Pooling and Fund Efficiency |
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January 2011 |
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Welcome
Richard Ernesti
Managing Director, Global Head of Client & Sales Management for Investors,
Global Transaction Services, Citi
The advent of UCITS IV is encouraging investment managers to look at new ways of driving efficiency by consolidating their fund ranges. UCITS IV makes it possible, for the first time, to establish UCITS master-feeder structures in Europe, both domestic and cross-border. It also facilitates domestic and cross-border mergers between UCITS funds. However, both of these solutions have their limitations from a commercial standpoint.
In this issue of Spotlight, we assess the pros and cons of the different options available to investment managers under UCITS IV and compare them with the benefits of asset pooling. What is clear is that consolidation under the UCITS framework remains cumbersome, may be problematic from a tax point of view and provides limited flexibility for investment managers, compared to the benefits offered by asset pooling solutions.
Shortcomings of the UCITS Framework
Bernard Hanratty
Managing Director, EMEA Investor Services,
Global Transaction Services, Citi
Europe’s investment landscape is populated with too many funds – on this most people agree. The imminent implementation of UCITS IV opens up new opportunities to consolidate disparate fund ranges and cut operating costs. Many investment managers are now looking at the mechanisms available and assessing whether to use them.
Fund of Funds Route
One avenue for consolidating funds across Europe has long existed. Under UCITS III, investment managers have been able to use structures akin to a fund of funds structure – though their limitations are well chronicled. The exposure of a UCITS fund of funds to any one UCITS must not exceed 20% of net assets, while the aggregate value of all non-UCITS holdings by a UCITS may not exceed 30% of the NAV of the UCITS. There are other restrictions, too, which limit the application of the fund of funds structure.
Fund Mergers
UCITS IV will facilitate both domestic and cross-border mergers between UCITS, regardless of their legal form. On the surface, mergers have a lot of appeal as a means of consolidating assets under management and reducing total expense ratios.
However, a cross-border merger of UCITS is likely to be cumbersome. Regulatory filings are required, an independent auditor or custodian must validate the valuation criteria and all investors must be given the right to redeem or exchange. With substantial legal input, the costs are likely to be significant. Except where a UCITS does not have a separate management company and is self-managed, those costs must be borne by the management company, not the UCITS or its investors.
There are other issues, too. A key question is how the merger affects the tax position of UCITS, the investors and the management company. Although UCITS IV itself is silent on these tax consequences, the tax regimes of the member states do provide for the tax consequences at fund level of (both domestic and cross-border) UCITS mergers.
In most member states, both domestic and cross-border mergers can take place in a tax-neutral manner – meaning that at fund level no tax is imposed as a result of the merger. However, the tax consequences for investors are another matter. Most member states still tax investors on the merger of their funds. In addition, there are commercial considerations to take into account. For instance, in many countries, investors prefer to buy local funds.
Master-Feeder Structure More Effective
Given the issues involved in mergers, the now permitted master-feeder structures of UCITS may prove to be a more effective means of consolidating assets. There is no danger of crystallising capital gains. From a commercial standpoint, master-feeder structures look an efficient way of expanding distribution channels while avoiding the cultural issues involved with mergers. They should also result in lower expense ratios and larger asset pools.
But, once again, there are limitations. Master-feeder structures only work where the different feeder funds are pretty much identical products from different fund ranges or jurisdictions. UCITS feeder funds must invest at least 85% of their assets into the UCITS master fund, leaving only 15% for what could be described as local strategies.
Tax can also be an obstacle here. Feeder funds take on the tax status of the master fund (just as the tax status of a fund of funds is significantly influenced by the tax status of the underlying funds). Master-feeder structures only make sense where the tax status of the feeders and the master are all aligned.
There is no point, for instance, consolidating a UK and an Irish fund through a master fund in Ireland if the funds are invested in US equities. The new fund would suffer 30% withholding tax on its US dividends, effectively twice the rate previously incurred by the UK fund.
There are also a lot of practical points to consider. If the UCITS master and the UCITS feeders have different custodians or auditors, detailed agreements must be drawn up between them. The flow of information and documentation between them must be managed. The valuation points between the UCITS feeders and the UCITS master must be coordinated. Managing and mitigating the risk of market timing activities poses further challenges.
Asset Pooling Can Accommodate Complex Structures
Karen Zeeb
Director, Global Head of Asset Pooling and Switzerland Head of Securities and Fund Services,
Global Transaction Services, Citi
By contrast, the asset pooling solutions now available share none of the potential pitfalls of funds of funds, mergers or master-feeder structures. They can support the most complex of structures and accommodate funds (both UCITS and non-UCITS) with widely different characteristics and requirements.
Participating funds may be from different countries and have different tax profiles – yet their tax status is mostly undisturbed as an asset pooling solution can be established to be tax-transparent. The funds may even originate from different long term savings products (e.g. retail, pensions and insurance products) and therefore subject to different regulatory reporting. All of this can be supported through an asset pooling solution.
The Benefits of Multi-layered Pooling
Asset pooling offers investment managers huge flexibility. Funds are often distributed in different jurisdictions, for different investor segments and under different brandings, but will still employ the same investment strategy. With a multi-layered pooling solution, different asset allocation models can be followed — without the limitations often associated with UCITS master-feeder structures or UCITS funds of funds.
In addition, firms that manage segregated mandates can, if the mandate allows, co-mingle these in a pool. That is not as easily achievable using any of the other consolidation techniques.
The pooling service offered by Citi may also enable each participating fund to continue to engage in securities lending on an optimal basis (or opt out of lending if it so chooses). Funds with different tax rates must lend their assets independently to secure the correct manufactured dividend rate. That particularly applies to UK funds, which are also subject to a stamp duty reserve tax. With pooling, funds may be able to lend securities according to their own tax profile. By contrast, a merger, master-feeder or fund of funds structure imposes one tax profile on participating funds.
Efficiency Gains
There are efficiencies to be gained from asset pooling. Some come in the form of cost-savings; with pooling enabling the use of a single management company, allowing for more cost-effective and efficient portfolio management and having the potential to reduce research, administration and custody costs. Others are business-driven; with broader asset diversification and greater flexibility around investment portfolio construction. The amount of seed capital required to introduce a new investment product may be massively reduced. It is possible, for instance, to launch a new fund with just a few thousand Euros of new money by participating in the existing pool of investments. Pooling may also materially shorten the time to market for new funds.
Citi has been working with pooling structures since 1992. Our advanced pooling solution was pioneered to achieve cross-border pooling and was part funded with grant aid from the Irish government. Today, we have live clients who apply the technology in its most complex form – using it for multi-manager pools, engaging in participant-based stock lending, and, in one case, establishing a tax-transparent cross-border UCITS pooled fund with multiple share classes.
However, we cannot stand still. Citi will continue to explore new applications in the drive for efficient and flexible tools to ensure that we can meet our clients’ strategic and business objectives on an ongoing basis.
