8.1 Major UK Funds & Fund Regulation

Question 1

What kind of investors make up the vast majority of the investors in the financial market?

Answer 1

Institutional investors

Question 2

Who are the largest institutional investors from largest to smallest?

Answer 2

Largest institutional investors from largest to smallest:

1. Pension funds
2. Insurance companies
3. Collective investment schemes (such as unit trusts)
4. Investment trust companies.

Question 3

Where do institutional investors record the set objectives that they wish to achieve for their funds?

Answer 3

In the constitutional documents for that particular institution, for example the trust deed for a unit trust or a statement of investment principle for an occupational pension scheme.

Question 4

What are the 2 broad categories fund objectives can be divided into?

Answer 4

1. Maximising returns
2. Matching liabilities

Question 5

List which category the major 6 fund types fall under maximising returns or matching liabilities.

Answer 5

The 3 following fund types can be grouped as having an aim of maximising returns:

1. Defined contribution pension scheme
2. Collective investment scheme
3. Investment trust company

The 3 following fund types can be grouped as having an aim of meeting liabilities:

1. Defined benefit pension scheme
2. Life assurance company
3. General insurance company

Question 6

What are funds that need to meet liabilities said to engage in?

Answer 6

Liability driven investments or assets and liability matching strategies. Institutions will try to ensure that the returns generated by any investment will meet the liabilities due on their due date.

Question 7

What do many liability driven investment strategies make use of?

Answer 7

Fixed income securities, such as government bonds.

Question 8

What is dedication? What is another name for dedication?

Answer 8

Fixed income securities give predictable cash flows that can be matched with the timings of liabilities; a process called dedication or cash flow matching.

Question 9

What are real liabilities?

Answer 9

Real liabilities are those that are affected by inflation. For example, if we consider a defined benefit pension scheme linked to an employee’s final salary. The employee is not due to retire for 20 years. In this scenario the liability that the pension fund needs to meet is exposed to the impact of salary inflation one would imagine that over the next 20 years, the employee’s salary will increase. Clearly, this will not always be a long-term liability, and, in 15 years, the liability becomes more imminent. Most long-term liability driven funds will adjust their asset allocation accordingly when the liabilities draw near.

In these situations, cash flow matching may not be appropriate, as the investor would need to anticipate inflation over a long period of time. Often investors facing real liabilities to match will use assets that increase with inflation – such as equities and index-linked instruments.
 

Question 10

What is considered to have the greatest impact on the returns of a portfolio? And is it as true for institutions as it is for individuals?

Answer 10

Asset allocation is considered to have the greatest impact on the returns of a portfolio. This is as true for institutions as it is for individuals.

Question 11

What is key to asset allocation?

Answer 11

The length of time a fund is able to commit its resources to investments.

Question 12

How does a longer investment horizon affect a fund?

Answer 12

The longer term the investment horizon, the more short-term risk a fund will be willing to take. In addition, a longer investment horizon will have an impact on the funds attitude to liquidity and, possibly, inflation.

Question 13

What sort of fund would an insurance company choose for a whole-of-life assurance policy for a healthy person in their thirties?

Answer 13

Probability would suggest that the liability faced by the insurance company on this particular policy is a long way in the future. This would allow the company to take an increased level of short-term risk without too much concern about liquidity, possibly opting for equity and property within the portfolio.

Question 14

What sort of fund would a general insurance company offering car insurance opt for?

Answer 14

Car accidents occur all the time, and the general insurance companies will pay out immediately. These immediate and uncertain liabilities would lead the company to take a short-term view of investments, possibly choosing cash deposits or money market instruments.

Question 15

What has has a major impact on the assets used for investment?

Answer 15

The tax status that a fund is subject to.

Question 16

List the institutional investors who pay tax on their investment returns.

Answer 16

• Insurance companies are liable for tax on their investments.
• Mutual funds in the UK, such as unit trusts and investment trust companies, also pay tax, but typically only on interest income from bonds and deposits, or property income.

Question 17

Which funds pay no tax in investment returns?

Answer 17

Some funds, such as pension funds and charities, pay no tax on investment returns (income or gains). However, there will be tax implications. Where investments are received net of tax, the manager will need to factor in the time to reclaim the tax. In addition, these funds are likely to avoid tax-free investments. Investments, typically, are tax free for a reason, and that is, typically, an additional risk to capital.

Question 18

Do many funds have restrictions placed upon them by laws and regulations?

Answer 18

Yes

Question 19

What must authorised collective investment schemes in the UK adhere to?

Answer 19

The FCA collective investment scheme sourcebook

Question 20

What does the FCA collective investment scheme sourcebook do?

Answer 20

It restricts the asset classes and the concentration of those assets within a fund that belongs to authorised collective investment schemes.

Question 21

What are general insurers required to keep?

Answer 21

General insurers are required to keep solvency margins, expressed as a percentage of net assets to net premiums.

Question 22

What are all funds governed by?

Answer 22

All funds will be governed by their constitutional documents, which once filed, become binding on the fund.

Question 23

Give an example of funds that restrict the allocation of assets in other ways.

Answer 23

Socially responsible investment funds will place restriction on investing in unethical firms, eliminating investment issued by, among others, arms companies, tobacco companies or countries with questionable human rights records.

Question 24

What directive regulating collective investment schemes throughout the EEA, did the EEA announce the implementation of in 1985?

Answer 24

This was the Undertakings for Collective Investment in Transferable Securities (UCITS) directive.

Question 25

Which incarnation of the Undertakings for Collective Investment in Transferable Securities (UCITS) directive are we currently on?

Answer 25

The fourth incarnation

Question 26

Name the 2 parts UCITS III is split into.

Answer 26

Management Directive and Product Directive

Question 27

Explain the Management Directive

Answer 27

Management Directive increases the scope of management companies’ activities that can be passported to include discretionary management, safekeeping and fund administration.

The directive also aims to protect investors by ensuring that management companies are suitably capitalised, and that they have appropriate measures in place for risk management and reporting.

It introduced the simplified prospectus, designed to provide investors with a shortened ‘core’ version of the current prospectus, but does not replace the actual prospectus.

Question 28

Explain the Product Directive

Answer 28

Product Directive expands the range and type of financial instruments that are permitted within UCITS funds, in particular allowing investment in derivatives for investment as well as for existing risk reduction purposes and investment in other funds.

Question 29

When did UCITS IV come into effect and what is the intention of this amendment?

Answer 29

UCITS IV came into effect in July 2011. The intention of this amendment is to promote greater efficiency in pan-European management of funds.

Question 30

What are the 6 areas UCITS IV covers?

Answer 30

1. Management company passport – a management company located in one country will be able to set up and run a fund in another
2. Supervision – a management company will be subject to the supervision and regulation of the country where it is based
3. Notification procedure – quicker, more simplified regulator-to-regulator communication
4. Key investor information – product brochures to be simpler than the existing ‘simplified’ prospectus
5. Mergers – a standardised framework governing both domestic and cross-border mergers between funds
6. Master-feeder structures – allow funds to build economies of scale across borders

Question 31

In order for a scheme to be allowed to operate and promote itself on a pan-European basis it must meet which 3 criteria laid down in UCITS.

Answer 31

1. The scheme must apply for permission (a UCITS passport) from its home state regulator to operate in other EEA member states
2. The scheme must be open-ended
3. The scheme must follow all UCITS regulations

Question 32

What has happened to UCITS funds authorised in the UK following the end of the transition period?

Answer 32

Following the end of the transition period, UCITS funds authorised in the UK can no longer passport automatically into the EU. The Collective Investment Schemes (Amendment etc.) (EU Exit) Regulations 2019 introduced the designation of a ‘UK UCITS’ for funds authorised in the UK that formerly fell under the EU’s UCITS regime. Despite the loss of automatic passporting, some funds may be able to continue to market in some parts of the EU, typically in a limited manner. The extent to which UK UCITS can operate varies country by country and prior notification is required to the relevant regulator, in a similar manner to how the temporary permissions regime TPR operates in the UK.

Question 33

What does the Alternative Investment Fund Managers’ Directive (AIFMD) cover?

Answer 33

The scope of the Alternative Investment Fund Managers’ Directive (AIFMD) is broad and, with a few exceptions, covers the management, administration and marketing of alternative investment funds (AIFs). Its focus is on regulating the alternative investment fund manager (AIFM) rather than the fund itself.

Question 34

What is an Alternative Investment Fund (AIF)?

Answer 34

An Alternative Investment Fund (AIF) is a ‘collective investment undertaking’ that is not subject to the Undertakings for Collective Investment in Transferable Securities (UCITS) regime. It includes hedge funds, private equity funds, retail investment funds, investment companies and real estate funds, among others.

Question 35

What does the Alternative Investment Fund Managers’ Directive (AIFMD) establish?

Answer 35

The Alternative Investment Fund Managers’ Directive (AIFMD) establishes an EU-wide harmonised framework for monitoring and supervising risks posed by Alternative Investment Fund Managers’ (AIFMs) and the Alternative Investment Funds (AIFs) they manage. The Directive also includes new requirements for firms acting as a depositary for an AIF. This harmonisation creates a permission for the AIFM to market their funds under an EU passport, rather than comply with local regimes.

Question 36

Under AIFMD, when does the AIFM need to seek authorisation with the home state regulator?

Answer 36

If they have assets under management in AIFs above:

• €100m if any of the AIF uses leverage; or
• €500m if the AIFs do not use leverage and do not give their investors a right of redemption within five years of initial investment in each AIF

Question 37

What are AIF that do not require authorisation from the regulator called?

Answer 37

Sub-threshold (lighter regulation applies)

Question 38

What are the two types of sub-threshold AIFM?

Answer 38

1. A Small Authorised UK AIFM which is FCA authorised and has not opted in to the AIFMD (most small private fund managers)
2. A Small Registered UK AIFM and either:
   – An internal AIFM of a corporate body, such as an investment trust;
   – The unauthorised manager of property funds which are operated by an FCA authorised operator; or
   – A fund manager which has applied for registration under the European Venture Capital Funds Regulation or the European Social Entrepreneurship Funds Regulation

Question 39

Which rules generally apply for sub-threshold AIFMs?

Answer 39

FCA SYSC and COBS rules

Question 40

A UK sub-threshold AIFM cannot benefit from what?

Answer 40

A UK sub-threshold AIFM cannot benefit from the EU marketing passport under the AIFMD, meaning that any marketing in the EU must comply with local regimes.

Question 41

AIFMD requires AIFMs to select brokers and counterparties that meet which 3 criteria?

Answer 41

1. Are subject to regulatory supervision;
2. Are financially sound; and
3. Have the necessary organisational structure.

Question 42

What are the 3 reporting requirements for AIFMs?

Answer 42

1. All AIFMs are required to submit quarterly, semi-annual, or annual reports to their respective member state regulator with information about the AIFM and its AIFs.
2. AIFMs are also required to submit an annual report with information such as the fund’s financial statements, activities, and information about the total amount of remuneration paid by the AIFM to its staff.
3. The AIFMD has special requirements that apply to AIFMs using leverage. AIFMs must disclose the extent of the leverage employed within their funds, and prove that leverage in any fund has been limited to a reasonable amount.

Question 43

What does AIFMD state about the number of AIFMs a fund can have?

Answer 43

The directive states that each fund can only have one AIFM, though the AIFM can delegate certain functions to other parties.

Question 44

Who can authorised fund managers located within the EU market their EU funds to?

Answer 44

Authorised fund managers located within the EU are permitted to market their EU funds to professional investors in any EU member state under an AIFMD passport.

Question 45

What changes have been made to UK AIFMs post Brexit under AIFMD?

Answer 45

Since Brexit, the AIFMD marketing passport is only available to EU AIFMs and UK AIFMs cannot use the passport to market their EU or UK AIFs. One option available to UK AIFs is to use the National Private Placement Regime (NPPR) for any AIFs as set out in Article 42 of the AIFMD. The UK AIFM will also need to consider whether they have engaged a third-party UK distributor, which has been using MiFID passports to distribute the fund product in the EEA countries, as these UK distributors will also lose their MiFID passporting rights after EU withdrawal. The implementation of the NPPR varies across the Member States and can lead to additional costs associated with registration and maintaining ongoing compliance within the individual regulatory regimes.

Question 46

What did the FCA do when it found weak price competition in the Asset Management Market Review?

Answer 46

On 5 April 2018 the FCA published new rules that require authorised fund managers to assess the value for money of each of their funds.

Question 47

What 3 things do FCA regulations (COLL 6.6.20R) require authorised fund managers (AFMs) to do?

Answer 47

1. Assess the value for money of each fund;
2. Take corrective action if it does not offer good value for money; and
3. Explain the assessment annually in a public report

Question 48

What are the seven minimum criteria that firms must consider when assessing the value for money of their funds set out in the FCA Handbook (COLL 6.6.21)?

Answer 48

1. Quality of service: the quality and range of service provided to investors
2. Fund performance: the fund’s performance, net of deductions of all payments out of scheme property
   as disclosed in the scheme prospectus
3. Authorised fund manager costs: the cost of providing each service to which each charge relates
4. Economies of scale: whether the fund manager has achieved savings from economies of scale
5. Comparable market rates: the market rate for each comparable service provided by the fund manager
6. Comparable services: the fund manager’s charges for comparable services provided to clients
7. Classes of units: whether it is appropriate for unit holders to hold units in classes subject to higher charges than those that apply to other classes of the same scheme with similar rights.

Question 49

When must the annual public value for money reports be published?

Answer 49

These annual public value for money reports must be published within four months of the fund’s annual accounting period end date.