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Tighter regulation needed to protect Ucits brand

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The increasing number of Ucits hedge funds launched in Europe means that tighter regulation is needed both to protect retail investors and the Ucits brand, a paper by PricewaterhouseCoopers says.

The paper, Future Newcits regulation?, includes some of Europe’s regulators giving their opinions on this growing trend, as well as views on the current conflict between welcome innovation and the need to carefully manage retail investor protection.

“Many European hedge fund managers are increasingly seeking to launch their own Newcits,” says Olwyn Alexander, head of alternatives, PricewaterhouseCoopers (Ireland). “Such funds involve a high degree of responsibility of ensuring the product launched is fit for purpose. It is now more important than ever that regulators strike the right balance between developing Ucits funds and anticipating any potential threats to retail investors.”

Alexander says there are many strategies that fit very neatly into the Ucits framework such as long/short equity or absolute return type strategies. Although such products allow for better protection in falling markets, Alexander warns that if some managers push at the boundaries too hard, this could act as a trigger for Ucits V.

European fund managers are bringing to the Ucits arena a great deal of product innovation which brings new complexity to a universe historically dominated by traditional funds, and primarily intended for retail investors. This has created contradictions to the Ucits principles and therefore poses challenges to the regulatory rules that govern the industry.

“I believe that the rules are strong enough and flexible enough to cope with this innovation,” says Grellan O’Kelly, senior regulator with responsibility for the derivatives and risk management policy group at the Irish Financial Services Regulatory Authority. “As ever, however, the hedge funds are pushing at the boundaries of gaining exposure to asset classes that you would not normally be able to gain exposure to in Ucits.”

The paper points out that Ucits rules impose limits on investment freedom that do not exist in unregulated funds. While welcoming the migration of hedge funds onshore, some regulators hope managers will eventually prefer the Alternative Investment Fund Managers Directive regime for complex and highly leveraged funds.

“Within Ucits III the investment restriction rules are tight and these rules might restrain hedge fund managers’ ability to launch pure alternative strategies,” says Patrice Bergé-Vincent, head of the asset management policy department at France’s Autorité des Marchés Financiers. “I would like to think that the AIFM rules will be preferable to hedge fund managers because there will be no investment restrictions but a passport for funds established in the European Union.”

The financial crisis has undermined many investors’ faith in straightforward equity investing, as it reversed the previous decade’s gains and as a result investors’ attention has become focused on the safeguarding of assets. In part the reason this Newcits trend has taken off is because of the safeguards the Ucits regulatory framework provides.

Jean-Marc Goy, counsel for international affairs at Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier, believes that the Ucits directive includes – in addition to the requirement for an adequate risk management process – a lot of other safeguards in order to assure adequate investor protection.

“In addition to that, the financial intermediaries who distribute Ucits fund products are subjected to the rules of the Mifid Directive, which obliges them to make sure that the risk profiles of the financial products they sell comply with the risk profiles of the investors, and which should prevent misselling practices,” he says.

However, the PwC paper adds that, as the Newcits universe grows, so does concern that innovative strategies may create investor protection issues, and tarnishing of a well developed brand. Addressing some of the critical areas is the Committee of European Securities Regulators Level 2 Consultation focusing on risk measurement, including global exposure and counterparty risk, the aim of which is to improve the rules regarding risk management for UCITS managers.

“Currently there are some anomalies in how risk management is measured,” says Alexander. “This is an area where we are very likely to see a tightening of regulations to ensure better protection.”

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