Covered Short Selling By UCITS Funds - The Debate Continues

Author:Ms Karen Jennings
Profession:Dillon Eustace
  1. Introduction

    In light of the current difficult market climate, pressure

    is mounting upon fund managers and pension funds to deliver

    ever-more important outperformance to their clients. As a

    result, the possibility of allowing UCITS funds to engage in

    short selling techniques is receiving more attention at local

    and European level. Karen Jennings of Dillon Eustace considers

    recent developments in relation to possible strategies

    available to UCITS funds.

  2. Short Selling by UCITS Funds

    Shorting is one of the most important strategic tools now

    available. Shorting provides added exposure to a given market,

    allowing the fund manager to take an overweight position (long)

    in securities they like, but also to go actively underweight

    (short) in those they do not. In selling a security they do not

    own, the manager anticipates that it will fall in value and can

    be bought back at a lower price. Whereas a hedge fund can

    physically short-sell a stock or bond, Regulation 72 of UCITS

    Regulations 2003, as amended, prohibits a UCITS from engaging

    in uncovered physical short sales.

    Physical short selling involves the actual sale of the

    security and it may be covered or uncovered. In light of the

    prohibition on UCITS funds from engaging in uncovered physical

    short sales, an alternative strategy for achieving the effect

    of shorting has become increasingly popular for UCITS fund

    managers, namely, synthetic shorting. Through the use of

    financial derivative instruments, a short exposure to the price

    of a security can be created, rather than physically selling

    the actual security. To date, 130/30 UCITS funds in the Irish

    market have relied upon such synthetic short selling techniques

    in order to allow fund managers to exploit negative opinions on


    Whilst it has been clear that a UCITS fund cannot engage in

    uncovered physical short sales, doubts have remained as to

    whether or not a UCITS fund can engage in covered physical

    short sales. On 5 October, 2007 the Irish Financial Services

    Regulatory Authority issued a revised policy note in respect of

    covered physical short selling by UCITS. The revised policy

    note purported to allow UCITS to borrow stock before it entered

    into the physical short sale of that stock and to treat such

    borrowed stock as constituting cover for the short sale

    provided that certain conditions were met. The basis for this

    policy rested upon the fact that Regulation 72 only prohibits

    uncovered physical short sales (not covered...

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