One of the cornerstones of UCITS since the introduction of the original UCITS Directive in 1985 has been the imposition of strict risk spreading requirements. This has been enshrined in what is commonly known as the 5/10/40 rule which is that a UCITS may invest no more than 10% of its net assets in transferable securities or money market instruments issued by the same body, provided that the total value of transferable securities or money market instruments held in issuing bodies in each of which it can invest more than 5% is less than 40%.
Under the original UCITS Directive, this principle created problems for UCITS which wished to track an index where the weighting of a constituent element of the index exceeded the 5% limit or where the relationship between two or more constituent elements of the index meant that they were considered to constitute a single issuer resulting in an aggregation of the exposure. As explained below, these problems were addressed by UCITS III.
(i) 20% and 35% Rule
Since the introduction of UCITS III, a UCITS whose policy is to replicate an index is permitted to invest up to 20% of net assets in shares and/or debt securities issued by the same body, with the 20% limit being raised up to 35% in the case of a single issuer where justified by exceptional market conditions. This flexibility is permitted where the relevant index is recognised by the Central Bank on the basis that it is sufficiently diversified, it represents an adequate benchmark for the market to which it refers and it is published in an appropriate manner.
(ii) Index Replication
The reference to "replication" of the composition of a shares or debt securities index is considered by the Central Bank to mean replication of the composition of the underlying assets of the index including the use of derivatives or other permitted UCITS efficient portfolio management techniques and instruments.
(iii) Sufficient Diversification
Although somewhat circular, reference to an index's composition being diversified refers to an index which allows for a maximum weighting per issuer of 20% with a capacity for a single constituent to exceed 20% but not exceed 35% of the index.
(iv) Adequate Benchmark
The reference to the index representing an adequate benchmark for the market to which it refers is a reference to an index whose provider uses a recognised methodology which generally does not result in the exclusion of a major issuer of the market to which it refers.
(v) Publication
The requirement that the index be published in an appropriate manner is taken as a reference to an index which is accessible to the public and where the index provider is independent from the index replicating UCITS. Note, however, that this second requirement does not preclude index providers and the UCITS forming part of the same economic group provided that effective arrangements for the management of conflicts of interest are in place.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
