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Are Revisions To UCITS Necessary?

Published by Charles Gubert

In 2016, a handful of well-known UK-based open ended property funds invested in UK commercial real estate were forced to implement redemption gates after Brexit, as it became clear that their assets could not be realised quickly enough to satisfy the flurry of client redemption requests. In this instance, gating was necessary and effective, as it prevented further market turmoil, a point made by the UK’s Financial Conduct Authority (FCA) at the time. What unfolded in June 2019 at Woodford Investment Management’s Equity Income Fund has not elicited as sympathetic a response from the market, however.

UCITS: A trusted brand under fire

Having accumulated more than EUR 10 trillion in assets from investors globally, UCITS enjoys a reach and influence that few mutual fund wrappers – such as 40 Act funds in the US – can relate to or compete with. UCITS’ success is based primarily on its flexibility (i.e. the simplicity by which a third country manager can set one up inside the EU), regulatory oversight, solid  investor protections, and strict depositary liability provisions. For many retail and institutional investors, UCITS is a trusted brand. But recent events at the Equity Income Fund – which itself was a UCITS – could threaten this long-held perception.

For years, experts have warned that the UCITS brand would be forever tarnished if a fund was forced to gate because of a liquidity crisis. Yet last month, this is precisely what happened at the Woodford Equity Income Fund. The worrying issue for the industry is that Woodford did not technically breach the UCITS rules (which precludes managers from having more than 10% of their assets invested in unquoted securities), but he did list a number of companies on the Guernsey Stock Exchange – which were illiquid and incompatible with the UCITS risk framework. While no laws were technically violated, the entire episode should force regulators to consider whether structural changes need to be made to the UCITS regime. 

The possibilities for regulatory intervention

That the FCA has delayed the publication of its eagerly-awaited report on illiquid assets and open-ended funds has not gone unnoticed. It is possible the 10% cap on unlisted assets could be reviewed and potentially lowered, but this will be up to the EU, who are behind the UCITS framework. Even so, this threshold was not even broken anyway.  A more sensible option would be to ensure there are tighter governance checks on UCITS to ensure risk and investment mandates are not being flouted. Alternatively, EU regulators could change the redemption terms for UCITS, permitting only the most liquid strategies to offer daily liquidity, but of course that would severely restrict the opportunity set for retail investors.

A more radical approach might be to curtail the ability of UCITS managers to offer daily dealing funds moving to monthly or even quarterly dealing. This would extend the time horizons for investors and managers alike, helping the industry to deliver more patient capital. It has also been suggested that the UCITS rules could be changed to limit investments in unlisted or illiquid securities, but given liquidity can fluctuate hugely, and always reduces in points of crisis (when it is most needed), this does not necessarily solve the problem.  Strategies that flirt with illiquidity should operate as closed-ended vehicles, where there is always a price available for clients to get out, albeit it may be at a steep discount (so the customer makes a choice about how important it is to have liquidity).