Mutual funds’ velvet revolution

Shift in focus How does Ucits III differ from its predecessor Ucits I? Rather than tying up portfolio managers in a complex code that can distract and obstruct them from the core objective of managing money as proficiently as possible, Ucits III has aligned itself with managers’ objectives, by placing at its core the thing that matters most– risk. By this we mean that Ucits III assumes that all forms of risk represent sources of opportunity. The goal of the legislation is not to limit investment choice, but instead to place the necessary governance upon the portfolio as a whole. This translates into Ucits III portfolios that may not be any more risky at the total portfolio level than their predecessors, but are populated with more diverse investment decisions. Since Ucits III allows increased flexibility to use derivatives as a means to achieving an investment objective (as opposed to merely hedging risk or equitising cash), its effect is to broaden the role of existing investment strategies and, secondly, to allow new investment strategies that were once prohibited. Take active currency management, for example. This is a strategy that was, for all intents and purposes, prohibited in mutual funds in Europe. Under Ucits I, the only instances when a manager could express a currency view was when it was associated with an overseas asset allocation decision. Consequently, currency views tended to be passive or, at best, sporadic, depended on other investment decisions and, for UK portfolios, demanded a negative view on UK sterling as you first must sell sterling to express your positive currency view. Under Ucits III, managers can express currency views actively – independent from other investment strategies and of the prevailing asset allocations decisions and reflecting both positive and negative views on the outlook for UK sterling. This is because derivatives, particularly swaps, CFDs and currency forwards, are eligible assets used to further the investment objective. With 10 major currency markets in the world, an array of different long-short currency permutations is now available to portfolio managers. Better portfolios The greatest accomplishment of Ucits III is buried within the practical details. By permitting derivative instruments to be used as a risk management tool, there can be a clear demarcation between each investment decision: each decision can be managed throughout its own life cycle with precision and, most importantly, without wreaking havoc on the performance of other investments contained in the same portfolio. Futures, swaps and forwards are the tools that serve to disentangle and separate out each category of investment. Active currency management is the clearest example. Irrespective of the composition of the assets held within the portfolio, the portfolio manager can implement active currency views independently of other investment decisions, using currency forwards. The relationship between assets and currencies has been severed – to allow currency to be managed as a separate asset class within the portfolio. Amidst the devilish detail of portfolio management, Ucits III has been a success. The mutual fund industry has been invigorated by the Ucits III legislation that enables retail investors to gain access to the full spectrum of investment manager resources and skills. Mutual funds have become more sophisticated, yet easier to manage as a result. The Ucits III legislation is still evolving and many anticipate that additional freedoms could be granted by law makers, to further advance the quiet revolution.