Despite experiencing one of the most difficult years for investment funds in Luxembourg and worldwide - at least in terms of assets under management - since the sector began its dizzying expansion more than 30 years ago, members of the industry from the grand duchy and beyond are convinced that new opportunities for growth are just starting to open up, according to speakers at Association of the Luxembourg Fund Industry's (ALFI) European Asset Management Conference on March 21 and 22.
In 2022, the assets of regulated Luxembourg funds declined from around €5.9trn to €5.1trn (although they rebounded in January this year), affected by the depressive impact on equity and bond markets of the outbreak of war in Ukraine, soaring energy prices and the prospect of shortages that did not in fact materialise, and central banks' rapid raising of interest rates to head off a surge in inflation.
But as Marco Zwick, head of fund supervision at financial regulator CSSF observed during the conference, Luxembourg funds deal with the issue of how to handle Russian and Ukrainian assets without major drama and with limited recourse to liquidity management tools.
The Association of the Luxembourg Fund Industry was established in 1988, the year that Luxembourg became the first European Community member state to adopt the UCITS directive into national law - paving the way for the emergence of a European cross-border fund sector with the grand duchy its heart and driving force. "We little knew that UCITS would become a worldwide brand," noted ALFI chairwoman Corinne Lamesch. "But even then, there were already around 500 funds with the equivalent of €53 billion in assets."
Seeds of future growth
As ALFI prepares to celebrate its 35th anniversary in July, Ms Lamesch argues that the seeds of the industry's future growth have already been sown. Since the Alternative Investment Fund Managers Directive took effect in 2013, Luxembourg has benefited from the growing appetite among institutional investors for regulated alternative investment vehicles, especially private equity and real estate, and more recently also private debt.
The next major opportunity could be the just-completed revision of the European Long-Term Investment Fund regime. The ELTIF 2.0 legislation looks like it will finally open up alternative strategies to non-professional investors, both expanding the range of options for the retail market at a time when traditional equity and bond assets have often delivered disappointing returns and expanding the capital pool available to fund Europe's infrastructure, including key aspects of the decarbonisation transition. As Lamesch points out, Luxembourg is already home to a majority of the ELTIFs established so far.
The country is also building an increasingly significant ecosystem of young, innovative fintech firms that are helping established institutions to address the challenges of digitalisation and automation everywhere from client relationships to compiling and analysing data to drive management decisions and for reporting to regulators and investors. Five-minute pitches interspersed through the conference highlighted the work of start-ups backed by the Luxembourg House of Financial Technology (LHoFT).
The grand duchy's finance minister, Yuriko Backes, injected a note of caution, observing that it's only a matter of weeks since analysts were fretting about the possibility of recession and ‘stagflation' in Europe. She says the government is committed to modernisation of the country's funds legislation following consultations with ALFI, to maintain its proactive stance in EU negotiations, and to be an early adopter of European legislation where this makes sense, as well as promising to avoid ‘gold-plating' of EU measures with additional national constraints.
Liquidity management tools
Backes also promised to focus on other issues that affect the financial industry, especially its ability to attract needed skills from abroad. "Housing prices are not a new problem, but it is important to address to enable Luxembourg businesses to attract talent," she said.
"We have been working on more flexible expatriate and profit-sharing regimes, we have created more public international schools, and the foreign ministry is preparing rapid action on proposals regarding spouse visas."
Verena Ross, who chairs the European Securities and Markets Authority, says asset managers mostly coped well with market stress in 2022 as the assets of the EU fund industry fell by 11% to €16 trillion, while credit risk mounted in tandem with higher interest rates, money market funds were subjected to fresh stress, and an ill-fated government borrowing policy shift in the UK threw liability-driven investment strategies used by pension schemes into turmoil.
Ross said the market turbulence of the past year has underlined the importance of liquidity management tools to help funds ride out economic shocks and avoid undue risks to the financial system: "The Financial Stability Board says there is no need for new policy tools - instead we need to use existing ones in areas such as liquidity management," she said, noting that ESMA is also prioritising revision of the rules governing money market funds "sooner rather than later".
Last year was a wake-up call for the global economy, observed Karen Ward, chief market strategist for EMEA at J.P. Morgan Asset Management. "The biggest result of the war and the energy price surge was the reawakening of inflation - we are permanently out of the low inflation, low interest rate rut," she said. Ms Ward argues that this is not an unmitigatedly bad thing: "Zero inflation was not a sign of [economic] health but of weak demand."
Environment for active managers
Despite the recent convulsions that engulfed Silicon Valley Bank and other small or specialised institutions in the United States and led to the collapse of Credit Suisse into the arms of UBS, Ms Ward insists that in general the financial sector, along with the overall economy, "is considerably more sound than in 2008" - not least because the past decade has seen no real economic boom that could turn to bust.
The current environment, argued Ed Venner, chief operating officer for distribution at Franklin Templeton, "should create opportunities for active managers to demonstrate the value of stock-picking and asset allocation. And it creates a new core role for bonds in generating income and opens the door to multi-asset income products."
A great deal of the focus of Luxembourg's fund industry, in terms of product design and investment strategy but especially regulatory compliance, is today related to sustainability. "We are at a much better place on the ESG journey than four years ago - it's no longer about ticking boxes," said Denise Voss, who chairs Luxembourg-based fund labelling agency LuxFLAG.
Conference panellists agreed that the implementation over the past couple of years of the EU's Sustainable Finance Disclosure Regulation has been extremely challenging for funds' boards of directors, not least because the legislation leaves a great deal of discretion, for example regarding the definition of sustainable investments, according to Massimo Greco, head of European funds management at J.P. Morgan Asset Management: "SFDR article 9 funds require a completely different research and investment process, and they need absolute credibility."
Frustrations of SFDR
But Gaëtan Parchliniak, head of regulatory affairs at management company Fundrock, complained that the wideness of definitions in the legislation has led to a great deal of confusion. "We now have to take into account principal adverse impact statements, along with the lack of verified and harmonised data, and ESMA's proposed guidelines on fund names could also be a challenge," he said.
"As things stand it's impossible to compare two article 8 funds, even if their strategies are similar, because they use different definitions and methodologies."
Even the gradual introduction, from 2025, of data reporting requirements under the Corporate Sustainability Reporting Directive, will not resolve all the problems, Mr Parchliniak argued, because small companies can't always provide the required data. Along with the issue of foreign companies not subject to reporting requirements, he warns that employing data specialists or outsourcing will entail huge costs for management companies or portfolio managers.
The latest report by the United Nations' Intergovernmental Panel on Climate Change, warning that without major emission reductions global temperatures are set to reach 1.5ºC above pre-industrial levels in the next decade and 2.5ºC by 2100 has highlighted the urgency of the green transition, according to Sarah Gordon, a senior advisor to the Impact Investing Institute.
"Solutions exist, but the question is how quickly and broadly they can be applied," she said. "Green investing represents a practical channel, although a just transition is essential - if it's not socially inclusive, it won't happen. This requires three elements: climate and environmental action, socioeconomic equity, for instance jobs, and community voice, which is often on the margins of investment decisions. But it will also provide amazing opportunities for financial returns. There are now many examples of successful transition investment."
Transition and biodiversity
Many fund industry professionals bemoan the failure of the SFDR to address the issue of how to incorporate high-emission businesses that are undertaking a decarbonisation transition.
Henrik Pontzen, head of ESG at Union Investment Institutional said: "Since there is no future sustainability rating system, we need to build one. It should incorporate strategy, not just their vision but how processes and products become more sustainable, money, whether the resources are there to make it happen, and governance, what incentives are in place for management to become sustainable."
Thomas O'Malley, head of policy at HSBC Asset Management, argued that the impact of nature on companies will drive increased focus on biodiversity in the coming years. "When fruit companies have to pay people to pollinate their crops, it is because a service previously provided by nature is no longer available," he said. "We expect biodiversity to be considered alongside climate impact over the next 20 years."
Green issues are among the most critical elements that will shape fund products in the future, according to independent director and former fund industry executive Noel Fessey. He pointed out that sustainability criteria can be hard to implement because it's not usually possible to boil it down to a single number or target: "There's no intellectual corruption, it's just hard to do it right."
Digitalising the value chain
Asset managers are also having to grapple with the implications for their business of the digital asset revolution, not necessarily because they intend to offer crypto-currency products but because techniques such as tokenisation offer potential advances for processes throughout the fund value chain. LHoFT CEO Nasir Zubairi noted that 10 digital asset custodians are already authorised in Luxembourg, and the country is also a pioneer of tokenised bond issues thanks to its comprehensive legal framework.
The vast majority of Luxembourg funds are highly unlikely to be caught up inadvertently by the OECD-sponsored measures to curb tax avoidance, arising from the organisation's campaign against base erosion and profit shifting (BEPS), that notable include a minimum 15% tax rate for multi-jurisdiction groups, according to Keith O'Donnell, managing partner for international and corporate tax at ATOZ Tax Advisers. "A very small sub-set of a small sub-set of funds are liable to come into scope," he said.
Schroders group head of tax Tim McCann noted the OECD should be credited for its agreement from the outset on a carve-out for funds, although he noted that there could be some grey areas, such as insurance groups. He said: "Holding companies and SPVs in alternative fund structures might pose a problem, but unless your fund is very big it shouldn't apply to you."
Ongoing and upcoming regulatory developments can be likened to a marathon - one where the finish line never actually arrives, observed lawyers Silke Bernard of Linklaters, Michèle Eisenhuth of Arendt & Medernach and Olivia Moessner of Elvinger Hoss Prussen in their review of changes ranging from the CSSF's outsourcing circular to the rules surrounding the PRIIPs key information document - and ramifications for sales in markets outside the EU, notable the UK and Switzerland.
Removing ELTIF obstacles
Their review also highlighted the potential for Luxembourg's financial industry of the introduction of the Pan-European Personal Pension regime, although take-up so far has been slow, limited to just two schemes in Slovakia. Ms Bernard also highlighted the finalisation of the ELTIF reform legislation, although its measures will take another nine months to apply to new funds. "Many barriers to its success have been removed or clarified, while offering easier access to retail investors and creating carve-outs for professional ones," she said.
The CSSF's Zwick, meanwhile, noted that the fund sector remains focused on ensuring compliance with the SFDR rules and their implications throughout the asset management process. "The concept of ESG is so fundamental that it entails a rethink of the whole risk management process," he said. "It is a difficult exercise, and if we get it wrong, we will lose the trust of investors." For the same reason, he warned the EU against repeated amendments to its sustainability rules, such as the addition of gas and nuclear energy to its category of sustainable fuels.
After five years in charge of fund supervision, Zwick concluded, "the Luxembourg industry is very dynamic and generates a great range of good ideas, many of which becomes reality". His advice for the next five years? "Prepare to embrace more regulatory change, it's not going away. Embrace technological change - we all need to do better, including the CSSF - and never under-estimate cyber-risk. And remember that serving investors is the ultimate goal, otherwise we will lose their confidence. The first one to get it wrong, gets it wrong for the whole industry."
This content was first published by ALFI. See the original version here.
