Financial Regulators throughout Europe should by now have finalised measures to adopt into national law Directive 2007/16/EC and CESR guidelines that enable UCITS to invest in hedge fund indices, which will be applicable from 23 July 2008. The Financial Regulator, continuing its strong reputation of compliance, was one of the first regulators to incorporate the requisite provisions.

The Financial Regulator has amended Guidance Note 2/07 to include hedge fund indices as permissible 'financial indices'.

Guidance Note 2/07 enables UCITS to invest in hedge fund indices subject to the following requirements:

• the methodology of the index must provide for the selection and the re-balancing of components on the basis of pre-determined rules and objective criteria;
  
  
• the index provider cannot accept payments from potential index components for the purpose of being included in the index; and
  
  
• the methodology of the index cannot allow retrospective changes to previously published index values ("backfilling").

The Guidance Note requires UCITS that wish to invest in hedge fund indices by means of OTC derivatives to comply the applicable requirements in accordance with the UCITS Regulations including those with respect to (i) eligible counterparties, (ii) valuation requirements and the ability to close a position, (iii) risk management requirements, and (iv) risk spreading rules.

UCITS are required to carry out appropriate due diligence including analysis as to the "quality" of the index. They are further required to keep a record of their assessment. The following factors, at the very least, must be considered in assessing the quality of an index:

• the comprehensiveness of the index methodology having regard to (i) whether it provides an adequate explanation of subjects such as weighting and classification of components and the treatment of defunct components, and (ii) whether the index represents an adequate benchmark for the kind of hedge fund to which it refers;
  
  
• The availability of information concerning the index such as (i) whether there is a clear narrative description of what it is trying to represent, (ii) whether it is subject to independent audit and the scope of the audit and (iii) how frequently the index is published and whether this will effect the ability to calculate the NAV of the UCITS; and
  
  
• Issues relating to the treatment of index components including (i) the policy adopted by the index provider to carry out due diligence on the NAV calculation procedures of index components, (ii) the level of detail concerning index components and the publication of their NAVs, and (iii) the standard of diversification of index components.

April 2008.

For further information please contact David Williams.