Financial Times

Why European Funds Are Outgunning U.S. Rivals

While the mutual fund was born in the United States, its European cousin – the Ucits fund – is becoming the dominant form of collective investing around the world. Ucits stands for “undertaking for collective investment in transferable securities” and is the name of the directive of the European Parliament that created them in 1985.

To be clear, the U.S. fund industry is still the largest in the world with assets of more than $11,000bn. European funds, by contrast, have less than $8,000bn in total assets.

But Ucits funds are rapidly gaining acceptance in Asia and Latin America – the fund markets that have been growing the fastest and have the highest potential for future growth. Ucits now have a majority share of the funds market in Hong Kong, Singapore and Taiwan. Similarly, they have become popular in government-sponsored retirement plans in countries such as Chile.

Why are Ucits beating out U.S. mutual funds? Because they are taxed more favourably, although the greater investment flexibility of Ucits also plays a role. On the tax front, a U.S. mutual fund must distribute all of its realised capital gains to its shareholders every year. This means that fund shareholders can receive a tax bill, even though they have continued to hold their shares in the fund.

A Ucits fund, on the other hand, is not generally required to distribute its realised gains each year. Instead, these gains are retained by the fund, and its share price increases in value to reflect these gains. Fund shareholders pay a tax on these gains only when they sell their shares in the fund.

The second attractive feature of Ucits is their investment flexibility. They can go beyond traditional stock and bond investing to engage in complex investment strategies often employed by hedge funds, becoming an “alternative Ucits” or “NewCITS” fund. A NewCITS fund might have significant short positions, giving it the ability to profit when securities prices decline.

NewCITS have three advantages over most hedge funds. First, they provide investors with more protections. For example, NewCITS are subject to the same rules as Ucits on conflicts of interest, disclosure of information and segregation of assets.

Second, NewCITS must allow investors to redeem their fund shares at least twice monthly. Investors in hedge funds, by contrast, are usually given an opportunity to sell their fund interests just once during a calendar quarter – or maybe even less frequently – and then only after giving notice.

Most importantly, NewCITS cost significantly less than hedge funds. The fees on a NewCITS will usually be in the range of 1.5 per cent to 2.5 per cent of assets per year. A hedge fund usually charges a similar annual fee plus 20 per cent of the fund’s annual realised net gains – but not 20 per cent of its realised net losses. U.S. mutual funds do not have the investment flexibility of NewCits. They are subject to strict regulatory limits on shorting and leverage and must allow their shareholders to redeem every business day. As a result, they are less able to compete with hedge funds for investor dollars.

Yet U.S. mutual funds have one critical advantage over all types of Ucits: lower fund expenses. The typical U.S. fund has annual expenses that amount to less than 1 per cent of assets – roughly half of the expense level for the typical Ucits.

U.S. funds are less expensive because they are much larger than Ucits. At the end of 2009, the average U.S. mutual fund had $1.4bn in assets – more than six times the size of the average European fund. This size difference is due primarily to the proliferation of funds in the European Union. Amazingly, there were 33,000 funds in Europe in 2009, compared with just 7,600 in the United States that same year.

Another reason U.S. fund expenses are lower is because of intense competition for investor dollars in the US. Here, open architecture forces distributors to offer investors a wide variety of funds from different managers. By contrast, fund distribution in many European countries is dominated by a relatively small group of local banks that tend to prefer their affiliated funds.

In short, Ucits are winning the global contest for mutual funds primarily because of more favourable tax rules, and secondarily because of greater investment flexibility. However, given the budget pressures on the U.S. Congress, it is unlikely to liberalise the tax rules for US mutual funds in the near future.

At the same time, Europe needs to bolster the superiority of Ucits by lowering their expense ratios. This means reducing the number of new funds started each year, and increasing competition among seasoned funds through more open architecture.