Henderson

Guide to UCITS

Important Information This document is solely for the use of professionals and is not for general public distribution.

Contents
Introduction UCITS: the original vision for Europe UCITS III Non-sophisticated and sophisticated funds Shorting and portfolio symmetry Derivatives Risk management requirements UCITS funds, hedge funds and Newcits funds The transition from UCITS III to UCITS IV UCITS comparison table Conclusion Glossary of terms Page 1 Page 2 Page 3 Page 4 Page 5 Page 7 Page 8 Page 9 Page 10 Page 11 Page 12 Page 13

Welcome to the Henderson Guide to UCITS

In 2007 Henderson wrote a Guide to UCITS III for investment advisers and their clients. The intention was to provide further clarity regarding the introduction of the third set of European Union (EU) directives known as the Undertakings for Collective Investments in Transferable Securities, or UCITS.
Back in 1985, when the first UCITS directives were introduced, the European fund management industry was still considered to be in its infancy. At this time it was felt that Europe required a distinctive operational and regulatory framework that would clearly define the boundaries of investment for fund management firms and their clients. UCITS II, the second phase in the regulatory process, was ultimately dragged down by the failure to reach an accord with the EU member states. UCITS III, however, was a notable step forward, both in terms of setting out product marketing parameters and establishing the sophisticated and non sophisticated investment strategies at the disposal of fund managers. Today, funds operating under the UCITS framework manage assets worth more than 5.5 trillion* for clients. That is not to suggest, however, that the evolution of UCITS has been an unbridled success. The industry remains hopeful that the next incarnation of UCITS will manage to address some of the problems identified with previous legislation. UCITS funds under management by asset class
Other UCITS funds 5% Equity funds 31%

An ever-changing investment landscape

Although UCITS III, consisting of a Product Directive and Marketing Directive, was initially passed as law in 2001, investment firms throughout Europe were given until February 2007 to ensure their funds were fully UCITS compliant. Three years later, and it is evident that the investment landscape has changed dramatically since UCITS III first took shape. The recent global financial crisis, the contagion-like effects of which came to a head in 2008, became a real life stress test for investment vehicles across Europe. Financial institutions that had been in existence for hundreds of years suddenly found themselves in peril, and in need of state assistance for survival. As a result, market volatility across all asset classes reached levels that had not been witnessed for decades. Since UCITS III was introduced the performance of many UCITS III-branded funds has been mixed, leading some to question the benefits of introducing more sophisticated UCITS powers into the retail market. We would argue that the fault lies less with the UCITS III directives themselves, but rather their interpretation. The UCITS product directive is far more flexible than the narrow interpretation that some investment houses have so far chosen. For example, several took the decision to use the powers afforded to them by UCITS III by creating new long/short funds known as 130/30 funds. These funds have a full market exposure (of 100%), but augment this with an additional long position up to 30% and a short position also up to 30%. The last couple of years of steep market volatility have provided us with a clear example of why it is not always helpful for a fund to have an inherent 100% market exposure regardless of economic conditions. UCITS III was designed to benefit investors by allowing fund managers greater freedom in making their investment decisions. This freedom must be used appropriately by fund management houses, by creating funds which have variable market exposure alongside the stock-picking ability of the managers. Both these features when used together can provide powerful risk adjusted returns for investors. At Henderson we have embraced the opportunities that UCITS has created and we shall continue to use the full flexibility of the new regulations in order to deliver the best performance to the benefit of our clients.
* Source: European Investment Fund Industry and Asset Management Associate data at 30 April 2010 (www.efama.org)

Money market funds 24%

Balanced funds 16%

Bond funds 24%

Source: efama.org, at 30 June 2010

UCITS: the original vision for Europe

As part of the EUs commitment towards establishing a single market for financial services and trade across Europe, the Undertakings for Collective Investments in Transferable Securities (UCITS) directive was created.
The new regulation was deemed necessary for two reasons: first, as investment vehicles and fund management techniques became more sophisticated, it was felt that investors needed a stricter regulatory environment in order to ensure that their investments were being responsibly managed. Second, despite the EU affording exciting opportunities in terms of cross border trading, investment firms were finding increasing difficulty in marketing their funds to the various member states within the European Union, as each member had its own regulations governing the sale of investment products. UCITS was designed to allow investment managers to market their products on a wider basis, and under the protection and watchful eye of just one single regulatory body, the EU. When setting up UCITS in 1985, the EU had three clear objectives: 1 Keep regulation up to speed with changes in the investment market. 2 Create a level playing field for funds established in different member states. 3 Ensure investors were well-protected by a single regulator across all EU markets. This regulator would dictate the type of investments deemed suitable for consumers.

An inauspicious start
It was not long after the implementation of UCITS began before cracks started to appear. The disparate rules of various member states still made it difficult for companies to effectively market their products across borders. Furthermore, the definition of the new permitted investments was already considered slightly behind the curve in relation to the latest techniques being used by fund managers. The first UCITS initiative was always considered very much work in progress, and it was no surprise that the legislation helped highlight several flaws. It was widely anticipated that the development of a second directive (UCITS II), the formulation of which began in the early 1990s, would be able to address such issues. Unfortunately, UCITS II managed to raise more questions than it answered and left the EU member states no closer to agreement about how best to market funds across borders. The proposed outline for UCITS II was subsequently abandoned after the council of member states failed to reach an accord over how far the proposals should go and what form they should take.

The third iteration

Undaunted, the EU pressed ahead with regulatory reform and, having allowed UCITS II to quietly disappear, finally published its plan for UCITS III in 1998. The new resolutions contained within UCITS III were drafted in two parts: the Management Directive and Product Directive. After three years of consultation and compromise, UCITS III was finally adopted in 2001. Fund management companies were given until February 2007 to ensure that their funds were fully UCITS III compliant.

UCITS timeline
Original UCITS Directive adopted by the European Union (EU)

EU publishes a new proposal drafted in two parts: the Product and Management directives

February 2007: the deadline by which firms were required to ensure funds were UCITS III compliant

1985

1990s
Plans for UCITS II published, but never go past the proposals stage

1998

2001
Proposals for UCITS III adopted in December 2001, allowing firms to passport their funds across EU member states and increasing the number of investment strategies

2007

2009
UCITS IV directive approved by European Parliament, with implementation expected to take place in 2011

UCITS III
The UCITS III legislation was divided into two distinct directives. The Management Directive determined the processes relating to how investments could be marketed across EU member states. The Product Directive dictated the type of investments and financial instruments that a UCITS III fund could invest in.

Basic features of a UCITS III fund

Can be sold anywhere within the European Union Investors must have access to a Simplified Prospectus relating to a recognised investment product Must not expose the investor to a loss beyond the amount paid for it Must be priced accurately, regularly and independently Must make available regular, accurate and comprehensive information on the portfolio and securities within it Securities invested in must be relatively liquid and negotiable Must be able to effectively measure the risk of the securities invested in

The Management Directive crossing borders

The Management Directive was created in order to smooth the process for companies wishing to market their funds throughout the EU. The introduction of UCITS III meant that any company wishing to sell their funds across Europe needed to ensure that its products were registered and considered fully UCITS III compliant by the EU. Instead of fund management companies having to seek permission to market their funds from the regulator of each individual member state, UCITS III provided companies with a European Passport. Once regulatory approval had been granted in the companys home country, this was expected to entitle the fund to be sold anywhere within the EU, subject to regulatory approval. The Management Directive also required the use of a Simplified Prospectus document, setting out the key features of the fund being marketed and doing so in a clear and simple format. Under the directive the Simplified Prospectus has to be made available to potential investors before a fund is purchased, allowing investors to make a fully informed decision.

The Product Directive broadening investment horizons

Whilst the Management Directive of UCITS III marked a significant step forward in the marketing of investment products across Europe, the Product Directive was a far more exciting piece of legislation as far as fund managers and investors were concerned. In short, the Product Directive meant that funds were able to invest in a wider range of financial instruments than previously possible within the standard long-only fund structure. Investors would have a choice between nonsophisticated and sophisticated funds the differences between the two are explained on the next page. The Product Directive ensured that investors would still be able to opt for the traditional long-only investment vehicle, packaged as a non-sophisticated product. Those investors who were seeking more efficient and innovative portfolios would be able to find these through those funds designated as sophisticated.

Non-sophisticated and sophisticated funds

Once UCITS III was adopted in 2007, firms were required by their home regulator to classify their funds as either nonsophisticated or sophisticated funds, depending on the investment powers they intended to use to manage the fund.
Non-sophisticated funds were able to continue to operate using the same portfolio structure as traditional long-only funds, consisting primarily of the purchase and sale of physical assets, such as equities and bonds. In contrast, sophisticated UCITS funds were granted additional investment powers that were expected to distinguish them quite dramatically from their nonsophisticated counterparts. Sophisticated funds had greater flexibility in terms of the types of assets in which they could invest, including derivatives and collective investment schemes (such as index tracker funds and exchange traded funds) that they were previously excluded from. Fund managers could also apply different investment strategies to enhance their portfolios or provide greater protection during periods of market weakness.

Key characteristics

Non-sophisticated funds
Traditional long-only equity portfolios that contain physical holdings as assets Derivatives are only used for Efficient Portfolio Management (EPM) Derivatives cannot be used to create symmetry within a portfolio No disclosure on derivatives required within investment objectives The commitment approach to risk measurement calculates exposure in terms of the obligation to a third-party, including predicted market moves Required to submit a non-sophisticated risk framework with regulators

Sophisticated funds
Additional portfolio scope, including additional asset types/classes, derivatives and investment strategies Symmetry, hedging and other derivative strategies permitted for investment purposes Required to disclose derivative usage in investment objectives Sophisticated risk measurement technique i.e. Value at Risk (VaR) must be calculated on a daily basis Required to submit a sophisticated risk framework with regulators

Shorting and portfolio symmetry

Arguably the most important aspect of the UCITS III Product Directive, from a portfolio management point of view, was the introduction of more sophisticated investment strategies. The most significant of these is the ability to short sell an investment.
The use of shorting
Short selling, or shorting, is widely considered to be one of the most important strategic tools available for modern day fund managers, although before the introduction of UCITS III in 2007, the ability to short a stock or index was restricted solely to the managers of unregulated hedge funds. So how does shorting work in practice? While a long-only fund consists entirely of securities that the manager holds, a long/short fund can contain holdings and positions that the fund manager does not hold. The manager borrows the security from a third party, such as a broker, for a small fee, sells it, and hopes to profit by buying the security back at a lower price if there is a fall in value. If the security appreciates in value, however, the short seller will lose money because to close the trade they will have to repurchase the security at a higher price than it was sold for. Shorting is based on the view that a fund manager who is able to identify attractive opportunities to profit from the good performance of a security (within which to go long), can also successfully spot significant shorting opportunities and therefore profit from the bad performance of other securities. If a fund manager researches a company and views it as a poor investment, this knowledge can be used to generate additional returns. Equal use of positive and negative information produces the most efficient conversion of risk into return. In other words, it produces the highest excess return for each unit of risk taken. The use of shorting within a sophisticated UCITS fund is, however, markedly different from that used by a hedge fund. A hedge fund can short sell a physical stock or bond (for example 100 shares in Company XYZ), whereas a UCITS fund can achieve a similar effect through the use of derivatives, thereby creating a synthetic short position on Company XYZ. We discuss derivatives in greater detail on page 9. Non-sophisticated UCITS funds cannot use derivatives for shorting purposes.

Shorting types
Naked shorting when a short trade is implemented without the seller borrowing the security. The German government previously initiated a ban on naked shorting on some financial securities, on the basis they cause dangerous market volatility. Hedging using exposure in one security or market to offset or limit exposure in another. For example, a manager may believe that oil Company As share price is undervalued, but is concerned that the oil sector is volatile. The manager could therefore go long on Company As shares, and sell a short position on its rival in the sector, Company B. If the value of Company A goes up, the managers long position will do well, but the hedge will lose money if Company B also rises. If however, oil price volatility causes the share price of both Company A and Company B to fall, the hedge means the manager will reduce his potential loss on Company A through the short position on Company B. Arbitrage an attempt to profit from market inefficiency through the mispricing of certain assets. An example of an arbitrage trade would be purchasing long futures contracts on a UK gilt, and shorting the underlying gilt itself.

Shorting: positives and negatives

Positive: using all available information In deciding which stocks to include in a long-only portfolio, fund managers naturally spend a great deal of time deciding what they do not wish to own. If the outlook for a company is poor, the strongest position a long-only manager can take is to not own the companys shares. However, short selling enables a manager to take a negative view of a stock to its logical conclusion, and therefore benefit from the opportunity. Positive: reducing overall portfolio risk Even while aiming to generate higher levels of excess return, a fund manager is able to employ the approach of taking highly diversified and symmetrical positive and negative positions across a wide range of stocks. In addition, the fund manager is able to mitigate unwanted risks by hedging long positions through shorting. Negative: the potential downside One frequent concern among investors is that while permitting shorting in a portfolio gives fund managers more scope to generate returns, it could also increase the scope for fund managers to lose money. In a long-only portfolio the fund manager can, in the worst case, only lose the sum of money paid out to acquire the funds securities. In the best case, their potential reward is unlimited as theoretically there is no limit to the price the funds holdings can rise to. Shorting effectively reverses this concept. The short sellers best potential reward comes from the securitys value falling to zero. On the other hand, should the security rise in value, the potential loss to the short seller is theoretically unlimited.

The importance of risk controls when applied to shorting

Among the key considerations when looking at such strategies are the suitability of the underlying investment process to the introduction of shorting, and the experience of the fund managers in implementing and managing short positions. It may take time for investors to become comfortable with the concept of shorting in core portfolios, but the potential benefits, and drawbacks, are plain to see.

Derivatives
As already discussed, UCITS III sophisticated funds cannot physically short sell a stock. However, by purchasing a derivative of that stock, a fund manager can achieve a similar effect, at considerably lower cost than can be achieved through trading in the assets themselves.
A derivative is simply a contract between two parties that relates to or derives from a physical asset. By investing in a derivative, a fund manager is making an investment decision based on the potential performance or risk characteristics of the underlying asset the derivative relates to. This allows a manager to increase their level of investment within a security, without the need to trade the underlying security itself. Derivatives can be used to increase levels of risk in a stock or market where a manager has the most conviction instead of being constrained to small deviations away from a traditional benchmark. A sophisticated UCITS III fund can theoretically hold no physical stocks and instead consist entirely of derivatives and cash or cash-like instruments.

What is leverage?
A fund manager can take a position in an asset in a number of ways, including owning physical stock. Derivatives, however, provide a method for the manager to take the same stake for a much smaller outlay, as a derivatives contract can be bought at a fraction of the cost of purchasing the physical asset. This is therefore a leveraged position, and while upside is amplified, downside is amplified too.

Back-office requirements
For those fund management firms seeking to launch and market sophisticated funds, a robust derivatives trading platform is vital. The development of an infrastructure that properly addresses the risks involved when using derivatives requires a lot of resources and manpower. Any fund management company has to create systems and processes capable of dealing with the added administration involved (ranging from instructions, trades, settlement, pricing and valuations), in order to ensure compliance with all regulatory requirements. These processes need to feed directly into the companys risk management framework to be submitted to the regulators. But more importantly, they need to be processed on an automated basis, with as little manual intervention as possible. Fund management companies who wish to trade derivatives on a regular basis are therefore required to make considerable investment in systems and architecture to ensure the monitoring, measurability and reporting capability of their derivatives exposure. This commitment is crucial to ensure that derivatives can be successfully integrated into sophisticated portfolios.

The benefits of using derivatives

Liquidity: Using derivatives means you can buy or sell an investment without actually owning it. Low cost exposure: Derivatives trade at a fraction of the price of the underlying asset. Flexibility: Fund managers can use derivatives to manage their portfolios, make changes to their investment strategy, or gain exposure to certain markets more easily than they could by purchasing the underlying asset.

Risk management requirements

One of the key features of UCITS III was the emphasis on risk management as an integral requirement for any fund seeking sophisticated status. The increased regulatory requirements reflected the importance regulators placed on being able to effectively calculate and measure the potential losses of a clients portfolio: a farsighted decision given the losses incurred by many investors since the global financial crisis occurred in 2008.
UCITS III risk measurement requirements
Sophisticated funds must apply Value at Risk (VaR). This estimates the potential loss that a portfolio could suffer within a certain time period and with a certain degree of confidence. The flaw highlighted with VaR is that it does not allow for exceptional events that might occur outside the confidence limits. It also relies on historical price data to calculate future potential losses, even if some of the past price data for certain securities is too limited to be reliable. To supplement VaR, it is also necessary to stress test the portfolio to take account of abnormal market conditions or events when correlation is affected and the benefits of diversification are reduced.

Stress testing
Stress testing is designed to analyse how a portfolio of securities would potentially react in times of extreme circumstances, such as during a major stock market crash (for example Black Monday in 1987, 9/11 or the banking crisis in 2008). Fund management companies are expected to calculate VaR on a regular basis and stress testing using historical and Monte Carlo (a mathematical analysis technique) methods should also be performed regularly. By subjecting the fund to these types of rigorous tests, it is hoped that consumers can be encouraged to feel a certain degree of confidence that a UCITS III compliant fund will behave as described by its stated objectives, even if the worst should happen. The 2008 banking crisis, however, offered proof that UCITS III offers no guarantee of immunity from risk.

Example
A VaR of 4 means an investment worth 100 million could lose 4% of its value (or 4 million) over a set period. The confidence level is set at 99%, which means that over the same period there is a 99% chance that the fund will not lose 4% of its value.

Explaining VaR
VaR is an attempt to summarise the potential loss to a portfolio of assets over a certain period of time. It is an effective measurement of risk while it happens and is an important consideration when firms make trading or hedging decisions. Almost all major financial institutions have now adopted VaR as a cornerstone of day-to-day risk measurement.

UCITS funds, hedge funds and Newcits funds

Although hedge funds came to prominence in the early 1990s, the term hedge fund was originally coined to describe a fund launched in 1949, which sought to minimise risk by taking long and short positions within the same portfolio. Another definition being that hedge funds seek to generate a positive total return for clients, regardless of the market direction.
In the 1990s, as the popularity of hedge funds grew, other managers tried to find ways to integrate long/short strategies, total return management techniques and methods of managing risk within their more traditional portfolios. The development of the UCITS III Directive, incorporating hedge fund management principles within a more regimented regulatory structure, was considered a necessary response to the changes in fund management thinking. Its development was also a response to the growing demand from investors for absolute return vehicles, instead of funds that were managed to outperform a benchmark. UCITS III gives fund managers the power to use similar strategies and techniques that were previously only available to hedge fund managers, but with the added security that comes with being a fully regulated investment vehicle. place for UCITS III funds, although more limiting compared to some hedge fund structures, do not really detract from the greater flexibility offered by the directive. UCITS funds offer the following additional benefits to clients, over and above hedge fund requirements: Regulated product: It must be approved before it can be marketed for sale in any country. Independent custodian: This is compulsory, therefore avoiding the situation that some hedge funds found themselves in following the Lehman bankruptcy where the ownership of assets was in question. Concentration limits: These apply within the portfolio so that diversification of holdings is built in to the rules. Daily Liquidity: The fund must have a daily price and clients are free to buy and sell every day. All of these restrictions are in stark contrast to many hedge funds, where investors do not have the same regulatory and liquidity protections.

The arrival of Newcits

Since the arrival of UCITS III there has been a notable shift in the balance of power between hedge funds and their retail counterparts. Hedge fund managers have started to appreciate not only the commercial benefits of being able to market their funds to a retail audience for the first time, but have also recognised the importance of having a recognised regulatory environment applied to their funds. This has resulted in the arrival of a new hybrid breed of fully regulated and marketable hedge funds, known as Newcits funds. The reasons for hedge fund managers launching these products are probably twofold. For the better managers, a retail version of a hedge fund product is a logical extension to the core hedge fund offering and allows investors to access a particular managers investment skill and experience in a potentially lower risk way through a more regulated product. Secondly, it is possible that some managers facing pressure in their core hedge fund business may be attempting to launch products into the UCITS III space in an attempt to replace the revenue streams that have been lost during the volatile markets of the last three years. The lines between traditional and alternative asset managers are therefore becoming increasingly blurred.

UCITS funds versus hedge funds

The UCITS III regulations are very flexible but they do have a number of key restrictions compared to those applied to hedge funds, and rightly so. For example, gross market exposures of a UCITS III vehicle cannot be more than 200% of the net asset value of the fund. In addition, borrowing is generally not permitted to a large extent and so the leverage possibilities are smaller than for the more aggressive hedge funds. However, these restrictions seem tougher in theory than they are in practice. For example, in a bull market having a long exposure of 200% is a significant demonstration of confidence by the manager. If the manager is correct in their positioning this can be extremely rewarding for investors. Borrowing money to invest in the equity market is not always a good idea, as many investors have discovered to their cost in recent times. Therefore, we believe that the restrictions in

The transition from UCITS III to UCITS IV

Following the introduction of UCITS III, the EU almost immediately began a review process that sought to address several key areas, mostly relating to the Management Directive. The main objective of UCITS IV, therefore, is to further improve the operational efficiency and reduce the management costs for Europes fund management industry. There has been little change made to the Product Directive
The proposals for UCITS IV include:

Management company passports

UCITS III funds were granted a European passport, which meant they could be sold anywhere in the EU without further approval. The new proposals take the passport concept a step further, by enabling UCITS fund managers domiciled in one member state to set up and remotely manage funds in another. This means that, for example, a fund domiciled in Dublin will no longer have to undertake a lengthy approval process with the UK regulator, the Financial Services Authority, in order for it to be available for sale in the UK.

Master-feeder structures
The new directive also looks to introduce master-feeder fund structures. This is a way for fund managers to benefit from economies of scale and the efficiencies associated with a large pool of assets (the master), by selling feeder funds across different investor markets. For example, this will enable a master fund to create a feeder version of the same fund in another jurisdiction. The feeder will invest 85% or more of its net asset value into the master fund, the remainder can be held in cash or invested in derivatives for hedging purposes. The feeder and the master can be located in the same or different member states, although agreements must be in place to ensure information is shared appropriately between different depositories and auditors.

Key Investor Information Document (KIID)

Replacing the Simplified Prospectus (SP), the new KIID document aims to provide clear, fair and understandable information for investors. The KIID document will be much more focused and regimented, following the stricter guidelines set under UCITS IV. The KIID will contain: Brief description of investment objectives Past performance (where applicable) Information on initial costs and management charges Risk/reward profile As with the SP, companies are expected to ensure that the KIID document is clear, fair and not misleading for potential investors.

Simplification of marketing rules within other member states

Administration barriers are to be removed, speeding up the process for a fund management company to obtain approval for the cross-border distribution of funds. Under UCITS III the regulator in the host state was responsible for determining when the marketing of a fund in its jurisdiction was acceptable. This frequently involved lengthy and costly negotiations with host state regulators. Under UCITS IV, the fund management company can notify its home state regulator, informing them of its intention to distribute funds in another member state. Marketing can commence once the home state regulator has notified the host, which should be done within ten working days. A host state will therefore no longer be able to slow down the approval process.

Facilitating fund mergers

UCITS IV will look to simplify and harmonise the authorisation procedure for mergers between UCITS funds, both domestically and across EU borders. The aim is to create a more transparent and cost-effective method for fund management companies to avoid unnecessary duplication of funds, and improve the level of information available to investors before a merger takes place. Member states have been given until July 2011 to formally implement UCITS IV.

10

UCITS comparison table

The process of creating UCITS regulation has been one of evolution rather than revolution. As a result, the regulatory path from UCITS to UCITS IV can be clearly mapped out, as in the table below. This is a quick reference guide that outlines the UCITS directives in each of their forms, separated in terms of permitted investments and other key provisions.

Directive
Directives approved Harmonisation across the EU

UCITS
1985

UCITS II

UCITS III
2001

UCITS IV
2009

Investments permitted within portfolios

Transferable securities Money market instruments Regulated schemes Deposits Approved securities Warrants Use of derivatives* 10% Unlisted instruments classified under 10% unapproved 10% Unlisted instruments classified under 10% unapproved 10% Unlisted instruments classified under 10% unapproved


(max 5%) 10% EU member states failed to reach agreement on UCITS II proposals

    

    

(max 30% Non-UCITS) (max 30% Non-UCITS)

 

*

Other provisions
Streamlined notification procedure Simplified Prospectus Capital and qualification requirements Supervision of management companies Comprehensive risk management processes Cross-border fund mergers Master/Feeder structure/Asset pooling Management Company Passport
* Efficient portfolio management (EPM) only Key Investor Information Document

       


   

       
11

  

Conclusion
Since its implementation, UCITS has become more than just another EU regulatory requirement for companies. In many respects it has evolved into a brand, a way of showing to potential investors throughout Europe that the product they have selected is fully regulated and offers them greater investment choice and transparency.
The fund management industry underwent a rigorous restructuring in order to be able to fully use the powers available through UCITS, but the events of the last few years have demonstrated that a successful application of the new powers has been far more challenging than many anticipated. Being a good long-only manager is not enough to successfully manage a long/short product. The skill set needed to be able to make money from shorting stocks is markedly different and takes time to learn. It is very difficult to overemphasise this point and should be remembered when looking at the new absolute return fund offerings from long-only managers.

Have the UCITS III directives been successful?

Despite the relative success of UCITS III in terms of marketing funds across Europe, there are still concerns that the process is not as straightforward as it could be. It has been argued that the Management Directive has been unnecessarily complicated by the different regulatory regimes of the various EU member states. It is hoped that these issues will be resolved by the implementation of UCITS IV in 2011. The positive aspects of UCITS should be readily apparent to all. It has opened the doors to European investing and made a number of exciting portfolio management techniques more widely available for mainstream investors. There is no reason to suggest that UCITS funds cannot be part of the same portfolio as long-only funds (or, if appropriate, hedge funds). Each fund has a part to play in a well constructed and diversified portfolio. Fund managers can continue to manage funds by using traditional methods that they are used to, or choose to embrace the new powers available to them creating portfolios that bear only passing resemblance to mandates of previous years, where benchmarked and relative returns were the order of the day. Investors can in turn choose funds that more closely suit their risk/reward profile and are capable of achieving the level of returns they require. It is too early to call the UCITS regulation an unbridled success, but what it has done has been to create a climate of greater choice for fund managers and investors alike.

12

Glossary of terms
Absolute return Absolute return is a measurement of the return of an asset over a period of time. Absolute return differs from relative return because it does not compare the fund with a benchmark. Absolute return funds look to make positive returns in all market conditions. An absolute return fund therefore generates returns with a degree of independence from movements within financial markets. Alpha is the standard measure for assessing the performance of active fund managers. It is the return in excess of a benchmark index, or risk free investment, and it enables clients to work out if the level of return they receive more than makes up for the additional risk they choose to take on, i.e. risk adjusted return. Asset allocation aims to divide an investment portfolio among different categories of assets, such as equities, bonds, property and cash, by different countries or regions, or different sectors. How much you choose to invest in each can have a significant influence on performance of the portfolio. A benchmark enables investors to compare the performance of the fund against a relevant index. For example, a UK invested fund might have the FTSE All-Share Index as a benchmark and a stated objective to outperform the index over a certain period. A measure of volatility that determines the risk of a security in relation to the wider market. A beta of 1.0 indicates that a fund carries the same level of risk as the market, and should therefore provide the same level of return. However a fund with a beta of 1.2 would in theory be 20% more volatile than the market, and should therefore offer investors the prospect of greater returns for the additional risk. A CDS is an agreement designed to switch investment exposure between two parties. The buyer pays a periodic fee for protection against a specific event (such as the default of an investment grade bond). A CDS is often used like an insurance policy, but there is no requirement to actually hold any asset, which makes it a derivative. A derivative is a financial instrument derived from another asset. Rather than buying or selling the asset itself, two parties enter into an agreement to exchange money, assets or some other value at a future date. Derivatives are used to increase or decrease exposure or reduce or increase levels of risk within a portfolio and are more cost-effective than purchasing the underlying assets themselves. The aim of diversification within an investment portfolio is to reduce your overall levels of risk. By choosing asset classes that behave in different ways you do not over-rely on one particular asset for returns. A portfolio of different kinds of investments, and in various geographical locations, will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Alpha

Asset allocation

Benchmark

Beta

Credit Default Swap (CDS)

Derivatives

Diversification

13

Duration

An indication of how sensitive a bonds price is to changes in interest rates. It takes into account all the cashflows received over the life of the bond (i.e. coupons and nominal value). The higher a bonds duration, the more sensitive (or volatile) its price will be to a change in interest rates. If interest rates were expected to fall, investors would normally benefit most from rising bond prices if they lengthened duration. If rates were to rise, they could limit the negative impact of declining prices by shortening duration. A fund management strategy that involves buying certain stocks long and selling others short, by borrowing stock from a third party at an agreed fee and selling it, and then buying the stock back later, at a lower price, or by selling short a derivative on a stock.

Long/Short fund

Exchange Traded funds (ETFs) Exchange Traded Funds (ETFs) are collective investment funds that aim to replicate the growth of an index by investing in the same basket of shares as an index or series of indices and is itself traded on an exchange (for example, members of the FTSE All-Share). Fund of funds Fund of funds (also referred to as multi-manager funds or manager-of-manager funds) are designed to increase diversification by investing in a variety of funds, including those managed by other investment managers. They provide a simple and cost-effective solution for investors looking for portfolio diversity by investing in a wide range of good quality funds. A UCITS III fund can be created as a fund of funds, but UCITS III funds are not permitted to invest in a fund of funds. Hedge fund A fund that uses an assortment of trading techniques and instruments to meet its objective. The aim is to provide positive investment returns irrespective of the performance of stock markets. A hedge fund can take short positions, employ derivatives, use leverage and has relatively few investment restrictions. A strategy used to offset investment risk, especially useful during periods of market uncertainty. A fund created to provide the same returns as a designated index. Therefore the fund invests in all the companies within the index according to a market value weighting. Leverage is essentially borrowing money to increase levels of exposure. It allows a manager to increase the amount invested in the fund to more than 100% of the total fund net asset value. A fund where investments are purchased and returns are derived from the performance of those holdings. This is in contrast to a long/short fund, where performance can also be generated from short positions, including stocks that the fund does not own.

Hedging

Index funds

Leverage

Long-Only fund

14

Market neutral investing

A market neutral fund strategy will result in an investment portfolio that does not display a correlation with the designated market. Therefore during a period of market weakness, the portfolio should theoretically be able to continue to generate positive returns. Investing in the stock market enables you to benefit from its growth potential over the medium to long-term. However, there is also a risk (market risk, also known as systemic risk) that you could lose your money if the stock market in which you have invested in experiences a fall in value. The securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid. A mathematical computer simulation that generates random scenarios so that infinite potential outcomes of an investment strategy are played out and are therefore known or visible. See fund of funds. Fund managers can apply a multi-strategy investment approach in order to allocate investment capital to a variety of different investment strategies and asset classes. This increases the diversity of the fund and can also be used to potentially reduce risk. A non-sophisticated UCITS III employs a traditional long-only fund structure restricted to the purchase and sale of physical assets such as equities and bonds and can use derivatives only for efficient portfolio management. An open-ended fund in the form of a company that continually creates and issues shares or units on demand as opposed to a closed-ended company whose price is affected by demand in addition to underlying assets growth. An investment that pools many investors into a single vehicle, offering access to a well-diversified portfolio of equities, bonds or other securities. New shares can be issued and redeemed when required. Fund managers can use portfolio symmetry in order to reduce risk and generate additional returns. The manager takes a short position in an asset class, while simultaneously adding a long position ensuring that the portfolio has symmetrical long/short exposure. An arbitrage strategy which aims to exploit an identified price inefficiency, for example the same stock listed on two exchanges where demand in one exchange pushes the price higher, and making the price on the other exchange relatively cheap.
15

Market risk

Money markets

Monte Carlo method

Multi-Manager Funds Multi-strategy approach

Non-sophisticated UCITS III fund

Open-Ended Investment Company (OEIC)

Pooled investment

Portfolio symmetry

Relative value

Risk framework

The risk management mechanism that a fund manager uses to monitor risk within portfolios. This will include the use of stress testing and regularly calculating Value at Risk (VaR). A short seller looks to profit from companies whose shares could fall in value by borrowing stock with the intention of buying the stock back at a later date, at a lower price, or by taking a short position using a derivative. Where a short position is initiated through physical stock and therefore stock lending the stock is returned to the lender at the agreed date, and the short seller makes a profit from the difference between the two prices, minus an agreed fee. A sophisticated fund uses advanced investment techniques including derivative instruments and trading strategies in order to achieve its stated objectives. Stress testing of portfolios is designed to determine how a fund will react to different financial situations, and is a useful method to calculate how a fund could potentially react during a financial crisis. The Monte Carlo simulation is one of the most widelyused stress-testing methods. The total return of an investment includes the income and capital appreciation of an asset, including interest, capital gains, dividends and distributions received over a given time period. The phrase over-the-counter (OTC) refers to financial instruments, such as derivatives, that are traded between two parties without the use of a central exchange. A fund with unconstrained asset allocation has the freedom to invest in a variety of asset classes, regions or size of company. A well-diversified portfolio of investments should derive returns from a variety of uncorrelated asset classes, so that performance remains consistent despite market downturns or volatility. VAR is a way of measuring the potential maximum loss of a fund over a specific time period or in a worst case scenario. A way to measure the tendency of a funds value to vary over time. Volatility tends to be measured by the variance or standard deviation of the price and is said to be high if the price typically changes dramatically in a short period of time.

Shorting

Sophisticated UCITS III fund

Stress test

Total return

Traded over the counter

Unconstrained asset allocation Uncorrelated returns

Value at Risk (VaR)

Volatility

16

This document is intended solely for the use of professionals, defined as Eligible Counterparties or Professional Clients, and is not for general public distribution. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investors particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially. Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment. Any investment application will be made solely on the basis of the information contained in the Prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the Prospectus before investing. Issued in the UK by Henderson Global Investors. Henderson Global Investors is the name under which Henderson Global Investors Limited (reg. no. 906355), Henderson Fund Management plc (reg. no. 2607112), Henderson Investment Funds Limited (reg. no. 2678531), Henderson Investment Management Limited (reg. no. 1795354), Henderson Alternative Investment Advisor Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no. 2606646) (each incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3AE and authorised and regulated by the Financial Services Authority) provide investment products and services. Telephone calls may be recorded and monitored. HGI36632/0810