Cerulli, Asia Pacific Edge: What Asia can learn from UCITS

Asia Pacific Edge, July 2013

Key points:

• The passport schemes proposed in Asia can learn several things from the UCITS experience in Europe
• Among them are a need for frequent evolution, an initial focus on simple securities, and a focus on a trusted brand.
• A single currency and harmonized tax framework would be useful but are not essential: UCITS works despite having neither, as not all EU nations are in the euro.

“There is no doubt that Undertakings for Collective Investments in Transferable Securities (UCITS) is a European success story,” writes  KPMG head of investment management Nathalie Dogniez in a KPMG study, The Perfect UCITs. “Created out of nothing some 25 years ago, it now represents the investment fund framework of reference, in Europe and beyond.”

That’s undeniable: according to the European Fund and Asset Management Association, over 70% of all assets in European regulated funds are in UCITS. More and more of them are genuinely cross-border. It is little surprise that many in the industry in Asia Pacific have looked closely at the structure and thought: well, why not here?

As discussed elsewhere in this report, there are two initiatives to bring about a UCITS-style passport in Asia. One is the Hong Kong-Mainland China mutual recognition, which has been described as a streamlined visa process for cross-border distribution between the two locations – not quite a UCITS passport, but an improvement in status that would allow recognized Hong Kong and mainland funds access to a fast and simple review by the corresponding regulator to be sold-cross-border. The other is an Asean funds passport which would allow the mutual recognition of cross-border offerings of collective investment schemes within the southeast Asian group, initially to non-retail investors, and ultimately to retail once sufficient protections are in place.

Chart 1, which shows the total number of cross-border fund registrations in Asia, illustrates that there is appetite for greater movement and distribution of funds in the region. But what should backers of these schemes be learning from the UCITS experience? In short, why did UCITS work in Europe?

One lesson is that UCITS did not get it right the first time and the European Commission has been happy to embrace evolution. UCITS 1 came in 1985 and has gone through several phases of reform and reinvention, most recently UCITS IV in 2008 and now UCITS V, a proposal around depositary functions and remuneration policies that was published by the European Commission in July 2012 and is gradually working its way through consultation, negotiation and adoption. A further twist, UCITS VI, was proposed in exactly the same month that its predecessor was published. (Indeed, as the FT put it the following month: “It seems hardly credible that there is already a consultation paper on UCITS VI when UCITS IV is barely bedded down and UCITS V is still in draft form, but so it is.”) There are positive and negative things backers in Asia can learn from this: one, to avoid constant meddling and labyrinthine processes for change; but two, to accept that nothing is sacred and that anything can be improved.

Related to this, it is useful to remember that a framework can start with relative simplicity and then evolve where practitioners want it to go – which means, for example, that not every asset class has to be included from the very outset. The UCITs experience has been to start with a framework covering long-only traditional asset classes like equities and debt, and then gradually to shift to alternative strategies, gaining complexity along the way. The point of the UCITS VI consultation is to ask whether more, or less, assets and complexity should be within the structure’s remit: commodities? Fund of real estate funds? Corporate loans? Questions like this will be integral to any true passport system in Asia and it is probably realistic to expect that it will start out only with equities and high-grade debt, with more alternative and less liquid assets following as the regime has begun to prove itself.

Similarly, UCITS today allow funds to engage in securities lending so as to boost performance, and permit synthetic (but not physical) short selling. This is the sort of sophistication that should not be expected in a new scheme but could develop over time if regulators feel it to be prudent.

Another lesson is the power of a brand. UCITS today doesn’t just convey something that can be sold across borders. It is a brand, and it represents something of a stamp of safety and professionalism. That is an opportunity in Asia too – a brand people can trust – but it has to be earned. Doing so will make regulators err on the side of caution and will probably be another prompt to start with simple asset classes.

Another theme is around tax. From a distance you might assume that UCITS funds must operate in a harmonized tax environment, but even after 25 years, it’s actually not true: some funds end up being taxed twice, once in the country of domicile, and once in the country of distribution. Moreover, double tax treaties may apply to some funds in one country but not in another, and since capital gains tax practices vary from place to place, it is difficult to provide relevant tax information to investors. KPMG says 80% of respondents want a harmonized tax framework, but the important point is that UCITS has still been successful without one. Similar issues will arise in Asia – it is going to be very difficult to get, say, Singapore, Thailand, Vietnam and Indonesia to agree on a single tax framework – but the UCITS example shows us that the fact that there is not unified tax at the outset need not jeopardise the whole passport structure.

It’s also common to think that UCITS has a huge advantage over any Asian initiative because of the European single currency. This is partly true, but remember that any UCITS registered fund can be freely marketed across the EU – including the UK (which uses pounds sterling), Sweden (krona), Romania (leu), Bulgaria (lev) and Denmark (krone).  Nevertheless, Asia – even just Asean – has a greater diversity of currencies and will have to overcome challenges around the national interest of individual jurisdictions, with local regulators likely to try to promote their own local asset management industries even as they open up to cross-border marketing.

Perhaps most importantly, UCITS worked primarily because people wanted it: there was a market for Germans to buy Luxembourg-registered funds run by British fund managers, or numerous other permutations. Without that, nothing will take off at all. There is a very clear imperative for the Hong Kong-China arrangement, with an enthusiastic market in both directions. But do investors in Malaysia want Indonesian funds? Or would an Asean passport just be a Singapore-hubbed distribution network with little cross-border flows between any other two states? The answers to questions like this are not always obvious until they have been tried out in practice, but without a keen market to buy cross-border product, no passport initiative will get off the ground.

Finally, backers in Asia should remember that mighty things rise from small beginnings. Today, there are 35,000 funds representing nearly Eu6 trillion being distributed around the world under the UCITS passport, all benefiting from the reputation of a robust legal framework. And they are sold far more widely than the European Union: in Asia, among other places, where 70% of all funds authorised for distribution in Hong Kong are UCITS; as well as Latin America and Africa. Chart 2 shows the number of UCITS in Asia as of July 2012, and chart 3 shows how those numbers have evolved over the previous five years, while chart 4 explains the restrictions on UCITS sales in different parts of Asia. It has been estimated that over 50% of UCITS assets are now sourced outside Europe. This is also a long-term possibility for any Asian passport scheme, to market funds further afield.

So even if an Asian passport is slow to get moving, and difficult to implement, UCITS provides a model for the benefits of persistence. Starting slowly is not an argument against long-term success.