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Page last updated
February 16, 2003




Funds of Funds:The Changing Legal Landscape

Recent developments liberalise the restrictions on "fund of funds" structures that have existed over the past three decades. Our writers survey the legal landscape in Europe, Hong Kong, and the United States.

The funds of funds environment will soon change considerably in Europe. Until now, except in very rare instances, funds of funds could only be sold in the country of their domicile. In other words, for every country of distribution, one had to create a local fund of funds structure. This is currently in the process of being modified as a result of the Common Position EC 24/2001 adopted by the Council of the European Union on December 4, 2001 to amend the European Directive relating to undertakings for collective investment in transferable securities (UCITS Directive 85/611). This is soon to be enacted into the local legislation of the individual EU Member States; the amended directive is known as "UCITS III". In a few months' time (but in any event no more than 18 months from the date of publication of the amended Directive in the European Union's Official Journal, funds of funds that comply with the conditions laid down in the Directive will benefit from what is known as a "European passport" allowing them, once they have been cleared for public distribution in their country of domicile, to be distributed in other EU Member States through a simplified procedure.

In order to benefit from this passport, funds of funds will have to invest in units or shares of other UCITS and/or other eligible collective investment undertakings. To be considered "eligible", non-UCITS target schemes must be subject to equivalent supervision to that laid down in European Community law. In addition, investment in non-UCITS will be limited to 30% of the assets of the fund of funds.

The cascade phenomenon will be avoided, as funds of funds of funds will not be authorised under the Directive.

Diversification rules will also apply: no fund of funds will be allowed to invest more than 10% of its assets in units of a single UCITS or other collective investment scheme. However, Member States can raise this limit to a maximum of 20%.

Rules on disclosure of the duplication of management fees will have to be followed. Similar rules aim at avoiding any duplication of subscription fees where the management companies of both the investing fund and the target fund are linked to each other.

This is not the only change brought in by the amended Directive as far as products are concerned. Other examples include cash, money market UCITS or index trackers of a new type. However, it is widely felt within the European fund industry that it is in the funds of funds area that the reforms will be most successful.

It is worth mentioning that feeder funds are not part of these newly passportable products. Notwithstanding all the legal and political debate that has taken place on this subject, it should be emphasised that the local legislation of most European countries does not authorise feeder funds (among other EU Member States, Germany, the UK, Italy and Belgium still do not authorise local feeder funds). In contrast, before the adoption of UCITS III, funds of funds were already allowed in the vast majority of EU countries. This may be viewed as an indicator that, at least in certain areas, Europe is still governed by consensus.

Hong Kong
Hong Kong already recognises funds of funds. These structures may be authorised pursuant to the Securities and Futures Commission ("SFC") Code on Unit Trusts and Mutual Funds ("Code") which sets out the requirements for funds which are to be authorised for sale to the public in Hong Kong. The Code does not distinguish between Hong Kong and overseas - domiciled funds and SFC's review is twofold: 1) focusing on the suitability of the fund's operators and 2) the fund's constitutive and offering documents.

Diversification requirements provide that a fund of funds must invest in at least five underlying funds with not more than 30% of its net assets in any one fund. The underlying funds must be authorised by the SFC or be recognised jurisdiction schemes (regulated retail funds established in the UK, USA, France, Germany, Ireland, Luxembourg, Isle of Man or the Channel Islands) although 10% of a fund of fund's assets can be invested in unauthorised non-recognised jurisdiction funds.

A fund of funds can borrow to meet redemption requests or operating expenses subject to a limit of 10% of net asset value.

A regular fund of funds is expected to focus on equity/bond investments and not more than 10% of the fund of funds' assets can be invested in warrant, leveraged or futures and option funds unless the fund of funds itself has a particular objective of investing in this type of category of funds in which case additional provisions will apply. A fund of funds is not allowed to invest in another fund of funds and the ability to double charge is restricted where a fund of funds invests in underlying funds managed by the same manager or its affiliate. All initial charges on the underlying funds must be waived in such a case. In addition, the manager of a fund of funds cannot obtain any rebate on fees and charges levied by an underlying fund.

When seeking authorisation, other general requirements of the SFC's Code will also apply, for example, regarding suitability of the operators of the fund. The fund of funds must also offer at least monthly dealing and performance fees can only be paid annually where the net asset value per unit exceeds the previous highest net asset value per unit at which the last performance fee was paid (on a "high on high basis").

Multi-manager funds are not recognised as a separate category of funds in Hong Kong. If a multi-manager fund (where the fund portfolio is allocated amongst different managers to manage as discretionary account rather than separate underlying funds), seeks authorisation the SFC would wish to approve each manager. Managers of Hong Kong authorised funds must be located in a jurisdiction with a suitable inspection regime acceptable to the SFC and the key personnel of the management company should possess at least five years' investment experience managing retail funds.

United States
US investment funds are subject to regulation by the United States Securities & Exchange Commission (the "SEC") under the Investment Company Act of 1940, as amended (the "Investment Company Act"). Subject to the exceptions described below. Section 12(d)(1) of the Investment Company Act places limits on the extent to which an investment fund may invest in other funds. In general, SEC-registered funds and certain funds that are exempt from registration are prohibited from acquiring securities of any SEC-registered fund if, as a result, the acquiring fund would own

n more than 3% of the total outstanding voting stock of the acquired fund;

n securities of the acquired fund worth more than 5% of the acquiring fund's total assets; or

nl securities of SEC-registered fund worth, in the aggregate, more than 10% of the acquiring fund's total assets.

Additional limits apply to investments in closed-end funds. In general, a registered fund may not acquire the securities of an SEC registered closed-end fund, if immediately after such acquisition, the acquiring fund and other registered funds having the same investment adviser would own more than 10% of the outstanding voting stock of the closed-end fund.

Notwithstanding these restrictive general principles, significant exceptions now exist as a result of the National Securities Markets Improvement Act of 1996. Most significant are the following:

Investments in Unregistered Funds.
The Investment Company Act no longer regulates investments in funds that are exempt from registration under the Investment Company Act (including most funds organised outside of the United States).

Funds of Affiliated Funds.
A SEC-registered open-end fund may now invest all of its assets in other funds within the same group of investment companies. Absent special exemptive relief from the SEC (described below), the acquiring fund cannot make other investments, except in US Government securities and short term cash equivalents. Other restrictions apply, including a provision which restricts duplication of sales loads and other distribution charges.

Expanded Exemptive Authority.
The Investment Company Act now specifically permits the SEC to grant exemptive orders from Section 12(d)(1) "if and to the extent that such exemption is consistent with the public interest and the protection of investors." In general, an organisation must apply to the SEC to receive its own exemptive order; it cannot rely by analogy on relief granted to others. Since the 1996 legislation, the SEC has used this authority to permit funds to pursue an investment program that exceeds the scope of the fund of affiliated funds exception described above. Under these orders, funds have been permitted to invest in a variety of assets that includes affiliated and non-affiliated investment funds and direct investments in individual securities.

José-Benjamin Longrée
Head of Sales & CRM
Head of Fund Structuring - Europe
Crédit Agricole Investor Services
Tel:+ 352 47 67 25 67

Geoffrey Kenyon
Goodwin Procter and Hoar
Tel: +1 617 570 10 00

Susan Gordon
Financial Services Group at Deacons
Hong Kong





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