Since the adoption of the original UCITS Directive in 1985, the variety of financial instruments has increased dramatically, which has led to uncertainty in the funds industry in concluding whether or not a financial instrument fits within the definitions contained in the UCITS Directive, as amended, and can thus be considered an appropriate investment for a UCITS fund.

The need to give clarification in relation to this rapidly evolving area has now been addressed in the form of Directive 2007/16/EC and the level 3 guidelines issued by the Committee of European Securities Regulators (CESR), which cover text not included in Directive 2007/16/EC. The Directive does not contain exhaustive lists of appropriate asset classes but instead provides basic criteria to be used to assess whether or not a financial instrument falls within the various definitions.

Due to the relatively new nature of hedge fund indices and their potential complexity, a separate consultation process was undertaken in relation to these indices. Two CESR papers were issued, an issues paper in October 2006 and a consultation paper in February 2007, which was discussed at an open hearing conducted in April 2007. CESR has now issued its guidelines on eligible assets and the classification of hedge fund indices as financial indices and has confirmed that hedge fund indices can be classified as eligible financial indices, provided certain conditions are met. The recently issued level 3 guidelines on hedge fund indices complete the package of measures designed to provide clarity in this area.

CESR members are required to adopt the Directive and all level 3 guidelines by March 2008 at the latest.

To be considered a financial index, a hedge fund index must comply with the conditions laid down in article 9 of Directive 2007/16/EC which are already applicable to financial indices, including the requirements that the index be sufficiently diversified, represent an adequate benchmark, and be published in an appropriate manner. These requirements already apply to common financial indices but hedge fund indices will also be subject to additional requirements in relation to the index methodology and information disclosure.

A hedge fund index will not fall under the definition of 'financial index' unless the methodology of the index proves for the selection and re-balancing of the components on the basis of predetermined rules and objective criteria.

A hedge fund index will also fall outside the definition of 'financial index' if the index provider accepts payments from potential index components for the purpose of being included in the index. Such payment in CESR's view does not accord with the principles of objective component selection and that index representing an adequate benchmark.

A hedge fund index cannot be classified as a 'financial index' if the methodology of the index allows retrospective changes to previously published index values, a practice known as backfilling.

Where a UCITS wishes to gain exposure to a hedge fund index by way of an over the counter derivative, the UCITS must comply with the requirements set out in the 1985 Directive and Directive 2007/16/EC, including requirements in relation to counterparties, valuation and the ability to close a position, risk management and valuation, and risk exposure.

The UCITS, or the UCITS manager, if applicable, must carry out due diligence, including consideration of the quality of the index. In assessing quality, a UCITS must take into account the following factors, at a minimum:

1. The comprehensiveness of the index methodology, i.e. information on weighting and classification of components.
   
   
2. The availability of information about the index, including information on what the index is trying to represent, whether the index is subject to an independent audit, whether the index is published and whether this will affect the ability of the UCITS to accurately calculate its net asset value.
   
   
3. Matters relating to the treatment of index components, i.e. what level of detail on the index components and their net asset value are made available and whether the number of components in the index achieves sufficient diversification.

The UCITS must keep a record of the due diligence checks carried out. Ultimately where a UCITS wishes to gain exposure to this type of index, it needs to carry out an informed assessment on whether the index is an appropriate investment, with reference to the UCITS' investment objectives and policies and risk profile, and be able to justify its decision based on this assessment. The level 3 clarification guidelines on hedge fund indices, together with Directive 2007/16/EC and the other level 3 guidelines, are a positive development in this area and should provide a common supervisory approach to the issue of eligible assets for UCITS funds.

August 2007.

For further information please contact Sarah Lyons.