Arthur Cox established the first Irish ETF in 1998 and continues to advise multiple ETF clients. Ireland is home to 50% of all ETFs in Europe and is increasingly the domicile of choice for new ETF launches. The market for exchange-traded products in Europe is more fragmented than other ETF markets such as the US. Our extensive involvement with ETFs allows us to assist our clients in preparing for the launch and sale of ETFs in Europe.
The European ETF market is undergoing a material increase in growth. In excess of US$260 billion of assets are currently held in Irish domiciled ETFs and commentators have projected this to reach $500 billion by 2020. Growth is occurring across all ETF asset classes and on a pan-European basis. ETFs are outperforming traditional mutual funds in terms of asset capture. This is driven by multiple factors which include:
- changes to European remuneration policies restricting the use of rebates;
- investor acceptance of the product type;
- a preference for greater liquidity and transparency in European funds;
- AIFMD making access to US ETFs more difficult; and
- acceptance of UCITS ETFs in the Asian markets.
The purpose of this briefing is to provide information on Ireland as a leading domicile for ETFs.
In Europe ETFs are typically structured as investment companies established as undertakings for collective investment in transferable securities ("UCITS"). These are funds established under the regulations implementing the EU's UCITS Directive. UCITS are very much recognised as a global funds brand and can be passported for sale throughout the EU and in many other jurisdictions.
The second category of regulated investment fund in Ireland comprises alternative investment funds ("AIFs"). These funds are subject to the regulations implementing the EU's Alternative Investment Fund Managers Directive ("AIFMD"). The London Stock Exchange has announced plans to facilitate the listing of AIFs however we have yet to see an AIF ETF list and trade. This briefing, therefore, focuses on the establishment of Irish domiciled UCITS ETFs.
A fund may be established in Ireland as a single fund or as an umbrella fund comprising one or more sub-funds, each with a different investment objective and policy. An umbrella fund may have multiple sub-funds with exposure to different indices or asset types and provides a simple and cost effective solution for establishing and adding new sub-funds over time. A sub-fund may comprise different classes of shares. Typically classes of shares are issued to allow for different fee arrangements, different subscription amounts and/ or different currencies within the same sub-fund. UCITS ETFs are typically established as umbrella funds with different currency classes. Irish UCITS ETFs organised as umbrella funds provide for segregated liability between their sub-funds as a matter of law.
APPROVAL, REGULATION AND SUPERVISION OF UCITS ETFS
The Central Bank is the regulatory authority responsible for the approval and supervision of all regulated investment funds in Ireland. All promoters, investment managers and discretionary investment advisers must be approved to act as such by the Central Bank. This approval process involves submitting to the Central Bank an application form and sufficient background information to enable the Central Bank to be satisfied that the applicant has the appropriate personnel, experience, financial resources and regulatory status to perform the role.
The UCITS ETF's prospectus, constitutional document and various service provider documents must be submitted to the Central Bank for review and approval. A UCITS ETF is typically approved by the Central Bank within six to eight weeks from the date of submission of the documents, depending on the complexity of the fund structure. Any amendments to these fund documents are also subject to prior approval by the Central Bank. A UCITS ETF must also produce for investors a pre-contractual document known as a key investor information document ("KIID"). The rules on the length and content of, and language used in, the KIID are prescriptive.
Each ETF is required to have a minimum of two Irish resident directors appointed to its board of directors. The Central Bank must approve all appointments to the board of directors in advance. Any proposed director must meet the fitness and probity standard in that the director must be fit and proper which means the director must be (i) competent and capable, (ii) honest and demonstrate integrity, fairness and ethical behaviour and (iii) be financially sound.
The day-to-day management and control of the ETF is provided by the board of directors. The board of directors may delegate certain duties to third parties (e.g. investment management, administration and custodial functions) but the ultimate responsibility to ensure that the UCITS is managed in the best interests of the shareholders remains with the ETF board.
It is expected that UCITS ETFs may also be established in the form of the new Irish Collective Asset Management Vehicle ("ICAV"). The ICAV is a corporate entity (that has a similar structure to the SICAV as used in other European jurisdictions) and operates outside of the Companies Acts in Ireland. A similar vehicle, known as the OEIC, is available in the UK.
The main advantage of the ICAV is that, if it elects to do so, it may meet the US "check the box" taxation rules. The ICAV can elect in its classification under the U.S. "check the box" taxation rules to be treated as a transparent entity for U.S. federal income tax purposes which will allow U.S. taxable investors to avoid certain adverse tax consequences that would normally apply to "passive foreign investment" companies.
Traditionally, Irish ETFs have been authorised as public limited companies and are required to comply with many of the rules applicable to non-investment fund type public companies – these rules have been particularly burdensome for ETFs. For an ICAV there is no requirement to hold an AGM, no need for shareholder votes on non-material changes to the constitutional document and separate sets of accounts may be prepared at the level of each sub-fund.
UCITS are subject to a number of investment restrictions which provide for diversification of a fund's portfolio. One key diversification requirement is the "5/10/40" rule. A UCITS is precluded from investing more than 10% of its assets in any one issuer. Where the fund invests more than 5% of its assets in any issuer the maximum amount of such holdings in excess of 5% is limited to 40% of the net asset value of the UCITS. However, index tracking funds, such as ETFs, can avail of more generous exposure limits with the prior approval of the Central Bank.
INDEX-TRACKING UCITS ETFS
UCITS ETFs are mainly passive funds which replicate an index. The rules around indices are of particular interest to promoters of ETFs. An index used by a UCITS ETF must be sufficiently diversified; represent an adequate benchmark for the market to which it refers; be published in an appropriate manner and be independently managed from the management of the UCITS. The prospectus for an index-tracking UCITS ETF must specifically address four matters (in addition to all other relevant Central Bank requirements). It should contain:
- a clear description of the index that is to be tracked (including details of its underlying components). It is permissible for the prospectus to direct investors to a website where the composition of the tracked index is published;
- information on how the index will be tracked (for example, whether it will follow a full replication or sample-based physical model or a synthetic replication) and the implications of the chosen tracking method in terms of investor exposure to underlying and counterparty risk. This information must also be summarised in the UCITS' KIID;
- a description of the factors that are likely to affect the index-tracking UCITS' ability to track the performance of the index; and
- information on the anticipated level of tracking error in normal market conditions.
There are additional disclosure requirements in the financial statements for UCITS ETFs. The annual and half-yearly reports of an index-tracking UCITS ETF must state the size of the tracking error as at the end of the period under review. The annual report should also disclose and explain any divergence between the performance of the UCITS ETF and the performance of the index tracked.
A UCITS ETF cannot invest in a financial index which has a single component that has an impact on the overall index return which exceeds the relevant diversification requirements, i.e., generally 20% or, where justified by exceptional market conditions, 35%. Investments in commodity indices that do not consist of diversified exposures are also restricted. For these purposes sub-categories of the same commodity (e.g., from different regions or markets derived from the same primary products industrialised process) are not considered to be the same commodity unless those sub-categories are highly correlated.
A UCITS ETF seeking to invest in an eligible financial index must carry out appropriate due diligence on the eligibility of the index and document this. This due diligence should take into account whether the index methodology contains an adequate explanation of the weightings and classification of the components on the basis of the investment strategy. The due diligence should also consider matters relating to the index components.
As part of the due diligence process the UCITS ETF should also assess the availability of information on the index including whether there is a clear narrative description of the benchmark, whether there is an independent audit of the index and the scope of such an audit and whether the frequency of index publication will affect the ability of the UCITS to calculate its net asset value. The UCITS ETF should also ensure that the index is subject to independent valuation.
ACTIVE UCITS ETFS
There is growing interest in ETFs providing actively managed strategies (i.e. which do not track an index), whereby the manager has discretionary control of asset allocation. Those considering active ETFs need to consider the impact of portfolio transparency as it relates to matters of market abuse, the need to protect proprietary information, and the need for intra-day market making in assessing the suitability of an actively managed investment strategy for exchange trading.
The essential difference between an ETF and a mutual fund is that the ETF is traded on an exchange like a share. In order to facilitate UCITS EFTs trading on exchange a third party, commonly known as an authorised participant, subscribes for ETF shares with the ETF and this is known as the primary market. The authorised participant will subscribe for shares either in cash or in specie (i.e. by providing a creation basket referencing the underlying holdings of the reference index or strategy). In Europe funds can use derivatives to achieve exposure to the underlying holdings in which case the creations are cash settled.
The ETF shares purchased by authorised participants are then available for purchase by investors from the authorised participants in smaller amounts in the secondary market. Where shares of a UCITS ETF are purchased on a secondary market (e.g. on exchange) are generally not redeemable from the fund, the prospectus and marketing communications of the UCITS must contain a specific warning about how the secondary market operates and the implication of trading fees or market pricing on returns.
Secondary market investors must have a right to sell shares directly back to the UCITS ETF in circumstances where the stock exchange value of the shares significantly varies from its net asset value (e.g., in cases of market disruption such as the absence of a market maker). The process and potential costs involved in such a redemption must be disclosed by the UCITS ETF in its prospectus.
UCITS ETF - NAMING CONVENTION
Every UCITS ETF must contain the identifier 'UCITS ETF' in its name and in its fund rules or instrument of incorporation, prospectus, KIID and marketing communications.
LISTING AND TRADING
Irish ETFs are most commonly traded on one or more of: London Stock Exchange, Euronext (Paris/Amsterdam), Borsa Italiana, SIX Swiss Exchange and XETRA (segment of Deutsche Borse). Arthur Cox has one of the largest listing teams in Dublin and can assist with this process. Ireland, through the Irish Stock Exchange, benefits from admission to trading rights on the London Stock Exchange. The costs of listing are generally not significant however ease of settlement and the cost of market making vary on a market by market basis.
A UCITS ETF authorised by the Central Bank is not subject to Irish tax of any kind. Certain Irish resident investors are chargeable to Irish tax on transfers or redemptions of shares or payments of dividends.
The process for launching a UCITS ETF in Ireland is well established. Some of the key drivers on why Ireland is a leader in ETFs are:
- Mature industry. The first Irish ETF was launched in 1998;
- Ireland has 50% of the European ETF market;
- Strength and depth in custody and administration services in Ireland;
- No Irish CGT, income or annual net asset tax for ETFs;
- Access to a strong double tax treaty network;
- Eurozone, English speaking country; and
- Home to over 900 fund promoters.
We are delighted to assist promoters as they assess Ireland as a domicile, or Europe more generally as a market, for exchange-traded products. If you have any queries on this briefing or require any further details on any aspect of ETFs please do not hesitate to contact a member of our team.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.