The Case for Labeling Newcits as Complex

Robert C. Pozen

If a fund uses derivatives heavily, does it become too complex for the average retail investor? That is the critical question facing the global fund industry right now.

The issue is particularly topical in Europe, where regulators have proposed that funds using derivatives extensively should be designated as “complex”, and be subject to more stringent rules on sales and marketing. The proposed rules would apply to Undertakings for Collective Investment in Transferable Securities Directives (UCITS) funds, which can be sold throughout the European Union using a simplified cross-border registration system.

When UCITS funds first appeared in 1984, they were plain vanilla investment vehicles. They could only buy stocks and bonds: no commodities, no short selling and only limited use of derivatives.

This simplicity served the European fund industry well. UCITS quickly became a trusted brand for core savings – not just in the EU, but in many other countries around the world as well, especially in some of the fast growing emerging markets.

Investors looking for more complicated strategies had to turn to hedge funds or other private investment pools – or at least that was the case until the middle of the last decade, when the list of permissible investments for UCITS funds was expanded to include credit default swaps, index futures and asset-backed securities, among other instruments.

In fact, most derivatives can now be held in a UCITS portfolio – and those derivatives can be used to generate substantial leverage, up to twice the value of the underlying assets.

Derivatives enabled UCITS to gain exposure to non-traditional investments, such as commodities, and provided the prospect for outsized gains – accompanied by the risk of large losses. UCITS using derivatives quickly became popular with investors looking for more aggressive portfolio approaches. According to FINalternatives, a source for hedge fund and private equity news, there are now over 1,000 of these “sophisticated UCITS” funds registered in Europe today.

But if these “Newcits” funds, as these sophisticated versions are widely known, have proved popular with some investors, they have raised red flags with regulators, who worry they are being sold to individuals who are not fully aware of their risks.

To fend off consumer complaints, the chief European securities regulator – the European Securities and Markets Authority or Esma – made a radical proposal this summer. It suggested dividing UCITS funds into two categories: non-complex and complex.

Fund distributors would be allowed under the proposal to sell non-complex UCITS to individuals without having to enquire first into their knowledge and/or experience with investing. In the regulatory jargon, they can continue to make “execution-only” sales.

For complex UCITS, however, distributors will have to go a step further. They will be required to apply an “appropriateness test”, assessing whether the client has sufficient knowledge of the markets to understand the risks involved.

Not surprisingly, such a sweeping proposal has both its detractors and its proponents. One of the most often cited negatives is the difficulty of defining what constitutes a complex fund. While this task will be challenging, there will be ample time to find the right answer. Esma will not begin this process until after the European Parliament’s vote on the proposal, which will not occur until early 2012. Opponents also worry that a divided UCITS brand will only confuse consumers.

Supporters of the categorisation approach suggest it will strengthen UCITS’ competitive position in Asia, a key market for European funds. Over 5,000 UCITS funds are already sold in the region, and prospects for growth are among the best in the world. Economic growth has been strong and steady, and many countries have established mandatory savings programmes that channel some of the new wealth into long-term investments – which are often UCITS funds.

Asian regulators are worried that, without controls, there is the potential for an unsophisticated investor in one of these programmes to end up owning a sophisticated UCITS. To avoid this mismatch, Hong Kong and Singapore have already imposed restrictions on funds that use complex strategies. Esma’s proposal obviates the need for this local regulation.

We believe both investors and the industry will be well served by clearly labelling some UCITS funds as complex and requiring a stricter vetting of customers for such funds. If clients are better matched to funds, there is less potential for risk-averse investors to experience unexpectedly large losses. At the same time, non-complex UCITS funds can continue to be a trusted brand for core portfolio positions.