UCITS IV: what investment management firms should do to comply and ensure growth

With UCITS IV coming into force from 1 July this year, the main objective is to make the fund industry more efficient while still maintaining a high level of investor protection. Windows of opportunity will be opened for those firms deploying the right investment management software solutions but disparate tax regimes tend to overshadow the benefits of the directive.

By Peter E. Hertel, Domain Manager for Fund Accounting, SimCorp

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The UCITS framework, originating from 1985 and updated several times since then, was intended to allow a real single market in investment funds to develop – since the funds all complied with the same rules, consumers could invest with confidence across EU borders. The rules increase investor protection and cost transparency, and set out basic requirements on organisation, management and oversight of funds.

Undertakings for Collective Investment in Transferable Securities (UCITS) have proved very successful over the past 20 years, emerging as an essential cornerstone in the development of the European investment funds industry. Although intended for EU member states, the UCITS brand has become global and recognised as a well-supervised retail financial product – UCITS funds have become successful in overseas markets such as Asia and Latin America.

UCITS IV is the latest reform of the UCITS directives – a series of efficiency and consolidation measures (see Figure 1) that will allow the industry to address lack of scale, experience cost savings and improve the efficiency of their European operations. It was approved by the European Commission in July 2010 and, pending EU member states’ legislative approval, it will take effect on 1 July 2011.

Figure 1. Most important amendments introduced by UCITS IV. The new directive comprises five new basic elements: two new mandatory changes and three new opportunities.

The directive foresees that the investment fund market will be able to consolidate funds and reduce the number of local management companies, resulting in cost savings and efficiencies. In addition, UCITS funds will become more competitive, and, with easier access to new EU markets, this will result in increased market shares.

The larger industry players by now are well prepared in respect to the mandatory changes (i.e. introduction of the Key Investor Information Document), which will also be in force by July this year. However, they are only beginning to prepare for the new consolidation opportunities.

WINDOW OF OPPORTUNITY

The directive really does open the window for increased cross-border operations. But once the window is opened, investment management firms face big challenges in respect to various tax-regime support and local regulatory specialities. Without a huge extra effort, the 27 different tax regimes of the various EU member states still stand as a barrier for attracting foreign investors.

One thing is to gain the needed tax knowledge, but just as important is to make sure that players have the right investment management systems to implement this knowledge. To obtain the necessary economy of scale, the trick is to sell the same fund to as many investors as possible, but still include their various preferences in respect to special distribution needs, risk preferences (hedge classes), large- or small-scale investments (various fee constructions), performance fees and tax support.

One of the main features of UCITS IV is the master-feeder structure, which provides for pooling of assets. This new fund opportunity adds an additional dimension to the complex tools for modelling structures that can target a larger investor group. Fund management companies have to invest time and/or money gaining the needed multiple taxregime and regulatory knowledge. Then they have to ensure that this knowledge can be implemented in an investment management system, where via a flexible definition and design of fund structures, pricing and fees they can put these changes to good effect. Without this the benefits on offer cannot be utilised.

The UCITS IV directive applies to practically all of Europe and the new master-feeder structure as well. For a long time fund administration centres like Luxembourg have operated with advanced fund structures in the form of multi-class funds and pooling structures.

However, UCITS IV has pushed many other member states into removing restrictions in respect to more advanced fund structures. It is therefore also expected that local fund managers in more member states in general will consolidate their funds and gain economies of scale as a spin-off of UCITS IV . So even the fund manager who only focuses on the local market should also look into the new opportunities in order to stay competitive.

The directive does open new opportunities but also forces changes in respect to cross-border investor communications and investor reporting. But even though this initially will increase costs for fund operations, it also marks an opportunity for the industry to standardise operations and investor communications.

NEW KID ON THE BLOCK

The Key Investor Information Document (KID) will replace the simplified prospectus existing up to now and will ensure a highly standardised and easily understandable form of information for investors that can be used to compare all UCITS funds.

Fund companies must provide this document at least once a year for every fund and for each class fund in a multi-class structure (although some exceptions exist). Furthermore, the document has to be translated into every language of jurisdictions where the fund is sold.

KID is a compact document covering several investment management software disciplines. It obliges the fund to have risk, performance and charges information integrated in one document and, as in more frequent fact-sheet reporting, displays the need to have an investment management software solution that can do this type of integrated reporting in a smooth, well-reconciled, auditable and reliable way. This will put stress on investment management software with multiple systems and different release cycles and incur high costs to keep interfaces up to date and reconciliation up to scratch.

There are several technical challenges in the recurring event of providing the information but the overall challenges can be summarised as follows.

The way things stand at present, many fund management companies simply do not have all the KID information housed or stored in one system (i.e. performance, risk, charges, explanatory texts, etc.). Should the required data be stored in a data warehouse or should one of the given systems be used as the central data holder for the information? Can any of the systems available contain this information? And, in general, how does a company make sure that the information used is internally consistent?

New KID reporting is not an annual event, as certain funds need to be updated more often in a year. Several events can cause this, and as an example, the Synthetically Risk and Reward Indicator (SRRI) has to be monitored weekly or at least monthly. The existing investment management system must be able to accommodate this, as the data and calculation methods behind the KID information must be available and auditable over a passage of years. Calculations approximating spreadsheets in this area will normally not be acceptable by auditors.

Even though the document is very strict in context and form, guidelines from the Committee of European Securities Regulators (CESR) contain provisions for non-standard information in respect to certain advanced fund types (i.e. structured funds). Many players in the market, while advocating support for KID reporting, have very few remarks as to how or if they support special needs for advanced funds.

Some of the key figure calculations can be handled via an external partner, but the basic data supply has to come from core operations; in several instances, the calculations cannot be outsourced but need to have internal special treatment (i.e. in the case of Value at Risk calculations and return scenarios).

In the short run, it might be an easier solution to outsource part of the calculations and reporting. One question is whether this setup will have support for the advanced funds. But in any case, responsibility cannot be denied for the data, the auditibility required or the general data quality, not to forget monitoring of the key figures.

Using a broader perspective, the KID requirement should be seen as just one of many reporting requirements. The frequent fact-sheet reporting and annual year reporting does include similar information and a technical solution could be applied in connection to this.

CROSS -BORDER SHOPPING MADE EASIER

The UCITS IV changes will result in increased cooperation between supervisory authorities. The notification procedure will be applied according to a regulator-to-regulator principle instead of today, when each fund company needs approval directly from local authorities. This will allow a UCITS fund to begin marketing its units in another member state (the ‘Host Member State’) no later than 10 working days after the date of receipt of the required standard notification letter.

Although it will now be quicker to apply the notification procedure, the products offered in the foreign markets still need to be attractive to foreign investors. With the European market being strengthened over many years via the introduction of UCITS funds and the common IFRS accounting standard, the EU still consists of 27 different tax regimes where specialised tax treatment often requires special detailed reporting in order to be tax efficient. The latest example of this is found in new Austrian taxation where specific Austrian rules have been introduced.

To utilise this improved access to new investor groups, investment management companies need – in the current tax-regime landscape – to have software and systems that can support the local required tax transparency – thereby avoiding penalty taxation.

MANAGEMENT COMPANY PASSPORT

A UCITS funds management company may be authorised to carry out its activities for funds domiciled in any member state.

If a fund company wants to carry out activities for funds domiciled in another country, it still needs to comply with the local regulatory requirements, and it is therefore important to have an investment management system that can support the specific requirements of the targeted countries.

CROSS -BORDER UCITS MERGERS

The new legal framework to facilitate cross-border UCITS mergers will open up for consolidation across borders and thereby enhance the economies of scale. With the average fund size in Europe as measured in terms of assets under management six times smaller compared to the average US fund, this amendment is seen by many as an important efficiency booster.

Unfortunately the guidelines do not include any common tax rules. Open questions in relation to the move of assets in relation to any merger, and existing investors’ tax position after the merger, have created major uncertainty in the market.

A July 2010 survey entitled ‘UCITS IV and Asset Servicing’ from Ernst & Young states that “... the view of many in the industry is that new requirements such as the Key Investor Information Document (KID) will push up fund costs, with no guarantee that asset managers will rush to merge funds, adopt master-feeder or rationalise management company structures.”

And a merger between UCITS funds will therefore have to be individually conducted as the rules very much depend on the member states of the outgoing and ingoing UCITS fund. Specific challenges can also arise in a cross-currency merger when cross-currency conversions and resulting residuals have to be handled.

Peter E. Hertel, SimCorp, urges fund management companies to ensure their investment management systems can address the increasingly complex fund structures with the required tax transparency.

MASTER-FEEDER UCITS STRUCTURES

The new option for creating master-feeder structures under UCITS IV has proved one of the larger discussion elements of the directive. The benefits of having this option are obvious, as it allows the fund management company to centralise the investment system in one state and still have local funds with a national flavour. Or alternatively, instead of establishing new local funds with their own asset management functions, it can enhance the distribution channel of larger master funds by establishing simple feeder funds investing into the master.

Previously, due to UCITS compliance rules (investor protection), one UCITS fund could not invest more than 10 or 20% (depending on the member state) into another UCITS. This rule still applies with the master-feeder structure proving an exception where the feeder must invest at least 85% in the master. Several fund managers have opted for less restricted rules where a feeder fund can have several masters. This makes it theoretically possible in a flexible way to define various feeder funds with the proper ‘mix’ of master funds, thereby offering a larger palette of risk profiles for investors. This is a structure widely seen in the pension and life insurance business. However, this has been viewed as being in conflict with diversification requirements (investor protection).

The master and the feeder funds are separate legal entities and akin to a fund-of-fund construction with specific links in respect to pricing, transparency, timing and accounting.

MISSING TAX FRAMEWORK

The missing tax framework in the UCITS directive has raised a number of unanswered questions for cross-border mergers. For master-feeder funds there are additional open questions such as:

• how should the transfer of assets from a migrated feeder fund (from normal fund to feeder) be handled fiscally?
• how should withholding tax be treated by the feeder side when originating in the master fund?
• how should transparency be treated in respect to security?
• how should transparency be treated in respect to income statement details?

As long as these questions remain open or cause issues on the investor side, we will not see a substantial amount of master-feeder funds in Europe.

FAIR TREATMENT

Another more general issue is the question of fair treatment of the feeders. According to the CESR, the feeder should be handled equitably, but there is no clear statement that the feeders should be handled equally. This actually makes it easier to treat the master fund as a multi-class fund with class-specific fees. If certain costs or market conditions can justify different fee structures, the various feeders can therefore invest in separate classes without any of them being ‘discriminated’.

TRANSPARENCY NEEDS

As mentioned above, the master-feeder construction is similar to a fund-of-fund construction with a link in respect to pricing transparency, timing and accounting. CESR Level 2 requirements (‘Box 2’) state that a master and a feeder must define the terms of agreement the feeder must have to ‘Access to information’, thereby enabling the feeder to perform its exposure, compliance and other risk management functions.

The CESR also states that the feeders should receive period P/L figures. For a simple fund-of-fund construction the period P/L figures in the fund-of-fund will be limited to the P/L directly on the fund certificate. But is this sufficient for the investors in the master fund? For tax reasons, it is likely that some investors will request that income is broken down into more details (i.e. dividend income, interest income or capital gain).

However, the question is how detailed these should be? And how can the master fund make sure to inform the feeders about their share of the period P/L when the ownership ratios have recorded changes over the last period?

Furthermore, how will tax authorities consider realisation within this concept? When the fund realises capital gain, there is no direct realisation in the feeder fund. Should the feeder receive a share of the realisation in the master? And how should the share be defined? Should the share be a pure pro rata share according to the current ownership ratio? Or will tax authorities request that the feeder should realise P/L as if the feeder had invested directly? This would imply requesting more advanced partnership accounts like P/L allocation according to accumulated unrealised P/L.

To be able to service the needs arising in the tax area, these various fund pooling techniques with P/L allocation features will be important tools to design the right level of transparency, thereby utilising the benefits that UCITS IV presents.

The master-feeder option should therefore not only be seen as a new fund structure type but as an additional tool to design a fund that can address a large number of investor groups. The question is: can the investment management system include this design element, and at the same time offer the required transparency?

WINDOW AJAR

UCITS IV opens the window for easier access to new investors and includes a series of much-needed efficiency and consolidation measures. The required investor reporting exposes the power of an integrated investment system. But to really benefit from the opening window, fund management companies have to examine tax regime requirements and make sure that their investment management software can address the increasingly complex fund structures with the required tax transparency.

UCITS IV has highlighted the importance of having an integrated investment management software system that in a flexible way can help design funds targeting large investor groups in a cost-efficient way.

Peter E. Hertel is Domain Manager for Fund Accounting in SimCorp’s Strategic Research department. He holds an M.Sc. in Economics from Copenhagen University. He joined SimCorp in 1988 and over the years has been involved in development, sales, support, project management, implementation and internal and external training. In the past five years he has been heavily involved in implementing fund accounting in Denmark, Finland and Luxembourg, heading up the global fund accounting domain in SimCorp’s Strategic Research department. Here he has worked on enhancing global support for complex fund structures and multiple tax regimes with a focus on optimising daily workflows, thereby helping to achieve growth with general risk control in a cost-efficient way.