid down in Community law; and
The level of protection for unit-holders of the scheme must be equivalent to that provided for unit-holders in a UCITS.
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”,
Whether memoranda of understanding exist or whether the other collective investment undertaking is based in a country which is a member of an international organisation of regulators or other co-operative arrangements which would ensure satisfactory cooperation between the relevant authorities;
Whether the management company of the target collective investment undertaking, its rules;
Choice of depositary have been approved by its regulator; and
Whether the authorisation of the collective investment undertaking is in an OECD country.
Investor protection “equivalent to that provided for unit holders in a UCITS
Whether there is an independent trustee/custodian with similar duties of safekeeping/supervision;
Whether pricing information is readily available;
The facilities and frequency of redemption;
The extent of asset segregation; and
any local requirements for borrowing, lending and uncovered sales.
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