Introduction

The EU’s Undertakings for Collective Investment in Transferable Securities (UCITS) is a voluntary framework for funds and ETFs seeking to be earmarked as compliant with minimum standards that make them suitable to be marketed to a broad investment audience.

These risk and fund management standards require products to satisfy criteria ranging from having diversified portfolios and safeguarding investors from misleading information to fraudulent activities and ensuring brokers get best execution on their orders for clients.

The first iteration – or directive – of UCITS was adopted on 20 December 1985 to facilitate investment vehicles to operate throughout the EU based on authorisation by one member state.

While modifications were proposed but never adopted under UCITS II, the first round of key changes came with UCITS III in 2002, introducing the use of more sophisticated investment strategies such as those using derivatives.

Under UCITS IV in 2009, a focus on facilitating cross-border distribution saw the introduction of a ‘master-feeder’ structure, enabling funds to be managed in one member state while being sold in another, as well as the introduction of management company passports.

UCITS V in 2014 sought to align member state regulation on depository functions, remuneration policies and sanctions including defining depository entities, their roles, liability and general remuneration applying to fund managers.

Another major development was the Key Investor Information Documents (KIIDs) for UCITS products being made mandatory.

UCITS VI discussed several topics ranging from a common framework for managing liquidity bottlenecks, delegation activities, changes to regulatory reporting and whether a depository passport should be introduced.

Future developments may include a review of the 2007 UCITS Eligible Asset Directive by the European Securities and Markets Authority (ESMA), which could see changes made to the list of asset classes eligible to be held by UCITS products.

What has UCITS meant for ETFs?

Almost four decades’ worth of regulatory development has gone into ensuring UCITS ETFs are diversified, transparent and liquid vehicles that satisfy a plethora of considerations.

Diversification is ensured by the commonly known 5/10/40 rule, requiring instruments to invest no more than 10% of their assets in securities issued by the same body, provided the combined value of securities it can invest more than 5% in is less than 40%.

However, index-tracking UCITS can employ the 20/35 rule, whereby they can invest up to 20% of assets into securities from the same issuer, with this limit being raise to 35% in exceptional market conditions.

Index tracking UCITS in Ireland are also required to use an ‘adequate benchmark’, meaning their index is a suitable representation of the market they are trying to capture and does not exclude major securities within that market.

Transparency is protected by mandatory disclosures and documentation, including the KIID, which summarises a fund’s objectives, risks and charges.

Index UCITS ETFs must also have a simplified prospectus with clear information on the components underlying their indices, the methodology used to track the index, anticipated tracking error and factors which may impact performance, including transaction costs, illiquid components or dividend re-investments.

Active ETFs must make it clear that they do not track an index and provide information on how the fund manager intends to fulfil its investment policy including its intention to outperform an index if stated.

Aside from concentration limits, liquidity is safeguarded by UCITS ETFs being required to be held separately from the fund promoter and supervised by an independent custodian.

ETFs can also only physically replicate indices comprised of eligible assets, whereas indices containing ineligible assets – such as commodities – can only be captured via a diversified basket of derivatives.

Overall, UCITS has played a vital role in establishing European investment schemes as credible and accessible instruments that are popular across Europe, Asia and Latin America.

UCITS funds and ETFs currently comprise around 75% of all collective investments by small investors in Europe, with the UK government working to ensure the framework continues in the UK post-Brexit.