The Financial Regulator has taken the opportunity to provide some direction to industry on a range of issues evolving from the increasingly complex nature of the instruments and techniques used by collective investment schemes. The Regulator, pursuant to a comprehensive consultation process, has published a number of new and revised guidance notes to add clarity for industry participants.

The use of financial indices by UCITS funds has become increasingly popular in the wake of UCITS III. The Financial Regulator has issued Guidance Note 2/07 setting out the procedure for deciding whether a UCITS must obtain approval from the Financial Regulator before using a particular index. It also clarifies the position in relation to indices comprising ineligible assets and sets out the prospectus disclosure requirements in these cases.

The responsibility for deciding whether an index should be submitted to the Financial Regulator for approval rests with the UCITS. The regulatory requirements apply to all financial indices, whether comprised of ineligible or eligible UCITS investments, used for investment or efficient portfolio management and whether exposure to an index is obtained directly or via financial derivative instruments.

The main aspects of the new guidance note can be summarised as follows:

Circumstances where an index submission is not required

Where a financial index is composed of assets that are considered eligible assets and it is clear that a UCITS could directly invest in the index constituents without contravening the UCITS Regulations then no submission for approval is required. "

Circumstances where an index submission is required

1. Indices based on eligible assets
   
   Where it would not be possible for a UCITS to comply with the regulatory risk spreading rules if it had invested directly in the underlying index, a submission to the Regulator is required. This does not apply where the UCITS is applying the 'look through' approach i.e. consolidating the constituents of the index with the assets it holds directly to ensure it meets its risk spreading requirements.
   
   
2. Index assessment criteria
   
   The Regulator will base any adjudication as to the permissibility of an index on a consideration of the following criteria.
   
   
   1. The index must be sufficiently diversified, with no one issuer representing more than 20% of the index weight. The Regulator may increase this to 35% where a UCITS applies for special dispensation.
      
      
   2. The index must represent an adequate benchmark for the market to which it refers. This requires the index to be rebalanced periodically and the provision of details as to how the index calculation methodology is verified.
      
      
   3. The index should be published in an appropriate manner on the internet or other easily accessible medium. This should include an indication as to performance, constituents and any changes.
      
      
   4. The index should be independently managed and separate from the management of the UCITS although this does not mean the UCITS and the index provider cannot be part of the same economic grouping, so long as effective arrangements are in place to avoid any conflicts of interest.

The Regulator has also added an index review checklist as an appendix to the guidance note. This should prove a very useful tool for applicants seeking approval of an index.

This Guidance Note deals with prospectus disclosures that need to be made in order to afford UCITS retail investors the opportunity to make an informed decision in relation to schemes employing complex trading strategies.

The Guidance Note deals with required disclosures in relation to the following types of instruments:

1. Financial indices
2. Structured notes (CDOs)
3. Financial derivative instruments
4. Systematic trading models (algorithmic trading strategies)
5. Capital protection strategies

The disclosure requirements section of the Guidance Note provides that at a minimum, the disclosures provided should clearly explain:

1. What the underlying exposure obtained through the strategy is, and
2. How the strategy will be executed (e.g. via financial derivative instruments, indices, model etc.)

The information should be carefully drafted and logical and should also aim to avoid highly technical language.

The Guidance Note also emphasises the need for clarity in relation to risk and return. The investor should be aware of the extent of the use of leverage generated through financial derivative instruments. Risk disclosures are required where 'relevant and material' to the investment. Investors should also be afforded information in relation to the potential payout in terms of a comparison with a benchmark index or through the use of graphs.

Following a lengthy process of consultation, the Financial Regulator has now issued revised guidance in relation to the treatment of hedged share classes and the applicable regulatory limits.

The most significant change is in relation to the treatment of over-hedged positions and additional flexibility is now afforded hedging policy. The Financial Regulator has now accepted industry submissions highlighting that factors outside the control of a scheme may cause a hedged class to be over hedged. In the case of UCITS funds and non-UCITS retail and professional investor funds, a hedged share class may now be hedged up to a limit of 105% of net asset value.

Any collective investment scheme that wishes to use hedged share classes must disclose the implications of the hedging policy. Hedged positions should be subject to ongoing review and any positions in excess of 100% of net asset value cannot be carried from month to month. It is not possible to use other currency classes in a fund to offset the exposures suffered by a hedge share class.

This Guidance Note has been updated to acknowledge the complexities of valuing 'over the counter' (OTC) derivatives held by an ever-increasing number of collective investment schemes.

A collective investment scheme may now choose to value an OTC derivative using either the counterparty valuation or an alternative valuation calculated by the scheme or some other independent pricing vendor. A UCITS must conduct this valuation on a daily basis while non-UCITS are obliged to carry out their valuations on a weekly basis.

Where a scheme values an OTC derivative using an alternative valuation it must be (i) valued in accordance with international best practice and (ii) provided by a 'competent' person approved for the purpose by the trustee of the scheme, or 'by any other means' as long as the trustee approves the result. The proviso here is that the alternative valuation is reconciled to the counterparty valuation on a monthly basis.

Where a CIS values an OTC derivative using the counterparty valuation, the valuation must be approved or verified by a party who is approved for the purpose by the trustee and who is independent of the counterparty and the independent verification must be carried out at least weekly in the case of UCITS and monthly in the case of non-UCITS.

Forward foreign exchange and interest rate swap contracts can be valued in accordance with these guidelines or alternatively by reference to market quotations.

Amendments to UCITS Notice 10 and non-UCITS Notice 16 have also been made following the guidance note amendments in relation to the valuation of OTC derivatives.

The changes summarised above prove that the Regulator is reacting to industry recommendation in a positive and expedient manner in order to maintain the development of the fund industry and safeguard the principle of investor protection in the regulated fund environment.

September 2007.

For further information please contact Sarah Lyons.