Investment managers rarely have a good word for European legislation. Yet two recent pieces of legislation from Brussels - UCITS III and MifID - have been welcomed by international asset managers as enabling rather than disabling in their effect.
UCITS III, the latest version of the Undertakings for Collective Investment In Transferable Securities Directive, was issued in 2002 to cover financial instruments included in current investment funds. All funds had to become UCITS III funds by February last year.
MifID, the Markets in Financial Instruments Directive, came into effect in November last year. It provides a harmonised regulatory regime for investment services across the 30 member states of the European Economic Area and replaces the existing Investment Services Directive.
Both pieces of legislation provide recognised regulatory frameworks which in turn provide comfort to financial supervisors and investors. They also enable asset managers to do things they were unable to do before.
Robin Creswell, the managing principal of Payden & Rygel Global, the London-based operation of US manager Payden & Rygel, suggests that UCITS III and MifID together will greatly expand the opportunities for global investing and global distribution.
Late last year, Payden & Rygel Global launched what it believes is the first global equity fund using a derivatives strategy under the UCITS III umbrella. The fund is an extension of the Payden Global Equity Fund, which has been running for the past 10 years and now has $2bn invested in it.
The UCITS III-compliant global equity fund gets its country, sector and currency exposure by using derivatives. "Global equities is one of those investment strategies that we think is best implemented in the derivatives market because there are efficiencies associated with trading entire countries instead of trading underlying stocks," says Creswell. "There are also efficiencies of speed - we can adjust currency selection more quickly - and now of course in the global market we can also trade sectors."
The five-year development of UCITS III has run parallel with developments in the derivatives market. This, says Creswell, has produced precisely the right conditions for the launch of a global equities fund which uses derivative instruments.
"While UCITS III was being developed a number of things were happening in tandem. First, the derivatives markets were expanding very rapidly. Before UCITS III, the only way we could implement a country exposure strategy would be to go out and buy cash equities in Japan or in the US. With UCITS III, it is much more efficient and flexible for us just go straight out and buy a Dow Jones future or a Nikkei derivative
Second, the exchange-traded funds (ETF) market was developing. UCITS III allows us to use these ETFs, albeit within quite tight limits. Now, if we want to make a sector bet, overweight or underweight a sector, we can do that in ETFs, something we simply couldn't do before.
"Third, there is the availability of forward foreign exchange contracts. When we buy a derivative on a stock exchange, all we are buying is the exposure to the index. What we don't get is the currency exposure, because we only own the derivative instrument, which we purchase on margin.
"So there are three quite sophisticated moving parts within a global equity strategy. With the UCITS III vehicle, they are all moving together."
To be able to use UCITS III in this synchronised way, Payden & Rygel had to adopt the ‘sophisticated' UCITS III designation when the directive was first introduced, rather than the plain vanilla UCITS III, which was broadly similar to the existing legislation. This meant putting in place a risk management plan which that would meet the approval of the regulator.
Drawing up such a plan can be onerous, says Creswell. "If you want to create a risk management plan you have to collect daily price data on all your securities, and do a daily VaR calculation. You also have to calculate counterparty risk and issuer concentration risk.
"We had an advantage here since we already had systems in place to collect the raw data. All we then needed to do was develop the macro system to collate and interpret the data in the way the risk management plan and the regulator require."
The ability to administer an approved risk management plan under UCITS III is a useful selling point for fund managers, says Creswell. "The systems for collating and interpreting data are not simple systems, and for large organisations that has proved to be quite a difficulty. A by-product of that is where we have been appointed third-party manager to institutions with their own UCITS III vehicles, they have asked us to run their risk management plan for them."
One important area of uncertainty in UCITS III was the extent to which the directive permits shorting. "The UCITS III guidance was very clear that if there was a financial derivative instrument we could use that to go outright short," says Creswell. "Where there was no guidance was our ability to go outright short a cash security where there's no underlying derivative."
This uncertainty has now been resolved, at least by one jurisdiction. In November last year the Irish Financial Services Regulatory Authority (IFSRA) issued a clarification ruling that allowed Ireland domiciled funds structured under UCITS III to short stocks outright, rather than having to use derivatives as proxies for short positions.
"The clarification has been very helpful," says Creswell. "What IFSRA has said is that as long as you borrow the underlying stock and then short it, that's fine. It means that we can now short securities so long as they are covered."
Creswell says that the ruling is unlikely to encourage a significant take-up of the option to short outright in the short term. "It will allow the current non-shorting fund to carry on as normal, and allow us to cater for that part of the market where institutions do permit shorting."
Yet shorting is likely to assume greater importance in the longer term, he believes. "There will be an evolutionary process where we think that what is going to happen is that institutions increasingly are going to ask us whether our funds allow shorting.
"That question will not be preparatory to saying we don't want to invest in it. It will be preparatory to saying that, in principle, we would like you to short, but we just want to know how you plan to do it."
The single most important feature of UCITS III is that it enables funds to be ‘passported' to other EU countries and sold with minimum intervention by national regulators and host states. "What UCITS III and MifID have done is effectively to resolve all of the thorny issues which previously each jurisdiction had to wrestle with on its own," says Creswell. "Now jurisdictions can point to a common standard and delegate their responsibility under this legislation."
Institutional investors as well as regulators should benefit from this application of a common standard. The value of UCITS III and MifID is that it will enable pension fund boards and trustees effectively to delegate part of their risk management process to European legislation.
"If you are an institution in Europe and a fund manager comes to you with an apparently sophisticated investment strategy that uses derivatives for investment purposes, you've got to do one of two things.
"Either you have to acquire the skills and monitoring capabilities internally to be able to understand properly what your delegated investment manager is doing on your behalf. Or you can say that somebody else has already done this work for us. There is a well-established framework that has the blessing of European legislation.
"I think what we're going to see in future is pension fund trustees and boards looking at these legislative frameworks and saying that UCITS III actually gives investment managers the flexibility they need to achieve anything I might want to accomplish as an institutional investor."
Increasingly, UCITS III could become the sine qua non of institutional investors, Creswell suggests. "Globally institutions have got a lot of flexibility as to the use of derivatives, hedging and leverage. But we've noticed over the past 18 months that the increasing number of institutions that are investing in a fund rather than a segregated account will only permit investment in UCITS funds, or funds regulated in a similar way."
"They have had time to look at UCITS III and they find it's a well thought out structure which is practical, flexible and operates in a strictly regulated environment."