Session I: The Future of Retail Funds in the EU and U.S.

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1 Session I: The Future of Retail Funds in the EU and U.S. Mark Amorosi, Partner, K&L Gates Washington. D.C. Sean Donovan-Smith, Partner, K&L Gates London Andrew Massey, Special Counsel, K&L Gates London Rodney Smyth, Consultant, K&L Gates London Copyright 2015 by K&L Gates LLP. All rights reserved.

2 OVERVIEW Retail fund landscape Product developments Distribution issues Specific initiatives Future of the industry 3

3 European Retail Fund Landscape European AUM in UCITS exceeding 9 trillion for first time ever Net assets (EUR bn) Category End 2014 March 2015 % change on previous month UCITS 7,955 9, % Non-UCITS 3,347 3, % Total 11,302 12, % Breakdown of UCITS by Category 31/12/2014 Change from 31/12/2013 UCITS types No. Share in % in No. Equity 12,117 37% 0.0% 0 Balanced 8,740 27% 3.1% 265 Total Equity and Balanced 20,857 64% 1.3% 265 Bond 7,290 22% 1.8% 132 Money Market (MM) 1,037 3% -11.2% -131 Funds of funds 882 3% 0.8% 7 Other 2,517 8% -6.2% -165 TOTAL 36, % 440 Source: EFAMA March 2015 Data 4

4 European Retail Fund Landscape Location of Firm Headquarters Top five countries Source: EFAMA June 2015 Data Source: Prequin Hedge Fund Analyst 5

5 U.S. Mutual Fund Market Investment Company Total Net Assets by Type ( ) (in billions) Closed-end Mutual funds funds ETFs UITs Total 1997 $4,468 $152 $7 $85 $4, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,217 Source: Investment Company Institute 6

6 Product Developments Rise of Alternative Funds

7 Convergence of Retail and Alternative Funds Collective Investment Scheme ( CIS ) (UK definition) Alternative Investment Fund ( AIF ) (AIFMD definition) Regulated CIS Unregulated CIS Glossary: ELTIF: Fund EuSEF: Fund EuVECA: FAIF: Funds UK UCITS 8 Regulated CIS Recognised UCITS (s.264 FSMA) European Long-Term Investment European Social Entrepreneurship European Venture Capital Fund Funds of Alternative Investment NURS FAIF PAIF NURS: QIS: PAIF: QIS Other recognised schemes (s.272 FSMA) E.g. Limited partnerships, exempt unauthorised unit trusts EuVECA, EuSEF Non-UCITS Retail Scheme Qualified Investor Scheme Property Authorised Investment Funds ELTIF Other AIFs E.g. closed-ended investment companies

Rise of Alternative UCITS in Europe 2014 2013 Commodities CTA Emerging Markets Equity Market Neutral Event-Driven Fixed Income Index FX Long/Short Equity Macro

8 Rise of Alternative UCITS in Europe Commodities CTA Emerging Markets Equity Market Neutral Event-Driven Fixed Income Index FX Long/Short Equity Macro Multi-Strategy Volatility 2014 Total Funds: Total AUM: billion 2013 Total Funds: Total AUM: billion Source: UCITS Alternative Index 9

9 Can my hedge fund strategy be used in a UCITS? Certain investment strategies can fit within a UCITS fund structure Traditional equity long/short or market neutral Absolute return Multi-strategy/multi-manager Merger arbitrage/event-driven/special situation Global tactical allocation Global macro strategies Credit strategies/convertible arbitrage/senior debt Managed futures Some hedge fund strategies are not a fit for a UCITS fund Illiquid strategies Highly concentrated portfolios Nonfinancial investments 10

(in billions) Total assets under management in alternative strategies

10 Growth of Alternative Funds in U.S. Cumulative flows to alternative strategies mutual funds ( ) (in billions) Total assets under management in alternative strategies funds were $311 billion at the end of (Source: Morningstar) Source: Investment Company Institute 11

11 Alt Funds Regulatory developments Intense SEC Focus on Liquidity, Valuation, Leverage and Disclosure SEC Alt Funds Sweep Exams Derivatives Review Enforcement Activity 12

12 Product Developments Rise of Exchange Traded Funds (ETFs)

13 The Rise of ETF UCITS in the UK Why? Pricing vs non-etf UCITS (e.g. index funds)? Real-time not forward Throughout the trading day not just once a day Cost vs non-etf UCITS? Both have low annual charges e.g. 0.30% p.a. S&P 500 and 0.50% p.a. FTSE-100 passive ETFs (including transaction costs) and 0.09% / 0.35% (excluding transaction costs) 14

14 Choice vs non-etf UCITS? One ETF UCITS manager in the market offers singlecountry funds for Brazil, Indonesia, Mexico, South Africa and Taiwan Although compare non-ucits ETFs: where another manager offers funds for coal mining, coffee, lean hogs, live cattle and shipping indices and spot palladium UCITS label vs non-ucits ETFs? UCITS suggests the fund is a safe investment (fit for widows and orphans ) Transparency vs non-etf UCITS? not really, at least for passive stock market index ETFs although most ETF UCITS disclose holdings daily (unlike other UCITS), the index is the index 15

15 Why not? Brokers commission on all ETF sales and purchases typically, 5/ flat fee per trade vs 0 for non-etf UCITS Temptation to day-trade ETFs because priced continuously Flat brokerage fees and small day trades don t mix! European ETF statistics: 5.5% of total investment fund AUM = EU 362 billion (30 September 2014) 16

16 ETFs Growing Popularity in U.S. Source: Investment Company Institute 17

17 ETFs Increasing Market Coverage percent of US ETF Total Net Assets Source: Investment Company Institute 18

18 ETFs More Strategies Source: Investment Company Institute 19

19 ETFs Regulatory Developments Less Transparent Actively Managed ETFs Systemic Regulatory Impact and SEC Request for Comment Derivatives Review SEC ETF Rule Custom/Non-Pro Rata Creation and Redemption Baskets 20

20 Product Developments European Long-Term Investment Fund (ELTIF)

21 ELTIFs Vehicle to encourage investment in long-term assets (energy, infrastructure, education and research, etc.) European passport enabling retail investment Composite regulatory regime, including: AIFMD ELTIF authorisation requirement and prescribed rules Prospectus Directive ELTIF prescribed rules: Investment policy At least 70% of capital in eligible assets Other investments limited Closed-ended? Redemption restrictions Transparency requirements 22

22 Distribution Issues

23 MiFID II Investor Protection Provisions Execution-only exemption for noncomplex instruments from appropriateness assessments Changes to list of exempt instruments Effect on distribution? Product and distribution governance Manufacturers Distributors Extension to UCITS managers and AIFMs? 24

24 MiFID II Intermediary Services and Payments Mandatory categorisation of advisory services Scope of prohibition on inducements/ commission payments UK Retail Distribution Review (RDR) Independent advice based on comprehensive and fair analysis of relevant market Restricted advice not independent; subject to prescribed disclosures Services: Advice Platform services Retail investment products Limited to retail clients For platform services, unit rebates permitted MiFID II Investor Protection Independent advice assess a sufficient range of financial instruments available on the market that must be sufficiently diverse with regard to their type and issuers or product providers Restricted advice not independent; subject to disclosure requirements Services: Independent advice Portfolio management MiFID financial instruments Not limited to retail clients No exception for unit rebates 25

25 SEC Focus on Distribution Payments SEC has attempted to adopt rule changes over the last 10 years to enhance regulation of distribution payments with respect to funds, but has been largely unsuccessful (e.g. point of sale proposal in 2005 and Rule 12b-2 proposal in 2010) 2013 and 2014 OCIE Exam Priority: The IA-IC Program is focusing on the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards oversight of the same. These payments go by many names most commonly revenue sharing, sub-ta, shareholder servicing, and conference support. The staff will assess whether such payments are made in compliance with.rule 12b-1, or whether they are payments for distribution and preferential treatment. OCIE Sweep Exams in Speech by Julie Riewe, co-chief, Asset Management Unit on February 26, 2015: We anticipate enforcement action from the Distribution in Guise Initiative, where we are axamining, among other things, conflicts presented by registered fund advisers using the fund s assets to grow the fund and, consequently, the adviser s own fee. 26

26 Some Specific Initiatives

27 UCITS V 28 Area UCITS V requirement AIFM Remuneration Remuneration policies and practices promote sound and effective risk management Staff whose activities have material effect on risk profile of UCITS or management company Remuneration committee (if proportionate) Fixed and variable remuneration appropriately balanced with fixed component sufficient for variable component to be fully flexible For variable component, at least 50% to consist of units of UCITS/equivalent ownership interest; at least 40% to be deferred. Disclosure in prospectus and annual report Depositary Depositary eligibility Single depositary expressly required Written agreement with prescribed contents Specification of functions: cash monitoring custody oversight Delegation restricted to custody function only Strict liability for financial instruments held in custody Sanctions Prescription of administrative sanctions and processes, categories of UCITS breaches, publication, and reporting to ESMA (in part) (in part) -

28 Packaged Retail and Insurance-Based Investment Products Key Investor Information PRIIPs Investment funds (incl. UCITS) Insurance investment products Structured products (deposits; securities) Not PRIIPs Shares and bonds held directly General insurance and life insurance Pensions PRIIPs KID For PRIIP available to retail investors Pre-contractual; stand-alone Max three sides Prescribed statements and sections What is this product? Risk-reward profile Compensation scheme Costs Term/minimum holding period Complaints Other relevant information For all UCITS UCITS KIID Pre-contractual; stand-alone Max two sides (three for structured fund) Prescribed statement and sections Objectives and investment policy Risk-reward profile Charges Past performance Practical information 29

29 EU Money Market Fund Reform Current Proposals Status: In trilogue European Parliament, Commission and Council (i.e. Member States) Latest published proposals Three types of MMF re. NAV CNAV (< 10% of CNAV and LVNAV) divided into: retail but this means only charities, non-profit organisations, public authorities and public foundations public debt 99.5% invested in public debt instruments (i.e. sovereign debt) so, no derivatives, securitisations or bank paper 30

30 LVNAV (> 90% of CNAV and LVNAV) May be redeemed at CNAV if actual NAV within 0.20% of CNAV Authorisation for only five years at a time Neither CNAV nor LVNAV Two types of MMF re. residual maturity Short-term maximum 397 days Standard maximum two years Daily valuation No external support (such as guarantees) to avoid investor uncertainty and financial contagion Weekly investor reporting liquidity, credit, portfolio, WAM (interest), WAL (principal), proportion held by top five investors Will extend to EEA EU MMF statistics: c.15% of total investment fund AUM = approximately EU 1 trillion (September 2013) 31

31 U.S. Money Market Fund Reform Key Changes Floating NAV Institutional MMFs will be required to price their shares based on a floating NAV Government and retail MMFs may continue to maintain a stable NAV of $1.00/share Liquidity Fees and Gates All MMFs will be permitted to impose liquidity fees and temporarily suspend redemptions (impose redemption gates ) during periods of market stress In certain cases, MMFs (except govt MMFs) will be required to impose liquidity fees Diversification: MMFs must meet enhanced diversification requirements Stress Testing: MMFs must satisfy enhanced stress test requirements, including ability to maintain liquid assets of at least 10% and to minimize principal volatility in response to certain events Disclosure: MMFs must satisfy new disclosure requirements, including new Form N-CR and website disclosure and amended registration statement and Form N-MFP disclosure 32

32 Pressure on Costs FCA identified that UK fund charges higher than overseas equivalents FCA thematic review (TR14/7): Findings (cause?): Investors lack of clarity regarding costs of investment Solution: Consistent use of ongoing charges figure ( OCF ) in all marketing materials Investment Association paper on disclosure of costs and charges: Advocate consistent approach based on OCF But grappling with how to fairly represent funds that are expensive to operate? 33

33 Mutual Fund Fee Litigation Developments Extraordinary wave of Section 36(b) cases challenging mutual fund advisory, administration and other fees in the US Common attribute of most of the cases is sub-advisory relationships Cases fall into two categories: defendants either employ a sub-adviser, or serve as a sub-adviser to other funds employing a similar investment strategy Premise of the complaints is that sub-advisers ostensibly perform all substantial services for a fraction of the advisory fees, assertedly rendering the advisory fees excessive in relation to the purportedly inconsequential additional services performed by advisers Focus on sub-advisory relationships can be traced to Curran v. Principal Management Corp. (S.D. Iowa 2010), holding that allegations that an adviser charged far more in fees than it paid its sub-adviser gave rise to a reasonable inference that advisory fees were excessive 34

34 Future of the Industry

35 Future Legal Trends for European Fund Industry Continued product innovation fueled by investor demand Constraints on UCITS fracturing of AIF categories Enhancing liquidity toolkit Increased operation and compliance costs Consolidation Increased market and regulator fee pressure More enforcement action; bigger penalties 36

36 Future Legal Trends for US Fund Industry Continued innovation and regulatory developments impacting product development, including exchangetraded products and alternative and other specialized products Increasing focus on risk management Challenging regulatory environment, with focus coming from multiple regulators and from multiple areas within the SEC 37

The European Long-Term Investment Fund ("ELTIF") Regulation in a nutshell

The European Long-Term Investment Fund ("ELTIF") Regulation in a nutshell On 20 April 2015, the Council formally approved a new regulation which was published in the Official Journal of the European Union