Onshore attractions

Last April the UK's Financial Services Authority decided to allow onshore investment vehicles to use derivatives and invest in a wider range of assets. Shamillia Sivathambu investigates why the regulated open-ended investment company structure is proving so popular among structured product providers

Until fairly recently, structured product providers were restricted to issuing unregulated offshore deposit structures if they wanted to cater to the UK retail market. Such structures tend to be relatively cheap and simple to launch, but they lack the tax advantages and flexibility of regulated investment vehicles. In an attempt to create a level playing field, and in the interest of enforcing the undertaking for collective investments in transferable securities (Ucits) III directive, the UK's Financial Services Authority (FSA) decided in April last year to liberalise the UK's onshore investment structure by streamlining existing retail structures and widening the scope for investment.

The FSA fundamentally altered existing retail investment structures by creating Ucits-compliant open-ended investment company structures (see box on page 22). These are onshore investments that are allowed to use leverage and invest in a wide range of alternative asset classes. Previously, the use of derivatives was strictly limited to offshore investments. Unsurprisingly, the regulatory changes have sparked a massive rush among structured product providers eager to tap the UK market with an "FSA-endorsed" investment structure. For the first time, they are operating on an equal footing with the regulated unit trust market.

For example, UK-based Sterling Assurance, a wholly-owned subsidiary of Zurich Financial Services, has just launched the Tracker Protected Profits Fund, its third open-ended protected fund aimed at UK investors. The fund is sold via the Sterling Investment Bond and Sterling's Isa, Pep Transfer Plan and Investment Account, as well as some of Zurich Financial Services' pension products. David Barclay-Miller, director of London-based Product Innovations Limited (PIL) says the fact that structured Oeics can be sold through tax-efficient wrappers such as these is a clear advantage for product providers, offering them greater flexibility and new sales channels.

Indeed, PIL is planning to launch its first structured Oeic within the next six months. As a regulated and FSA-licensed investment structure enabling the sale of derivatives through a unit trust-type vehicle, structured Oeics are admissible assets that can be used in tax-efficient investment wrappers such as Isas, Sipps (self-invested personal pensions) and Peps. This has sparked a lot of demand from independent financial advisers for regulated structured products, Barclay-Miller adds.

Meanwhile, Axa Investment Managers (Axa) launched one of the first capital-protected onshore Oeics last April, following the rule changes by the FSA. The five-year 2009 90% Capital Protected Fund has £48 million in assets under management and is subject to the same tax advantages as any other UK-authorised onshore fund, explains Severine Blonde, London-based head of UK structured products at Axa.

"The main difference between Oeics and deposit structures, which are the typical investment vehicles adopted by UK structured product providers, is that in the former you are buying into a fund," Blonde says. And as such, you are offering investors transparency, tax efficiency and the reassurance of investing in a regulated product, she adds.

"By contrast, investing in an unregulated note or certificate of deposit means all you are doing is buying paper. So if the counterparty defaults, you are done for," she adds. But a regulated unit trust-type structure allows providers to pool investors' funds, which are held in trust by a recognised bank or other financial institution who acts as custodian. "Oeics are the structure of choice for Axa," Blonde says.

Henderson Global Investors and the Royal Bank of Scotland (RBS) are also planning to launch structured Oeics, while firms such as Standard Life have made a strategic decision to issue only Oeics, abandoning the traditional offshore deposit structure altogether.

The UK Post Office, which currently issues guaranteed equity bonds (GEBs) manufactured by the Bank of Ireland, may well launch Oeic funds in the future, says Claire Oldstein, London-based head of marketing at Post Office Financial Services. "We are reviewing our plans and while we don't have an Oeic platform at the moment, we are not ruling it out," she adds. With others going down the Oeic route, it is clearly the direction in which the market is heading.

The new rules

The FSA rule changes for UK-authorised collective investment schemes (CIS) were introduced to allow retail investors access to a wider range of investment opportunities and product features, says an FSA spokesman.

The Oeic structure dates back to 1997. It was created to resemble UK-domiciled unit trusts, which are FSA-authorised investment schemes. UK Oeics are also similar to the collective investment funds available in most EU countries. The main difference between an Oeic and a unit trust is that the former packages its investments into shares rather than units and is traded with a single price. There is no bid/offer spread as is the case with unit trusts.

But it was not until early 2004 that the FSA decided to liberalise the CIS rules that govern Oeic structures by creating the Collective Investment Scheme Sourcebook (COLL). "All the changes we have made to the CIS were very much driven by Ucits III," adds the spokesman.

The Ucits III directive calls for a more harmonised approach to cross-border investment rules. To hasten this process, the FSA decided to rationalise the plethora of retail scheme categories into two broad types, comprising Ucits and non-Ucits Oeic structures.

The UK-authorised Ucits Oeic structure has directive-imposed requirements on the spread and quality of assets in the fund while a non-Ucits type structure is able to invest in a wider range of assets, including property and commodities - two asset classes currently outside the scope of the Ucits directive. The former may be passported in the EU but both structures are regulated and licensed for retail distribution in the UK.

The non-Ucits structure is also referred to as Nurses (non-Ucits retail schemes) and is used when a provider has no intention of marketing the product into the EU or if there is a need to gain derivatives exposure above and beyond the level permitted within a Ucits structure, which is a maximum of 5% exposure to any one counterparty or 10% if it is an authorised bank. It is also used when the underlying is a non-permissible asset such as commodities.

Despite the accessibility of Nurses, most providers still prefer Ucits-compliant retail schemes. PIL's Barclay-Miller says the firm originally planned to launch a non-Ucits structured retail scheme but has now opted for a full Ucits-complaint Oeic, which offers far more flexibility.

Clear advantages

Ucits-compliant retail structures are open-ended vehicles that allow managers to issue more shares to attract additional money from investors. The ability to sell the product across the EU is another attraction, notes Edinburgh-based Gerry McGrath, product manager for investment products at Standard Life.

There are also clear tax advantages when using a Ucits retail structure. Standard Life's entire Oeic range is Ucits-compliant and is therefore subject to capital gains tax rather than income tax. This means investors can use their capital gains tax allowance, McGrath says. So returns that do not exceed £8,000 are effectively exempt from tax, he explains.

Investors could, therefore, invest their entire £7,000 Isa allowance in an Oeic, whereas only £1,000 of the allowance would have qualified for investment in a GEB, which is subject to income tax, McGrath adds.

The fact that share prices are published daily means that Oeics offer greater transparency and accessibility, McGrath says. "With GEBs or non-Ucits structures, investors cannot access their money early. Oeics, on the other hand, allow them to cash in some of their shares before maturity, subject to a small fee," he notes.

The main advantage of structured Oeics, he says, lies in the money that can now be garnered through Sipp wrappers. Ucits III allows investors to use leveraged products providing they account for no more than 10% of their portfolio, while the regulated nature and clear tax advantages of structured Oeics mean they can be used for asset allocation or portfolio planning within Sipp contracts to give investors returns that are comparable to those of cash or the stock market, McGrath says.

"We took a lot of money into Standard Life's structured Oeic range, the Secured Capital Plan, using Sipps. One case was worth £300,000 and there were quite a few worth between £100,000 and £200,000. Previously, the average amount we attracted from Sipp accounts when using the GEB structure was in the mid-to-high teens."

The limitations

Despite the merits of regulated investment structures, they do have their critics. London-based Mike Chatdney, director of market investment solutions at Henderson Global Investors, for example, is keen to develop structured Oeics and has resisted going down the Nurse or GEB route because he is convinced that a regulated investment platform with EU distribution powers has a greater chance of success.

But Chatdney says his firm's plans to launch a structured Oeic platform are currently on hold due to uncertainties over the regulations. One cause for concern for product providers is the FSA's definition of assets eligible for inclusion in Oeics regulated by the Ucits III directive. For example, the use of commodity index swaps is not permitted in Oeics, only in Nurses, says an FSA spokesman. "We would not want to authorise a Ucits retail scheme that might fall outside the directive," he adds.

With such uncertainty surrounding what is permitted under the Ucits III directive, product providers such as Henderson Global Investors are awaiting clarification from the Committee of European Securities Regulators (CESR). "Regulatory uncertainty means we are no closer to launching anything. We want to get clarification first," Chatdney explains.

CESR, which is set to hold its second consultation on assets eligible for inclusion under Ucits III, expects to confirm its results by mid-January, according to a statement issued last month.

Apart from the issues surrounding the eligibility of assets, the Ucits retail scheme has other limitations. Under the Ucits directive, a structured product is permitted a maximum of 10% derivatives exposure. "This is usually not an issue," explains Axa's Blonde. "The product's capital protection feature makes this limitation workable," she adds.

Classification can also be problematic. The term "guarantee" cannot be used within an Oeic structure, but under certain conditions the term "protected" may be used, explains Andy Jones, marketing and partnerships manager for third-party distribution at Bristol & West.

While the similarities between traditional unit trusts and Oeics places structured products on a level playing field with the UK's regulated fund industry, it is also these very similarities that sway some providers away from the Oeic route altogether.

Bristol & West plans to offer onshore regulated structured products within the next three or four months and initially voiced a preference for launching Nurses. "But we discovered there were very subtle differences between unit trusts and Nurses and even with the differences, the unit trust structure would still be suitable," says Jim Goddard-Jones, head of third-party distribution at Bristol & West.

Bristol & West has now decided to launch a traditional unit trust platform rather than an Oeic or Nurse platform but will convert them to Nurses if and when the need arises - if, for example, non-eligible assets are needed as underlyings. Goddard-Jones explains that parent company Bank of Ireland has expertise in structuring unit trusts, and because the difference between the Oeic and unit trust structures is relatively small, the bank decided to stick with what it knows.

Aside from familiarity, another significant factor when deciding whether or not to launch onshore investment vehicles is cost. French bank BNP Paribas considered venturing down the Oeic route but cost considerations persuaded it to stick with its existing offshore closed-ended fund structure.

"At present, demand from IFAs for structured products is not that significant," says London-based Paul Nevin, head of UK and Middle East structured products, at BNP. "This makes it hard to justify the additional administration and set-up costs BNP would have to take on by developing its own Oeic platform." The providers that venture down the Oeic route tend to be those with experience in such vehicles and an existing platform to work from, Nevin says. This way, the legal expertise and initial platform administration costs are already justified.

BNP's existing investment structure, channeled through its offshore protected cell company, the Harewood PCC, works well right now, Nevin explains. "But if demand for Oeics picks up, we will reconsider our approach to onshore Ucits structures," he says.

Oeics versus GEBs

Open-ended investment companies

These are unit trust-type structures, and as such are onshore, regulated investment vehicles. But unlike unit trusts, Oeics package their investments into shares, not units.

They are open-ended vehicles, meaning the number of shares issued can rise and fall as shares are bought and sold. Oeic shares have a single price with no bid or offer spread, while initial charges are built into the share price and set out separately. Returns are subject to capital gains tax rather than income tax.

Ucits-compliant Oeics allow providers to market their products across Europe but non-Ucits retail schemes are similar to Oeics although they are not allowed to be marketed outside of the UK, namely due to its use of non-Ucits complaint assets like property and commodities.

Guaranteed equity bonds

These are deposit-based structures, where investors "loan" their money to a bank, which is then listed under liabilities on the bank's balance sheet, with a promise to repay the money.

Part of the deposit is then used to purchase derivatives instruments (options) that are built into the growth of the underlying. The remainder is used to purchase protection through a zero coupon bond.

As offshore vehicles, GEB's are unregulated investment vehicles and returns are subject to income tax. The certificate of deposit is issued for a fixed period only (closed-ended).