Legal Structure of ETFs: UCITS

The UCITS billing is a mark of quality assurance that means your ETF conforms to European Union regulations designed to protect the general public from unsuitable investment vehicles.
 
The rules have been so successful that 75% of ordinary investors in Europe have their holdings tucked inside UCITS funds according to the EU. UCITS stands for Undertakings for the Collective Investment of Transferable Securities, just in case you were dying to know. But sitting under that bureaucratic bonnet, is a system of safety standards that govern all UCITS ETFs.
 
First and foremost, an ETF must be diversified so that no single holding is worth more than 20% of the fund’s NAV (Net Asset Value). This can flex to 35% under certain market conditions but is an important rule that caps your exposure to any single security.
 
Next, the assets of a UCITS ETF must be segregated from those of the ETF provider under the supervision of an independent custodian. This ring-fencing ensures that investors’ assets cannot be seized to settle the liabilities of the provider, should it ever run into financial difficulty.  
 
UCITS also requires an ETF to be liquid and open-ended so that an investor can redeem their holdings at any time. In particular, if trading is disrupted on the stock exchange (perhaps due to a Flash Crash or other market turmoil), then investors can ask their broker to redeem their shares directly with the ETF provider.   
 
Some ETFs use financial derivatives to hedge or to track their index - synthetic ETFs wouldn’t exist without this provision. But derivatives expose investors to the chance that the other side (usually a large financial institution) might fail to fulfill their part of the bargain, a slim possibility known as counterparty risk.
 
UCITS steps in to limit exposure to any single counterparty to a maximum of 10% of the ETF’s NAV. Further rules require ETF managers to cover derivative exposure with collateral that:

• Is valued daily to at least 90% of NAV.
• Meets certain quality criteria.  

You may not always feel grateful for it when leafing through pages of ETF documentation, but UCITS is also responsible for imposing a minimum standard of transparency on providers including the requirement to publish:

• The Key Investor Information Document (KIID)
• Prospectus
• Annual and semi-annual reports

The other unsung benefit of the UCITS regime is that it reduces red tape and costs by enabling ETFs created in one EU member state to be easily sold and marketed across the rest – increasing choice for all European investors.
 

Non-UCITS ETPs

ETFs are only one branch of the Exchange Traded Product (ETP) family. Their siblings are Exchange Traded Notes (ETNs) and Exchange Traded Commodities (ETCs).
 
Neither ETCs nor ETNs meet UCITS standards because they are debt securities not funds.
 
That enables ETCs and ETNs to track assets unavailable to ETFs but removes the protection investors enjoy under UCITS.
 
ETCs commonly track the fortunes of a particular commodity or pair of currencies. That means they are highly concentrated and can be 100% exposed to counterparty risk.
 
ETNs track indices like ETFs but don’t physically own the underlying assets. They are typically issued by large banks offering exposure to the more exotic reaches of the market. They are especially risky because they are 100% dependent on the creditworthiness of the bank and don’t usually offer a collateral safety net.  
 
These products can be labelled UCITS eligible but that doesn’t make them proper UCITS funds. UCITS eligible just means that investors can invest in the product just like they are used to as with UCITS compliant ETFs.
 
Be aware that not every ETF is a UCITS ETF either. ETFs issued outside of the EU (think Switzerland, Sweden or the US) may not comply, in which case they’ll be missing the magic acronym from their name.
 

UCITS timeline

The UCITS regulations have been regularly updated to cope with the ever-evolving financial markets: