The murky world of non-Ucits ETFs

The murky world of non-Ucits ETFs

In Europe there are exchange traded funds (ETFs) that are structured as Ucits funds and as non-Ucits funds. Understanding the differences is essential, because of the divergent levels of investor protection and the tax treatment associated with these products.

Similarly, there are exchange traded products (ETPs) that use non fund structures like exchange traded notes (ETNs), and exchange traded commodities and currencies (ETCs), which are typically debt securities.

Non-fund exposures are typically structured as debt securities and will typically offer exposures not available under the Ucits regime. The fact that these are securities rather than funds, though, means their distribution is governed by the Prospectus Directive.

This means that while neither the type of exposure nor the method of exposure is regulated, the security may still be offered on a pan-European Union (EU) basis, provided its offering document complies with the terms of the directive.

In Europe there are two broad categories of funds: Ucits funds, which are harmonised and regulated at the EU level, and funds that are non-harmonised and which are regulated at a national level.

The legal structure and the investment objective will determine whether a fund is Ucits/harmonised or non-Ucits/non-harmonised.

Defined by domestic laws

Non-Ucits/non-harmonised funds are regulated at the national level and do not generally follow the prudential EU rules for Ucits funds. Rather, they are allowed broader investment policies and objectives pursuant to national rules.

This type of fund cannot currently avail of any passport-style arrangement and is only available in its home state or where private placement rules in another state allow its sale to certain classes of investor.

Non-Ucits that have EU distribution

Equally, highly regulated non-Ucits funds, such as those ETFs authorised under the US 1940 Act which are designed for retail investors, will fall under the local rules for non-harmonised funds for distribution purposes in EU markets.

In Europe at the end of 2011 there were 54,365 investment funds, with €7.9 billion in assets under management. Non-Ucits funds account for 28.9% of the overall assets and 33.5% by number of funds according to the European Fund and Asset Management Association. Approximately 5% of the 1,844 ETFs in Europe are non-Ucits accounting for 12 % of the $302 billion in assets under management in the European ETF industry, according to ETF Global Insight’s monthly report for February 2012. 

The majority of non-Ucits ETFs are Swiss investment funds that are providing exposure to a commodity or commodity indices through investment in a physical precious metal, or through swap-like arrangements designed to deliver commodity index returns.  

While the concept of a fund typically suggests diversification, it is permissible to have a single exposure in Swiss investment funds. It should be noted that this is in the context of a highly regulated regime, unlike other undiversified arrangements in Europe.

Leaving aside the degree of regulation of the market exposure itself and the mechanism by which that exposure is delivered to you, there are two further issues to consider when investing in non-harmonised or non-Ucits funds or notes-backed ETP exposures. Typically there are different investment limits and there is significant potential for different tax treatment. 

At a high level, Ucits funds can invest up to 30% in non-Ucits funds and 20% in individual Ucits funds. It is critical, though, that the non-Ucits fund offers an equivalence of protection to a Ucits fund – the definition of equivalence taxing many compliance departments. Ucits funds may hold up to 10% of the single issuance of a debt security issuer, with more than 20% total exposure to that issuer.

The investor, through a segregated mandate, will equally need to appreciate the distinction between these ex facie identical products to ensure they are within the terms of this mandate.

Variable tax treatment

Tax treatment of non-Ucits funds will be driven by a number of factors, including the tax status of the investor and the type and tax categorisation of the underlying fund. It also depends on the type of income or gains derived, the underlying investments in the non-harmonised fund, the complex interaction of double tax treaties and the ability to apply withholding tax credit and withholding on distributions paid by the fund. This makes investing in non-Ucits more challenging, owing to an inability to accurately determine the tax implications. Suffice to say this area is sufficiently complex to make it essential that investors take specialist advice to ensure they make the right investment, according to their individual circumstances.

Investors need to understand the nature of what they are buying. For as long as this debate continues and we await clarification across the regulatory spectrum and the various initiatives governing this area, it is a point we shall need to revisit.