Financial Services Quarterly Report - First Quarter 2013: The UCITS Agenda

by Dechert LLP

The first item on the UCITS agenda for 2013 – the ESMA1 Guidelines on ETFs and Other UCITS Issues (the “Guidelines”) – has gone live. This article provides an update and clarity around the recently finalised Guidelines2 since the initial consultation, as well as addressing other important UCITS agenda items: ESMA’s Opinion on Trash Ratios, key provisions of UCITS V and UCITS VI, and UCITS alignment with the AIFM Directive.

The Guidelines, initially published by way of ESMA’s report and consultation paper in July 2012, have now been updated to include ESMA’s Guidelines on Repurchase and Reverse Repurchase Agreements dated 4 December 2012 (the “Consolidated Guidelines”). The Consolidated Guidelines came into effect on 18 February 2013, marking the end of a two-month period following their publication on the ESMA website, during which time national regulators had to adopt either a “comply” or “explain” approach.

Consolidated Guidelines

Following the broadening of the scope of eligible assets under UCITS III, there was an increase in the use of “hedge fund”-style strategies by UCITS, as well as synthetic and more complex structures by UCITS ETFs. In response to concerns raised by industry participants, ESMA initiated a consultation to review investor protection and market integrity under the UCITS III model. The results of the consultation formed what have now become the Consolidated Guidelines. The main provisions of the Consolidated Guidelines are discussed below.

Index Funds

One of ESMA’s main concerns in relation to the use of indices by UCITS was the perceived lack of sufficient disclosure to investors. The Consolidated Guidelines seek to enhance disclosure to investors by requiring fund documentation3 to disclose the components of the index, how it will be tracked (including any exposure to risk), and the anticipated level of tracking error. The size of the tracking error must additionally be set out and reported in the semi-annual and annual accounts. The Consolidated Guidelines encompass all physical and synthetic indices, not only index-tracking ETFs per the initial consultation. UCITS managers will need to review the fund documentation and ensure that it is in line with the Consolidated Guidelines.


The Consolidated Guidelines define what constitutes a UCITS ETF and prescribe that “UCITS ETF” must be used as an identifier in the name of the fund. If the fund does not fall within the specified ESMA definition of a UCITS ETF, it cannot be marketed as such. There is no restriction on a non-UCITS ETF using the term “ETF” in its title.

The question as to whether the identifier should be used at the umbrella or sub-fund level has been addressed by ESMA’s Questions and Answers on the Consolidated Guidelines, published on 15 March 2013 (“ESMA’s Q&A”), which states that if not all sub-funds in an umbrella are UCITS ETFs, the labelling requirement should apply at the sub-fund level only. If all sub-funds are UCITS ETFs, the UCITS may decide to apply the label at the umbrella level also.

The Consolidated Guidelines set out that UCITS ETFs must disclose their portfolio transparency policy in their fund documentation and also where the indicative NAV, if applicable, can be found. In addition, fund documentation must clearly disclose whether or not the UCITS ETF is actively managed. Currently most UCITS ETFs comply with these two provisions, so compliance should not be overly burdensome.

Under the Consolidated Guidelines, there is provision for a direct redemption option for investors. Initially, this was to apply at all times, but following push back from the industry regarding the operational difficulties involved, this was revised and now applies only if the stock exchange value differs significantly from the NAV. Wording specified in the Consolidated Guidelines must be included in the prospectus and marketing communication for the fund to accommodate this. UCITS ETFs will therefore need to review and amend their redemption policies in order to comply with the Consolidated Guidelines.

Efficient Portfolio Management

UCITS using financial derivative instruments (“FDI”) for efficient portfolio management (“EPM”) must fully disclose, inter alia, the techniques used, the risks involved and the impact on fund performance, in the prospectus, the risk management process document and the annual report of the UCITS in order to comply with the Consolidated Guidelines.

A UCITS must be able to recall securities lent or terminate its stock lending agreements at all times. In addition, a UCITS entering repurchase or reverse repurchase agreements (including fixed-term agreements not exceeding seven days) should ensure that it can recall the full amount in cash or terminate the agreements at any time. UCITS managers should take this into account when developing liquidity management processes to ensure they can comply with the UCITS’ redemption obligations.

A controversial provision of the Consolidated Guidelines relating to revenue sharing between the UCITS and stock lending agents has been clarified by ESMA’s Q&A. The Consolidated Guidelines state that “all the revenues arising from [EPM] techniques, net of direct and indirect operational costs, should be returned to the UCITS”. ESMA’s Q&A indicates that the Consolidated Guidelines do not prohibit the payment of fees to stock lending agents “as normal compensation for their services in the context of [EPM] techniques”. Therefore, this falls into the “direct and indirect operational costs” bucket – which is positive news for stock lending agents. However, a UCITS must disclose, in its annual report, any costs and fees paid to identified parties in relation to EPM techniques, together with the other direct and indirect operational costs and fees incurred. It should also disclose, in either its prospectus or annual report, if such identified parties are related to the management company or the depositary.

Derivatives Use

In relation to derivatives use, the Consolidated Guidelines provide for enhanced disclosure. The prospectus of a UCITS using total return swaps (“TRS”) or other FDI with similar characteristics should disclose information on the underlying strategy, the counterparties and the risk of default. The annual report must further disclose the underlying exposure obtained through the FDI, the identity of counterparties and the type and amount of collateral received by the UCITS to reduce counterparty exposure.

Collateral Management

The counterparty risk exposures arising from OTC FDIs and EPM should be combined when calculating counterparty risk limits. Collateral should, inter alia, be:

  • highly liquid;
  • valued daily;
  • high quality;
  • issued by a party independent of the counterparty; and
  • sufficiently diversified in terms of country, market and issuers.

A UCITS receiving collateral for at least 30% of its assets must have appropriate stress testing in place to ensure the collateral can stand up to normal and exceptional liquidity conditions. Generally, UCITS have until 18 February 2014 to align their collateral portfolios with the Consolidated Guidelines, except in the case of re-invested cash collateral, which must comply immediately. The UCITS’ collateral policy (including haircut policies) must be disclosed in the prospectus and the risks related to the management of collateral should also be disclosed in the risk management process.

Financial Indices

The Consolidated Guidelines increased the scope of the consultation to include all financial indices in which UCITS may wish to invest (for investment purposes and not merely as a performance benchmark). A UCITS may not invest in an index where a single component exceeds the 20%/35% diversification requirement. In the case of investment in commodities indices (the only way to gain exposure to commodities), the indices must consist of different commodities. For the purposes of diversification, sub-categories of commodities are treated as the same commodity. Indices must also have an adequate benchmark. The index is not considered to have an adequate benchmark if it has been calculated at the request of a limited number of market participants. Also prohibited for investment are indices that an investor cannot replicate due to the frequency of rebalancing and indices for which the components and weightings are not published.

UCITS managers will need to revisit their investment strategies and review their prospectuses to ensure that adequate disclosures are made and that any positions in indices that are prohibited under the Consolidated Guidelines have been closed out.


The Consolidated Guidelines entered into force on 18 February 2013. New UCITS established on or after 18 February 2013 must comply immediately. UCITS in existence prior to such date may make use of a one-year transition period, with certain exceptions. Structured UCITS in existence prior to such date will not be not required to comply with the Consolidated Guidelines, provided they are closed to new subscriptions. Relevant implementation dates are set forth below.

Implementation of Consolidated Guidelines


Implementation Date



 UCITS established on or after 18 February 2013

 18 February 2013

 UCITS existing before 18 February 2013

 18 February 2014

 Exceptions to one-year transition period


 Reinvestment of cash collateral

 18 February 2013

 Treatment of secondary market investors

 18 February 2013

 Alignment of investments in financial indices

 18 February 2014

 Alignment of collateral portfolio

 18 February 2014

 Revenue sharing arrangements

 18 February 2014

 ETF identifiers

 18 February 2014 (unless the name of the
 fund is changed for another reason, in which
 case the date is the earlier of the two

 Update of existing fund documentation (M&A/trust
 deed, prospectus, KIID and marketing

 18 February 2014 (unless they are being  
 replaced for another reason, in which case the
 date is the earlier of the two instances)

 Publishing of information in accounts

 Applies to accounting periods ending after 18
 February 2013

ESMA Opinion on Trash Ratios

UCITS III broadened the scope of “eligible assets” and permitted UCITS to invest 10% of NAV in transferable securities and money market instruments other than the eligible assets referred to in Article 50(1) of the UCITS III directive (known as the “trash ratio”). Over time, questions were raised as to the correct interpretation of the trash ratio by national regulators. ESMA has now formally opined on this, stating that the trash ratio applies only to investment in transferable securities and money market instruments, and not to shares in collective investment schemes. Accordingly, UCITS can no longer invest in unregulated hedge funds and should redeem their positions prior to 31 December 2013 or earlier if required by the home Member State. National regulators who do not enforce this are required to explain non-compliance.4


The main priorities of UCITS V are remuneration, aligning depositary rules with those under the AIFMD and harmonising the implementation of financial sanctions across Member States. The European Central Bank (“ECB”) published its opinion on the draft proposals in January 2013. While the ECB broadly welcomes the proposals, it suggested some drafting changes and specifically commented on certain areas in relation to delegation, liability, eligibility to act as a UCITS custodian and the reuse of assets by a UCITS depositary.

At the time of writing, we have become aware, through press reports, that the Economic and Monetary Affairs Committee of the European Parliament (“ECON”) is proposing significant changes to the proposed remuneration regime, which would seek to limit bonuses to 100% of fixed income and to impose penalties for UCITS that do not meet their benchmark. We will report further on these controversial proposals once they have been published.

ECON is scheduled to vote on the UCITS V proposals on 21 March 2013, while the European Parliament will consider the proposals in its plenary session in early July 2013, after which there will be a better guide as to timing. Once finalised, Member States usually have two years to transpose the provisions into national law, meaning implementation could be end 2014/early 2015.


The focus of UCITS VI is new and includes areas other than those prioritised under UCITS V. The key areas addressed are the depositary passport, a review of eligible assets (including further scrutiny of money market funds) and, following recent findings on shadow banking, exploration of EPM techniques and OTC derivatives use within the UCITS framework.

In terms of timing, the consultation has now closed and responses have been issued. However, it is not yet clear when draft proposals will be published.

AIFMD Alignment

In the same way that the AIFMD provisions with respect to the depositary are likely to be aligned by UCITS V, similar alignment by UCITS is expected with respect to some of the more controversial elements of the AIFMD. The most notable of these relate to delegation/letter box entity rules, cash monitoring requirements for depositaries, and remuneration – particularly the requirement that the remuneration provisions should apply on a “look-through” basis to delegates. As these issues become clearer through the AIFMD implementation process, so will the likely impact on UCITS.

Conclusion – What Do I Need to Do Now?

Although there has been a flurry of UCITS activity recently, action required by fund managers of existing UCITS is not immediate, with some exceptions pursuant to the Consolidated Guidelines (see chart entitled “Implementation of Consolidated Guidelines”). Existing UCITS can avail themselves of the one-year transition period before they must fully implement the provisions of the Consolidated Guidelines and there is still some time before the provisions of UCITS V and VI are finalised and take hold. Instead, managers need to prepare for the changes coming down the track and allocate sufficient time and resources (financial, personnel and information technology) to ensure compliance when the time comes.

*The authors would like to thank Johanna Stohr for her research for this article.


1 European Securities and Markets Authority.

2 For further information regarding the Guidelines, please refer to DechertOnPoint, ESMA Guidelines on ETFs and Other UCITS: What They Mean for Managers.

3 For the purposes of this article, references to fund documentation include the prospectus, key investor information document (KIID) and all marketing communication.

4 For further information, please refer to DechertOnPoint, ESMA Rules that UCITS May Not Invest in Unregulated Hedge Funds.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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