An Empirical Analysis of Fund Regulation and Scope of Distribution of European Investment Funds

Abstract

This paper examines the impact of the 2001 UCITS III Directive on international distributions of European investment funds from 2002-2008. We analyze several dimensions of the notification decision: (1) whether the fund is distributed cross-border; (2) the number of countries where funds are notified for distribution; and (3) the population size implied by the notification list. Although UCITS III facilitated international distributions, it did so with costs that disadvantaged smaller funds, and did not have effective procedures to facilitate fund mergers. Consistent with these regulatory impediments, our comprehensive dataset on European investment funds shows that larger fund promoters and funds domiciled in smaller countries have much wider distributions, but merged funds have a narrower scope of international notifications. Also, we document that the international scope of notifications is concave in that fewer new countries are notified over time. As well, we empirically show an increase in the number of fund promoters that distribute UCITS funds outside the European Union, notably in Asia, which can be attributable to the superior investor protection of UCITS regulation. We find that notifications in Asian countries are mostly done by non-European promoters (primarily US promoters).

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Electronic copy available at: http://ssrn.com/abstract=1494304
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An Empirical Analysis of Fund Regulation and Scope of
Distribution of European Investment Funds

Douglas Cumming
York University, Schulich School of Business

Gael Imad’Eddine
Université catholique de Louvain, Louvain School of Management

Armin Schwienbacher*
Université catholique de Louvain, Louvain School of Management
University of Amsterdam Business School

This version: 25 October 2009

Abstract:
This paper examines the impact of the 2001 UCITS III Directive on international distributions of European
investment funds from 2002-2008. We analyze several dimensions of the notification decision: (1) whether the
fund is distributed cross-border; (2) the number of countries where funds are notified for distribution; and (3) the
population size implied by the notification list. Although UCITS III facilitated international distributions, it did so
with costs that disadvantaged smaller funds, and did not have effective procedures to facilitate fund mergers.
Consistent with these regulatory impediments, our comprehensive dataset on European investment funds shows
that larger fund promoters and funds domiciled in smaller countries have much wider distributions, but merged
funds have a narrower scope of international notifications. Also, we document that the international scope of
notifications is concave in that fewer new countries are notified over time. As well, we empirically show an increase
in the number of fund promoters that distribute UCITS funds outside the European Union, notably in Asia, which can
be attributable to the superior investor protection of UCITS regulation. We find that notifications in Asian countries
are mostly done by non-European promoters (primarily US promoters).
Keywords: Mutual funds industry, International distribution, UCITS, Law and finance
JEL Classification: G23, G15, G18, K22

*Contact author address for correspondence: Université catholique de Louvain, Louvain School of
Management (Louvain-la-Neuve campus), Place des Doyens 1, 1348 Louvain-la-Neuve (Belgium), Phone:
+32-10-47.84.40 (office A.204), Email: armin.schwienbacher@uclouvain.be

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Electronic copy available at: http://ssrn.com/abstract=1494304
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An Empirical Analysis of Fund Regulation and Scope of
Distribution of European Investment Funds


Abstract:
This paper examines the impact of the 2001 UCITS III Directive on international distributions of European
investment funds from 2002-2008. We analyze several dimensions of the notification decision: (1) whether the
fund is distributed cross-border; (2) the number of countries where funds are notified for distribution; and (3) the
population size implied by the notification list. Although UCITS III facilitated international distributions, it did so
with costs that disadvantaged smaller funds, and did not have effective procedures to facilitate fund mergers.
Consistent with these regulatory impediments, our comprehensive dataset on European investment funds shows
that larger fund promoters and funds domiciled in smaller countries have much wider distributions, but merged
funds have a narrower scope of international notifications. Also, we document that the international scope of
notifications is concave in that fewer new countries are notified over time. As well, we empirically show an increase
in the number of fund promoters that distribute UCITS funds outside the European Union, notably in Asia, which can
be attributable to the superior investor protection of UCITS regulation. We find that notifications in Asian countries
are mostly done by non-European promoters (primarily US promoters).
Keywords: Mutual funds industry, International distribution, UCITS, Law and finance
JEL Classification: G23, G15, G18, K22

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1. INTRODUCTION
Regulatory fragmentation limits international sales of investment funds to retail investors. In Europe,
regulatory fragmentation has given rise to much smaller funds on average, and as such many European
funds do not capture the benefits of scale economies in fund management that are enjoyed by their US
counterparts. In 2001, for example, the average investment fund in the US was Euro 910 million, while
in Italy, the Netherlands, the UK, Germany and France average fund sizes were Euro 417 million, 389
million, 248 million, and 233 million, respectively, and all other European countries have substantially
smaller average fund sizes (Heinemann, 2002). More recently, the European Fund and Asset
Management Association (EFAMA) reported that there are currently 32,000 funds registered in Europe,
four times more than in the US (EFAMA, 2008), although the US mutual funds market is larger. It is well
documented that expense ratios are a significantly declining function of fund size; US fund sizes enable
expense ratios to be roughly 50-75% smaller than their European counterparts (SEC, 2000). To this end,
it is important and worthwhile to empirically investigate attempts to mitigate regulatory fragmentation
in international sales of investment funds.
An important contribution to a better understanding of recent developments in mutual fund industries
worldwide was made by Khorana et al. (2005), from a macro-economic perspective. However, the fact
that Europe and the US differ significantly in the size of their funds indicates that different dynamics
may take place within countries. Given these expense ratios declining with fund size, an investigation on
the fund-level is likely to provide complementary findings to Khorana et al. (2005).
In this paper, we empirically investigate the impact of The Undertakings for Collective Investment in
Transferable Securities (‘UCITS’) on international distributions of European investment funds. Our main
research question is to understand the determinants of the scope of distribution of investment funds.
More specifically, to what extent can a harmonized regulation improve the efficiency of investment
funds industry? Because Europe is both a cluster of independent nations and an incompletely unified
entity, we have a unique opportunity to test the effect of supra-national regulations on the
development of infra-national activities. As we show in this paper, the European regulation has a
significant impact in reshaping the investment fund industry in Europe, but moreover its effects go
beyond the boundaries of the European Union to reach some Asian countries with major financial
centers.
The first set of rules, UCITS I, were adopted in 1985 to allow for open-ended funds investing in
transferable securities to be subject to harmonized regulations throughout Europe. In practice, Member
States created obstacles for cross-border marketing of UCITS, which limited the ability of a fund to
distribute cross-border. UCITS II was an ambitious attempt at curtailing these problems, but too
ambitious to secure agreement from Member States and therefore never implemented. In 2001, UCITS
III was introduced, which brought about regulatory changes to facilitate cross-border distributions
within the European Union. By 2005, approximately €5 trillion were invested in collective investments
throughout Europe, of which approximately 70% were UCITS funds.

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UCITS III comprised two directives: a “Management Directive”1 and a “Product Directive”2. The
Management Directive enabled a simplified and more cost-efficient prospectus which permitted a
greater scope of activities for management companies to operate throughout Europe. The Product
Directive enabled a wider range of financial instruments and permitted UCITS money funds, derivative
funds, index-tracking funds, and funds-of-funds.
UCITS III, however, was not without barriers to integration. As at January 2009, the UCITS IV directive
was approved for implementation in 2011. UCITS IV differs from UCITS III by enabling more cost
effective notification procedures, key investor information and adapted frameworks for mergers, among
other things (Ferguson, 2009). These changes still imply the existence of hurdles for cross-border
notifications under UCITS III but fewer than under the UCITS I regulation. In particular, under UCITS III
we expect a smaller scope of distribution for funds that do not have a large top ranked promoter, and a
smaller scope of distributions for merged funds. Further, as the costs of international distribution are
nontrivial under UCITS III, we expect relatively more frequent international distributions for funds which
have greater benefits, such as those domiciled in smaller countries.
We empirically test these propositions with a new comprehensive dataset covering the bulk of European
investment funds creations over the period 2002-2009. The data strongly support the idea that under
UCITS III the regulatory costs and barriers to international notifications limited such notifications,
although UCITS funds are more widely distributed than non-UCITS funds. First, we find top-50 ranked
fund promoters have much wider distributions. This finding is consistent with the view that the
regulatory costs of international distributions are equal for all funds regardless of size, and thereby
larger funds can better economize on such costs than their smaller counterparts. Second, we find strong
evidence that funds domiciled in smaller countries are more likely to have a greater number of
international distributions. Much however is attributable to Luxembourg and Ireland, the two most
important centers of domiciliation for mutual funds in Europe. After controlling for a larger number of
other factors, promoters that are commercial banks (and thus have easier access to local retail investors
through their large range of branches) do not seem to set up funds with a broader scope of distribution.
However, non-European promoters have funds with greater scope, irrespective of the measure of scope
of distribution used. Non-European promoters included in our analysis originate by far from the US
(there is only one from Australia; all others are from the US).
We note that despite these regulatory impediments under UCITS III, UCITS III nevertheless has become
extremely well regarded as a vehicle to distribute funds outside of Europe, due to its superior investor
protection. Therefore, several Latin American and Asian countries now allows since a few years
European UCITS funds to be distributed also in their own country. This is mostly the case in Chile, Hong
Kong, Singapore and Taiwan. We empirically show in this paper that much of this trend is attributable to
top tier promoters. Interestingly, we find that notifications of UCITS funds in Asian countries are mostly
done by US promoters that domicile their funds in the European Union, as compared to European

1 Directive 2001/107/EC of the European Parliament
2 Directive 2001/108/EC of the European Parliament and of the Council

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promoters. A find a similar pattern for the notification of UCITS funds in the Americas (essentially Latin
America).
Our paper is related to a growing body of international evidence that shows regulation matters for fund
distribution. Heinemann (2002) discusses the benefits of UCITS III for international fund distribution
over that of UCITS I, but does not examine barriers to international notification and/or test for the effect
of such barriers. Jayaraman et al. (2002) and Ding (2006) document benefits of mutual fund mergers,
but does it in a US context where international distribution cannot be addressed. Romero-Avila (2007)
and Cumming and Johan (2007) examine the effect of regulatory harmonization on growth of the
banking and private equity industries in Europe, respectively, but do not examine the mutual fund
industry. Cumming and Dai (2008) examine the impact of regulation on the flow-performance relation
for institutional investors to hedge fund managers, but do not consider mutual funds or retail investors.
Ferreira et al. (2009) likewise examine the impact of regulation on the flow-performance relation of
mutual funds, but do not examine international notifications of funds in respect of UCITS. Khorana et al.
(2005) examine the size of the mutual fund industry around the world, but do not examine the effect of
UCITS on international distributions. Our analysis complements these existing studies and is consistent
in that it indicates regulation plays a pronounced role in understanding the economics of the mutual
fund industry around the world.
This paper is organized as follows. Section 2 provides information on the European investment fund
market and its regulatory environment. Section 3 summarizes our testable hypotheses. Section 4
describes the data. Summary statistics on the European investment fund industry are provided in
Section 5. Multivariate empirical analyses of the scope of international distributions are provided in
Section 6. Section 7 provides complementary evidence on UCITS funds notifications outside of Europe.
Concluding remarks follow in Section 8.
2. THE EUROPEAN INVESTMENT FUND MARKET AND THE REGULATORY ENVIRONMENT
In this section we present the regulatory environment of the European investment fund market. More
specifically we detail the evolution of the Undertakings for Collective Investments in Transferable
Securities (UCITS) regulation that specifically targets the retail market (although institutional investors
also invest significantly in UCITS funds). To understand the purpose behind the UCITS Directive, one
must keep in mind that the intention was to allow a wider, cross-border distribution of funds across
Europe in order to increase the potential market, but in a setting that gives strong investor protection. In
other words, management companies (promoters) may sell their products on a large scope to retail
investors, but they must comply with a certain set of rules that limit the type of instruments they can
hold as well as the investment strategies they are allowed to follow.
Recognizing the importance of a harmonized market in Europe for investment funds, the European
Commission has pushed for regulation on the European Union level that facilitates cross-border
distribution of fund products and thus an integrated market in which the scope of national regulations
does not generate too high costs. In 1985, the directive 85-611/EEC which codifies the notion of