Investors require peace of mind when investing their monies in collective investment schemes or any other instruments, especially the retail investors who have neither experience nor in-depth knowledge of investments. It is for this reason that the Undertaking in Collective Investments in Transferable Securities (“UCITS”) Directive gives such importance to investor protection.
UCITS is a European Union Directive which governs collective investment schemes suitable for sale to the general public, that is, the retail investors. The first directive came into effect in December 1988, with the primary aim of facilitating and harmonising cross-border offerings of collective investment schemes to retail investors. Updates to this Directive were carried out throughout the years, with the latest update, known as UCITS V, came into force on the 21st March 2016. The Directive aims to provide retail investors with a secure environment for collective investment scheme investing, by setting out universal rules on how these schemes should be structured, managed and governed, and how their assets should be safeguarded. Any collective investment scheme, as long as it meets the standard UCITS notification requirements, and hence qualifies as a UCITS, may be sold freely to the public in any EU country. Not all collective investment schemes qualify as UCITS, however those which do qualify, need to adhere to stricter rules and regulations than those that do not.
One may argue that the UCITS standards of investor protection constitute the most important element in the development of this Directive over the past two decades. Rules on the eligibility of assets a collective investment scheme may invest in, the diversification of these assets, liquidity, valuations, risk management and compliance, oversight and safekeeping and the information provided to the retail investors are the factors which ensure that utmost protection is provided to the retail investor.
Collective investment schemes which qualify as UCITS are subject to rules on the eligibility of assets they are allowed to invest in. Not all collective investment schemes invest in the same assets, and a prospective investor may refer to the investment policy section of the prospectus of a collective investment scheme to understand in which asset types a collective investment scheme is to invest. As a rule of thumb, a collective investment scheme which qualifies as UCITS may only invest in transferable securities, money market instruments, and other collective investment schemes or in other liquid financial assets. Under certain conditions, collective investment schemes which qualify as UCITS, may also use financial derivative instruments, such as futures, options or swaps based on an eligible UCITS asset or an approved financial index, either for investment or hedging purposes.
Furthermore, the Directive provides guidelines as to the diversification of assets a collective investment scheme which qualifies as UCITS may hold. Diversification is a vital means of reducing risk for investors of all kinds. Different types of collective investment schemes give investors access to asset classes and strategies whose performance may vary according to the market and economic conditions. The UCITS Directive ensures that collective investment schemes which qualify as UCITS offer investors diversification in terms of the assets in which collective investment schemes invest in, the business sectors they cover, and the countries or regions where investments are located. Since collective investment schemes which qualify as UCITS are designed to be suitable to the retail investors, the UCITS rules ensure certain levels of diversification, with the aim of reducing the vulnerability to the performance of a small number of assets. The most commonly known restriction is that which is known as the 5/10/40 rule. This states that a maximum of 10 per cent of a collective investment scheme’s net assets may be invested in transferable securities from a single issuer, and that investments of more than 5 per cent with a single issuer may not make up more than 40 per cent of the whole portfolio of the collective investment scheme. Other similar rules are enforceable under the UCITS Directive in relation to investments in other collective investment schemes, bank deposits and the use of financial derivative instruments. In general, the more different assets a collective investment scheme holds, the less the risk to investors of losing a substantial portion of their portfolio if one particular asset falls in value.
Another important characteristic of the UCITS Directive is that it provides retail investors with an ease to buy or sell their shares in a collective investment scheme which qualifies as UCITS. The Directive allows investors to buy or sell their shares in a collective investment scheme which qualifies as UCITS at least twice a month. However, in the majority of cases, collective investment schemes which qualify as UCITS offer daily liquidity solutions. The price at which shares in a collective investment scheme are bought or sold is determined by the Net Asset Value of that collective investment scheme divided by the number of shares held by investors. The Net Asset Value is determined by a valuation of all the assets held by the collective investment scheme, which again offers protection to the retail investors given that the UCITS Directive also governs this aspect of a collective investment scheme. Investors buy shares or units in a UCITS collective investment scheme without knowing the exact price, which is only established after the deal has been placed.
In the next part of the article, we will focus on risk management and compliance, oversight and safekeeping and the information provided to the retail investors as the other factors which ensure that utmost protection is provided to the retail investor.