Tighter controls

The FSA has strict rules governing retail funds to ensure investors understand exactly what they are buying. Could such regulation stretch to non-retail funds?

The general approach of the UK Financial Services Authority (FSA) to retail investment funds is predicated on the need to protect investors.

For this reason, regulations governing the marketing of retail funds put major emphasis on potential investors being given a clear picture of the nature of the fund in question ensuring that they fully understand what they are being offered.

Guaranteed and capital protected funds

One aspect of the FSA's policy has been tight control over the naming of regulated funds. Aside from a statutory prohibition on undesirable misleading names from Section 243 of the Financial Services and Markets Act 2000, the FSA has recently refined and restated its policy on funds which call themselves 'guaranteed' or which imply in their names a degree of capital security.

This policy is now embodied in rule 2.7 in the Collective Investment Schemes Sourcebook, which forms part of the FSA's handbook of rules and guidance.

The policy covers both authorised unit trusts and open ended investment companies/investment companies with variable capital (Oeics/ICVCs).

The requirements to be satisfied before a regulated fund will be permitted to include the word 'guaranteed' in its name are extremely onerous and in summary are as follows:

n The guarantee must be given by an authorised person (or equivalent under European Directives). The manager of the regulated fund must be able to demonstrate the guarantor has the authority and the resources to honour the terms of the guarantee.

n These first two requirements effectively exclude any possibility of a special purpose vehicle, perhaps with thin capitalisation, being set up to provide the guarantee.

n The guarantee must cover all the investors in the fund in question and be legally enforceable by each of them.

n The guarantee must cover the total amount paid by the investors for their shares, including any front-end load.

n The guarantee must provide for payment at a specified date(s) and must be unconditional.

These requirements will be very hard to satisfy, if not impossible, at least in commercial terms. This is because any such guarantee would only be available at a cost which either the manager of the fund would have to meet or which would have to be passed on in higher charges to investors, thus rendering the product unattractive.

Thus the FSA's controls, ostensibly on the naming of funds, may for practical purposes exclude guaranteed funds from the retail market.

What may prove more attractive is establishing a fund which offers a measure of capital security, short of a full guarantee.

The CIS Sourcebook allows the name of a fund to include words implying a degree of capital security, such as 'capital protected', subject to certain conditions.

The first is that the fund satisfies all the conditions set out above for use of the word 'guaranteed', but with a guarantee of less ' but not materially less ' than the total amount paid for shares. This will nevertheless still be very difficult to satisfy on any sensible economic basis.

Alternatively, a fund's name can imply a degree of capital protection if its investment objectives and policy show a clear intention to provide a material degree of security in respect of the total amount paid for a share.

The name of the fund must not overstate the degree of capital security which the fund provides and the FSA will assess funds on a case by case basis to decide if the name is justified. In making this assessment the FSA will take into account the nature of the arrangements put in place to provide the security.

These arrangements may take a variety of forms. There are no rules or guidance on how capital security can be provided, beyond the general limits on investment and borrowing powers which are contained in the CIS Sourcebook.

It is worth noting the recent implementation of Ucits 2 provides regulated funds with greater scope for using derivatives than they had previously although existing funds will be obliged to obtain the consent of investors before making use of the new investment powers.

Consent for this purpose takes the form of a resolution passed at a meeting of investors called for the purpose.

Limited issue funds

There is a commonly held view that building protection into the structure of a fund is a challenge where there is an ongoing obligation to issue new shares at any time and, conversely, to redeem or repurchase the shares on demand.

In response to this, part four of the CIS Sourcebook now sanctions the creation of 'limited issue shares'. That expression covers shares the issue of which is limited by the occasion or occasions on which the shares can be issued or by the amount or value of shares which can be issued.

The document constituting the fund must expressly provide for the distribution of limited issued shares. This means the instrument of incorporation or trust deed for the fund, and its prospectus, where the nature of all classes of shares or units needs to be set down.

In the case of an umbrella it will be necessary to have at least two sub-funds which do not distribute only limited issue shares. This is because one of the essential characteristics of an umbrella fund is the ability to switch between sub-funds If all sub funds were 'limited issue' only then would it not be possible to switch. Equally, if only one sub-fund offered non-limited issue shares then it would be impossible to switch out of that sub fund ' therefore there must be at least two of them.

The other side of the coin is the question of offering shares with limited rights of redemption.

This is regarded as a more sensitive issue as it has always been a key characteristic of UK regulated funds that the investor has a right to exit the fund at net asset value ' or something very close to it ' at any time.

A fund which only offered limited redemption rights would strike at the root of that principle and, for the time being at least, the FSA has not sanctioned the creation of limited redemption funds or share classes.

Further developments

Developments run alongside a wider review by the FSA of the regulated funds arena. Consultation has already taken place on the question whether hedge funds, or any particular classes of hedge funds, should be brought into the FSA's sphere of regulation.

It is acknowledged that tackling this question is not helped by the fact that there is no accepted definition of a hedge fund. It is also accepted that a number of the techniques commonly employed by hedge funds may not be consistent with the FSA's job of protecting investors.

These would include significant gearing, short selling and the use of aggressive derivative strategies. The indications are that the established hedge funds community may not be greatly attracted by the idea of offering funds to the retail market, which would inevitably bring a greater regulatory/compliance burden than is applicable to existing hedge funds, in return for the ability to access the retail market, which most hedge fund operators probably do not regard as an attractive target in any event.

Conversely, the UK's Investment Management Association, which represents a large number of operators of retail funds, has indicated that in its view it would be premature to allow a wide range of hedge funds to be authorised for sale to retail investors. It has also indicated that in any event there is not at the moment a significant demand for hedge funds from retail investors.

It may be a different story among institutional investors and some high net worth private clients, and the FSA is also exploring the possibility of providing regulated funds for non-retail investors.

These would have wider investment powers than those available to retail funds, and would be subject to a lighter regulatory regime, but it would not be possible to offer them to the general retail market. The FSA is due to consult on this later in the year.

This raises the possibility of the creation of a regulatory framework for non-retail funds with some of the powers commonly employed by hedge funds. If funds of this nature were to receive the same tax treatment as existing regulated funds, including tax free roll up of gains within the fund, then this would be an interesting development and a step on the way to having UK-domiciled hedge funds.

Key Points

The FSA has recently refined and restated its policy on funds which call themselves ˜guaranteed' or which imply in their names a degree of capital security.

The FSA is exploring the possibility of providing regulated hedge funds for non-retail investors.