The Anatomy of European Investment Fund Law

Why do assets under management of European investment funds experience growth? As of 31 December 2016 investment fund managers in the European Union (EU) and the European Economic Area (EEA) managed more than €14trillion, equivalent to 33.2% of worldwide investment fund assets; all asset classes and fund types experienced significant growth for more than a decade. I seek to answer that question from a legal perspective in my recent paper ‘The Anatomy of European Investment Fund Law’.

While outside of Europe most commentators point to the UCITS brand’s success to explain the steady growth, little is known about the legal fundamentals underpinning European investment law. As I point out in my paper, at least to some extent the remarkable growth story of European investment funds is due to unique features of European investment fund law and regulation. Drawing on this hypothesis, I introduce the principles of European investment law, summarize the most important legislation and highlight to what extent European investment law differs from other fund management legislation.
After providing an overview of the relevant sources of law, I introduce the regulatory objectives of European investment law. Next I explain the pillars of European investment fund law, including the investment triangle, and the joint basis of European manager, depositary, sales and product regulation. I go on to discuss the crucial definitions of, and difference between, UCITS and AIF (Alternative Investment Funds), prior to unveiling the unique features of the UCITSD, and hence the UCITS product. I conclude with an analysis of the future trajectory of European investment fund law.

I hold that three factors contributed to European investment fund growth. First, the clear-cut product regulation paired with the interlocking control functions of the UCITS ManCo, or the AIFM, respectively, and the depositary are important factors that reduce the likelihood of fund managers violating investment rules. However, the mutual control relationship between fund manager and depositary is unlikely to prevent losses from lawful investments.

A second aspect catering to both the UCITS and AIF success is flexibility. UCITS today can be modified to respond to any investment trend. For instance, UCITS are open to function as Exchange Traded Funds, 130/30 funds, money market funds, pure equity and bond funds. They will also be open to automatization, regardless of the strategy that the fund manager applies. The same is true for AIF, ranging from ‘special funds’ for institutional investors and HNWIs to retail real estate funds of both the open and the closed ended type.

Third, the UCITS brand has kept out of trouble and worldwide scandals for the better part of its 25-year existence. This may have contributed to its legendary status. While money market funds failed in the US, European money market funds were not marketed to investors as a cash substitute. Investors in turn deemed money market funds an investment rather than cash. Where scandals occurred (as in the response to the Madoff scandals) financial intermediaries for the main part stood up for the investors’ losses on a voluntary basis. European intermediaries helped to build trust in the European investment fund brands.

In order to explain this positive influence of intermediaries it is helpful to understand the pro-competitive landscape among financial centres in Europe. I assume that the community of financial centres that thrive on the success of UCITS and AIF and where most international distribution takes place (including Luxembourg and Ireland) exerts additional discipline on market participants. This has encouraged intermediaries to act responsibly vis-à-vis their investors rather than let them bear losses when this was opportune from a short-term perspective. This exertion of control is due to the insight that any scandal will lead to restrictions on cross-border distribution which is harmful to the financial centre. In the worst case it could lead to a repeal of European passports granted by an EU Member State or the abolishment of the European passport altogether. These centres rely on gatekeepers (such as established law firms) and additional non-legal means (including peer pressure and subordination to strong depositaries) to restrict intermediaries’ conduct in the centres’ collective interests.

Dirk A. Zetzsche is the ADA Chair of Financial Law/Inclusive Finance at the University of Luxembourg.