Joëlle Hauser has worked as a partner in the Luxembourg office of since 2001 and practises mainly in the area of investment funds, advising banks, financial services institutions and asset managers. She specialises in regulated retail and institutional investment funds (securities, derivatives, real estate and private equity), and asset management work, as well as in advice on custody and administration for the financial services industry. Joëlle is a law graduate (magna cum laude) of the Université Catholique de Louvain-la-Neuve, Belgium, and is admitted to the Luxembourg Bar.

Marie Petit has worked as an associate in the Luxembourg office of Clifford Chance since 2005 and practises mainly in the area of investment funds and corporate law. She is a law graduate (magna cum laude) of the Université Catholique de Louvain-la-Neuve, Belgium, and is admitted to the Brussels Bar.

Abstract

This paper aims to analyse how recent legislative developments have led to the development of innovative products within the context of undertakings for collective investment in transferable securities (UCITS). In particular, it will focus on two alternative strategies newly pursued by Luxembourg UCITS: (i) seeking exposure to hedge fund indices; and (ii) using 130/30 strategies via synthetic short selling. Moreover, the paper will examine how and why these techniques and instruments are suitable for the retail market.

Keywords: undertakings for collective investment in transferable securities (UCITS); derivative; hedge fund index; 130/30; short selling

INTRODUCTION

The first undertaking for collective investment in transferable securities (UCITS) subject to Pt I of the Luxembourg Law dated 20th December, 2002, on undertakings for collective investment, as amended ('the 2002 Law')¹ tracking the performance of a hedge fund index has been recently approved by the Commission de Surveillance du Secteur Financier (CSSF), the Luxembourg regulatory authority. Although the possibility for Luxembourg UCITS to invest in financial derivatives instruments on financial indices has existed since the adoption of the 2002 Law, the industry took five years to develop such types of fund.

This paper aims to explain how, following an in-depth analysis and clarification of the UCITS legislation, UCITS are now taking advantage of the full flexibility of the UCITS regulations. In particular, it considers how UCITS investors may gain exposure to derivatives on financial indices, or benefit from a 130/30 strategy via synthetic short selling. It will further examine how and why these techniques and instruments are suitable for retail investors.

The eligibility of financial derivative instruments on financial indices, including hedge fund indices, for investment by UCITS

European Council Directive of 20th December, 1985, on the coordination of laws, regulations and administrative provisions relating to undertaking for collective investment in transferable securities (the 'UCITS I Directive')² has been amended by Directives 2001/107/EC (relating to management companies)³ and 2001/108/EC (relating to products)⁴ of 21st January, 2002, of the European Parliament and the Council (the 'UCITS III Directives' and, together with the UCITS I Directive, known collectively as the 'UCITS Directive').

The UCITS Directive, implemented in Luxembourg by the 2002 Law, represents an important step towards a unified European market in UCITS while ensuring a high level of protection for investors. A number of issues remain unresolved, however, in relation to the consistent implementation of the UCITS Directive: for example, how it relates to the use of derivatives on financial indices.

In October 2004, the European Commission (the 'Commission') gave the Committee of European Securities Regulators (CESR) a formal mandate for advice in the form of clarification of definitions concerning eligible assets (namely, derivatives and credit derivatives) for investments of UCITS. Having listened to the comments from market participants during two rounds of consultations and following careful consideration, on 26th January, 2006, CESR published its final advice to the Commission on clarification of definitions concerning eligible assets for investments of UCITS (the 'CESR Advice on Eligible Assets').⁵

The Commission considered the CESR Advice on Eligible Assets and adopted an implementing Directive on 19th March, 2007, that reflects the contents of the Advice in relation to the clarification of certain definitions of the UCITS Directive (the 'Clarification Directive').⁶ The Clarification Directive has been implemented in Luxembourg through the adoption of the Grand-Ducal Regulation of 8th February, 2008, concerning certain definitions of the 2002 Law.⁷

CESR has compared the text of the Clarification Directive with its Advice on Eligible Assets and has decided to adopt guidelines to cover that text which was not included in the Clarification Directive in March 2007 (the 'CESR Guidelines on Eligible Assets').⁸

But the classification of hedge fund indices as eligible assets for investment by UCITS remained outstanding. On 17th July, 2007, CESR published its guidelines on the classification of hedge fund indices as financial indices (the 'CESR Guidelines on Hedge Fund Indices').⁹

On 19th February, 2008, the CSSF adopted Circular 08/339 regarding the guidelines of CESR concerning eligible assets for investment by UCITS. The purpose of this circular is to draw the attention of the Luxembourg UCITS to the publication of the CESR Guidelines on Eligible Assets and the CESR Guidelines on Hedge Fund Indices, to be read in conjunction with the Clarification Directive.

The CSSF requires that UCITS take into account these guidelines when assessing whether a specific financial instrument can be considered as an eligible asset for investment within the meaning of the relevant provisions of the 2002 Law, as further specified in the Grand-Ducal Regulation of 8th February, 2008.

The first part of this paper will explain how, through this legislative evolution, the first hedge fund indices have been recently admitted in Luxembourg as eligible for investment by UCITS.

Part I - Eligibility of hedge fund indices for UCITS investment
The UCITS Directive
The possibility of UCITS investment in financial derivative instruments on financial indices
UCITS are defined in Art. 1(2) of the UCITS Directive as undertakings, the sole object of which is the collective investment in transferable securities and other liquid financial assets referred to in Art. 19(1) - the latter including financial derivative instruments.

Article 19(1)(g) of the UCITS Directive gives UCITS the possibility of investing in financial derivatives instruments, provided that:
i) the underlying assets consist of instruments covered by this paragraph, financial indices, interest rates, foreign exchange rates or currencies, in which the UCITS may invest according to its investment objectives as stated in the UCITS' fund rules or instruments of incorporation;
ii) the counterparties to financial derivative instruments dealt in over-the-counter (OTC) derivative transactions are institutions subject to prudential supervision and belonging to the categories approved by the UCITS' competent authorities;
iii) the OTC derivatives are subject to reliable and verifiable valuation on a daily basis, and can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS' initiative.

Risk-spreading rules - the transparency of investments in derivatives on financial indices

Article 21(3)(para. 3) of the UCITS Directive states that a UCITS may invest, as a part of its investment policy and within the limits laid down in Art. 22(5), in financial derivative instruments provided that the exposure to the underlying assets does not exceed. in aggregate. the investment limits laid down in Art. 22. The member States may allow that, when a UCITS invests in index-based financial derivative instruments, these investments do not have to be combined to the limits laid down in Art. 22.

Article 21(3) of the UCITS Directive clearly specifies that UCITS may benefit from an exemption to comply with the look-through approach set forth by Art. 22, regarding risk-spreading rules - that is, the 5:10:40 per cent ratios. The UCITS Directive does not, however, explicitly state whether these financial indices should be based solely on eligible assets or whether they may also be based on non-eligible assets. Moreover, the UCITS Directive does not provide any criteria in relation to the transparency of the indices.

The Clarification Directive

The Clarification Directive reflects CESR's Advice on Eligible Assets by clarifying, in Art. 9, that derivatives on financial indices:
i) the composition of which is sufficiently diversified,
ii) which represent an adequate benchmark for the market to which they refer, and
iii) which are published in an appropriate manner,
fall under the category of derivatives as financial liquid assets within the meaning of the UCITS Directive.

'Sufficiently diversified'
Indices are sufficiently diversified when the following criteria are fulfilled:
i) the index is composed in such a way that price movements or trading activities relating to one component do not unduly influence the performance of the whole index;
ii) should the index be composed of 'eligible assets' - that is, assets referred to in Art. 19(1) of the UCITS Directive - its composition is at least diversified in accordance with Art. 22a of the UCITS Directive.¹⁰ The CESR Guidelines on Eligible Assets add that if the composition of the index is not at least as diversified under the ratios of Art. 22a of the UCITS Directive, its underlying assets have to be combined with the other assets of the UCITS according to Arts 21(3) and 22 of the UCITS Directive in order to avoid undue concentration; and
iii) should the index be composed of 'non-eligible assets' - that is, assets other than those referred to in Art. 19(1) of the UCITS Directive - it is diversified in a way that is equivalent to that provided for in Art. 22a of the UCITS Directive. According to the CESR Guidelines on Eligible Assets, if derivatives on an index composed of non-eligible assets are used 'to track or gain high-exposure to the index', in order to avoid undue concentration, the index should be at least as diversified as set out under the diversification ratios according to Art. 22a of the UCITS Directive. If derivatives on the index are used 'for risk-diversification purposes', provided that the exposure of the UCITS to the individual indices complies with the 5:10:40 per cent ratios, there is no need to look at the underlying components of the individual indices to ensure that they are sufficiently diversified.

'Represent an adequate benchmark'
Indices represent an adequate benchmark for the market to which they refer when the following criteria are fulfilled:
i) the index measures the performance of a representative group of underlying assets in a relevant and appropriate way;
ii) the index is revised or rebalanced periodically to ensure that it continues to reflect the markets to which it refers, following criteria that are publicly available; and
iii) the underlying assets are sufficiently liquid, which allows users to replicate the index, if necessary.

'Published in an appropriate manner'
Indices are published in an appropriate manner when the following criteria are fulfilled:
i) the publication process relies on sound procedures to collect prices, and to calculate and subsequently publish the index value, including pricing procedures for components in relation to which a market price is not available; and
ii) material information on matters such as index calculation, rebalancing methodologies, index changes or any operational difficulties in providing timely or accurate information is provided on a wide and timely basis.

The CESR Guidelines on Hedge Fund Indices

According to CESR, the Guidelines on Hedge Fund Indices represent the standards that must be complied with if a UCITS is to gain exposure to a hedge fund index.

i) For the purposes of Art. 19(1)(g) of the UCITS Directive, to fall under the classification of a 'financial index', a hedge fund index must comply with the conditions laid down in Art. 9 of the Clarification Directive - that is, the conditions set out above.

ii) In order to differentiate it from a fund of hedge funds, a hedge fund index shall qualify as a 'financial index' if the methodology of the index provides for the selection and the rebalancing of components on the basis of predetermined rules and objective criteria.

iii) By virtue of the principles of the objective component selection and the index being an adequate benchmark, a hedge fund index shall not qualify as a 'financial index' if the index provider accepts payments from potential index components for the purpose of being included in the index.

iv) A hedge fund index will not fall under the classification of a 'financial index' if the methodology of the index allows retrospective changes to previously published index values - that is, 'backfilling'.

v) When gaining exposure to a hedge fund index by means of an OTC derivative, a UCITS must comply with the relevant requirements laid down in the UCITS Directive and the Clarification Directive. These include:
   • a) requirements about counterparties (Art. 19(1)(g) of the UCITS Directive);
   • b)requirements about valuation and the ability to close a position (Art. 19(1)(g) of the UCITS Directive and Art. 8 of Directive 2007/16/EC);
   • c) requirements about risk management and valuation processes (Art. 21(1) of the UCITS Directive); and
   • d) requirements about risk exposure (Art. 22 of the UCITS Directive).

vi) When gaining exposure to a hedge fund index, a UCITS must carry out appropriate due diligence - that is, an overall assessment of the quality of the particular hedge fund index, based on the criteria set out above and any additional criteria that the UCITS feels is relevant. This includes consideration by the UCITS of the 'quality' of the index.

In assessing the quality of the index, the UCITS must take into account at least the following factors:

i) the comprehensiveness of the index methodology, including:
   • a) whether the methodology contains an adequate explanation of subjects such as the weighting and classification of components (eg on the basis of the investment strategy of the selected hedge funds), and the treatment of defunct components; and
   • b) whether the index represents an adequate benchmark for the kind of hedge funds to which it refers;

ii) the availability of information about the index, including:
   • a) whether there is a clear narrative description of what the index is trying to represent;
   • b) whether the index is subject to an independent audit and the scope of the audit (eg that the index methodology has been followed and that the index has been calculated correctly); and
   • c) how frequently the index is published and whether this will affect the ability of the UCITS to accurately calculate its net asset value (NAV);

iii) matters relating to the treatment of index components, including:
   • a) the procedures by which the index provider carries out any due diligence on the NAV calculation procedures of index components;
   • b) what level of detail about the index components and their NAVs are made available (including whether they are investable or non-investable); and
   • c) whether the number of components in the index achieves sufficient diversification.

The UCITS must keep a record of its assessment.

The first hedge fund indices approved by the CSSF as eligible for use by UCITS

Credit Suisse Solutions (Lux) has recently been approved by the CSSF as a Luxembourg UCITS that aims to track the performance of the Credit Suisse (CS)/Tremont AllHedge Index. The CS/Tremont AllHedge Index is a diversified investable hedge fund index. It includes the ten sector indices weighted according to the broad index weights of the CS/Tremont Hedge Fund Index, a widely recognised asset-weighted hedge fund index.

The methodology of the Greenwich Composite Investable Hedge Fund Index, an index specifically designed to track the returns of the entire hedge fund asset class, has also been recognised by the CSSF as a properly constructed hedge fund index and is eligible for use by UCITS.

Part II - Developing a 130/30 strategy via synthetic short selling

As outlined in the research on investment policies of UCITS published by the Commission in February 2008, 'another increasingly prevalent investment strategy (of the UCITS industry) is the "130/30" strategy'.¹¹

The second part of this paper aims to show how this investment strategy is applied by Luxembourg UCITS, although these funds are not authorised to physically short sell investments.

130/30 strategies in general
Long portfolio vs short portfolio
In a 130/30 fund, 130 per cent of the fund's assets are invested in a long portfolio, while 30 per cent are invested in a short portfolio (although other ratios can be used such as 120/20 or 150/50).

On the one hand, the fund is buying long, allocating 100 per cent of its NAV to long positions: it seeks to profit from price rises. On the other hand, the fund is selling short securities to the value of 30 per cent of its NAV: it attempts to benefit from assets that it believes will depreciate. The proceeds from the short sale are then used to acquire additional long positions, thereby bringing the total exposure to 130 per cent long and 30 per cent short.

Physical short selling vs synthetic short selling
Short selling is a big part of the 130/30 strategy and two main techniques of short selling may be distinguished: physical short selling and synthetic short selling.
   • Physical short selling involves the actual sale of securities that the fund does not hold.
   • Synthetic short positions are effected through the use of financial derivative instruments to create an exposure to the price of the security, rather than the actual sale of the security.

In physical short selling, the security is typically borrowed from another party. The security is then sold on in the market, in the belief that, when the time comes to return it, it will be possible to buy it more cheaply. The profit is the difference between the sale and purchase prices, less the cost of borrowing and any transaction costs incurred.

130/30 strategies in UCITS
Physical short selling vs synthetic short selling
Short selling exposes a fund to potentially unlimited increases in the value of the shorted security. In order to avoid heavy losses for UCITS, Art. 42 of the UCITS Directive prevents a UCITS from carrying out uncovered sales ¹² of transferable securities or other financial instruments referred to in Art. 19(1)(e) (ie units of other UCITS or UCI), 19(1)(g) (ie financial derivatives instruments) and 19(1)(h) (ie money market instruments other than those dealt in on a regulated market) of the UCITS Directive.

Fund managers looking at 130/30 strategies for UCITS therefore incorporate exposure through synthetic short exposure, because physical short selling by UCITS is not allowed.

In the 130/30 UCITS, assets are invested in long positions in physical securities. Additionally, 30 per cent is invested via derivatives in long positions in the most attractive assets; another 30 per cent is invested in short positions in the least attractive assets, also by means of derivatives. The 100 per cent in physical securities, plus the additional 60 per cent invested in derivatives, provides investors with a 160 per cent gross exposure to the market.

Covered synthetic short selling
The synthetic short positions have to be covered adequately. Section IV.1 of CSSF Circular 07/308 on rules of conduct to be adopted by UCITS with respect to the use of a method for the management of financial risks, as well as the use of derivative financial instruments, dated 2nd August, 2007, provides rules on how short positions under derivative instruments should be adequately covered (whether listed or OTC).

These rules may be summarised as follows.

i) Derivative transactions providing for cash settlement
In the case of contracts that provide for cash payment, automatically or at the UCITS' discretion, the UCITS is allowed not to hold the specific underlying instruments as cover. The UCITS must hold enough liquid assets (after the application of appropriate safeguard measures - that is, discounts, etc) to allow it to make the contractually required payments (eg margin calls, interest payments, contractual cash payments, etc). Given the number of different situations that might arise, the CSSF leaves it up to the UCITS to decide the method by which it will determine the coverage level of the contracts that are payable in cash. This method must, in any event, allow the UCITS to meet all payment obligations at any time.

ii) Derivative transactions providing for physical delivery
In the case of contracts that provide, automatically or at the counterparty's choice, for the physical delivery of the underlying financial instrument on the due date or the exercise date, such transaction is only allowed if physical delivery is common practice in relation to the considered instrument and the UCITS must hold the underlying financial instrument as cover. When the underlying financial instrument of the derivative instrument is sufficiently liquid, however, the UCITS is allowed to hold other liquid assets (including liquidities) as cover, provided that these assets (after applying appropriate safeguards - that is, discounts), held in sufficient quantities, can be used at any time to purchase the underlying financial instrument to be delivered.

iii) Liquid assets
The liquid assets referred to above, besides cash, are liquid debt securities or other liquid assets (investment-grade debt instruments, shares comprised in the main index, etc.) that can be converted into cash on very short notice at a price corresponding closely to the current valuation of the financial instrument on its market.

iv) Risk measurement
It is up to risk management to check regularly whether the coverage available to UCITS, either in the form of the underlying financial instrument or in the form of liquid assets as described above, exists in sufficient quantity to meet future obligations.

An evaluation of the suitability of alternative strategies for retail investors

On the European investment fund market, UCITS manage total net assets of 5,704bn.¹³ Among these funds, only a very few seek exposure to hedge fund indices or use a 130/30 strategy.

It is arguable that the low levels of interest in these instruments and strategies to date stems from a lack of understanding of and discrepancies in interpretations of the UCITS Directive. Under pressure from the European UCITS industry, the Commission and the CESR undertook a long clarification process of the UCITS Directive, ending in 2007 with the adoption of the CESR Guidelines and the Clarification Directive. Since that time, new strategies have been implemented by UCITS and there should be a trend towards a larger use of these techniques.

Indeed, the use of innovative products within the context of a UCITS allows retail investors to access alternative products by benefiting from appropriate safeguards and protection.

First of all, the disclosure requirements imposed on UCITS offer greater transparency of the product to the investors. Fees and risks must be adequately described in the prospectus, providing the investor with a comprehensive view of the costs and risk considerations remitted to his or her investment. The total expense ratio (TER) and portfolio turnover ratio (PTR) mentioned in the simplified prospectus will also give the investor the opportunity to assess the performance of a prospective investment.

The skill of the manager and the quality of risk management are key to funds using these alternative instruments successfully. UCITS will draw up a detailed risk management process, to be reviewed by the competent supervisory authority; the appointment of its manager will be subject to regulatory approval. Additional safeguards are therefore offered to the investor.

conclusion

This paper has demonstrated how the recent demystification of the UCITS rules paved the way for convergence between traditional retail funds and hedge funds. The latest amendments and clarification of the UCITS rules have created new opportunities to create 130/30 UCITS or UCITS exposed to hedge fund indices.

This paper also showed how retail investors may adequately invest in products offering alternative strategies while benefiting from the UCITS regime and risk management process.

Retail investors' demand for alternative products is growing and it will be up to the fund promoters and regulators, with the assistance of European authorities such CESR, to ensure that the developments towards alternative-type strategies remain within a suitable regulatory framework for retail investors, sufficiently protective of their interests.

References
(1) Mémorial A , No. 151, 31st December, 2002, p. 3660.
(2) Council Directive 85/611/EEC of 20th December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), OJ L/375, 31st December, 1985, p. 3.
(3) Directive 2001/107/EC of the European Parliament and of the Council of 21st January 2002 amending Council Directive 85/611/EEC of 20th December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management company and simplified prospectuses, OJ L/41, 13th February, 2002, p. 20.
(4) Directive 2001/108/EC of the European Parliament and of the Council of 21st January 2002 amending Council Directive 85/611/EEC of 20th December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with regard to investment of UCITS, OJ L/41, 13th February, 2002, p. 35.
(5) CESR (2006) CESR's Advice to the European Commission on Clarification of Definitions Concerning Eligible Assets for Investments of UCITS , January, CESR/06-005 (published with a feedback statement - CESR/06-013).
(6) Commission Directive 2007/16/EC of 19th March 2007 implementing Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards the clarification of certain definitions, OJ L/79, 20th March, 2007, p. 11.
(7) Mémorial A , No. 19, 19th February, 2008, p. 303.
(8) CESR (2007) CESR's Guidelines Concerning Eligible Assets for Investment by UCITS , March, CESR/07-044.
(9) CESR (2007) CESR's Guidelines Concerning Eligible Assets for Investment by UCITS: The Classification of Hedge Fund Indices as Financial Indices , July, CESR/07-434.
(10) In accordance with Art. 22a of the UCITS Directive, the weight of any single index constituent will not exceed a maximum of 20 per cent (by derogation to the 10 per cent limit, as provided by Art. 22 of the UCITS Directive).
(11) EU Commission DG Internal Market/Pricewaterhouse Coopers (2007) Study on Investment Funds in the European Union: Comparative Analysis of Use of Investment Powers, Investment Outcomes and Related Risks Features in Both UCITS and Non-harmonised Markets , p. 73, available online at http://ec.europa.eu/internal_market/investment/other_docs/index_en.htm.
(12) Uncovered sales are defined as 'all transactions in which the UCITS is exposed to the risk of having to buy securities at a higher price than the price at which the securities are delivered and thus making a loss and the risk of not being able to deliver the underlying financial instrument for settlement at the time of maturity of the transaction' (Commission Recommendation of 27th April 2007 on the use of financial derivative instruments for UCITS, 2004/383/EC, whereas (9), OJ L/144, 30th April, 2004, p. 34).
(13) EFAMA (2008) Trends in the European Investment Fund Industry in the First Quarter of 2008 , Quarterly Statistical Release No. 33, June, available online at www.efama.org.

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