On 30 January 2017 the European Securities and Markets Authority (ESMA) published its opinion, addressed to national regulators, setting out four high-level principles which UCITS must follow when setting up different share classes in order to ensure a harmonised approach across the EU.
Why has ESMA published the paper?
ESMA identified diverging national practices as to the types of share class that are permitted within the same UCITS (or sub-fund), ranging from very simple to much more sophisticated share classes.
What are the common principles?
These include the following:
- Common investment objective
- Non-contagion
- Pre-determination
- Transparency
Common investment objectives
Share classes of the same fund should have a common investment objective reflected by a common pool of assets.
What about derivative overlays?
ESMA considered the concern that the use of derivative overlays within a share class could lead to that class having a risk profile, and therefore an investment objective, which would no longer be in line with the overall investment objective of the fund.
In ESMA’s view, hedging arrangements at share class level are not compatible with the requirement for a fund to have a common objective. This seems to rule out duration-risk-hedged or volatility-risk-hedged share classes within the same fund as share classes where such risks are not hedged. However, as an exception to the above, ESMA is of the view that currency risk hedging at the level of a share class is compatible with the common investment objective requirement.
Non-contagion
UCITS Managing Companies (ManCos) should implement appropriate procedures to minimise the risk that features which are specific to one share class could have a potentially adverse impact on the other share classes of the same fund.
ESMA states that the use of derivative overlays in a currency risk hedged share class could introduce potential counterparty risk or operational risk for investors in other share classes of the fund which could lead to a risk of contagion. Such additional risks should be mitigated and monitored appropriately; and the risks (and any additional risk management costs) should be borne by investors in the share class that uses the derivative overlay where such risks materialise.
To ensure the derivative overlay used to hedge the currency risk does not lead to spill-over risk, the overlay must be scaled and managed appropriately in accordance with a minimum set of operational requirements. Accordingly, ESMA is of the view that the following operational principles need to be observed:
- the notional of the derivative should not lead to a commitment to deliver or receive securities with a value which cannot be serviced by that portion of the common pool of assets on which the share class unit-holders have a claim
- the UCITS ManCo should put in place a level of operational segregation which, at a minimum, ensures that there is a clear identification of assets, liabilities and profit/loss to the respective share classes on an ongoing basis (at the very least at the same valuation frequency of the fund)
- the ManCo should implement stress tests to quantify the impact of losses (relating to share class-specific assets that exceed the value of the respective share class) on all investor classes
- the overlay should be implemented according to a detailed, pre-defined and transparent hedging strategy.
ESMA acknowledges that daily subscriptions and redemptions lead to conditions where it is difficult to attain a perfect hedge within a fund or share class. To ensure that the above operational principles are met, the ManCo should, at the level of the share class with a derivative overlay:
- ensure that the exposure to any counterparty of a derivative transaction is in line with the limits laid down in the UCITS Directive spread rules in respect to the net asset value of the share class
- ensure that over-hedged positions do not exceed 105% of the net asset value of the share class;
- ensure that under-hedged positions do not fall short of 95% of the portion of the net asset value of the share class which is to be hedged against currency risk
- keep hedged positions under review on an ongoing basis, at least at the same valuation frequency as the fund, to ensure that over-hedged or under-hedged positions do not exceed/fall short of the permitted levels stated above
- incorporate a procedure in its review to rebalance the hedging arrangement on a regular basis to ensure that any position stays within the permitted position levels stated above and is not carried forward from month to month.
Pre-determination
All features of the share class should be pre-determined before it is set up in order to allow the potential investor in the fund to gain a full overview of the rights and/or features attributed to his investment. In share classes with hedging arrangements, this pre-determination should also apply to the kinds of risk which are to be hedged out systematically i.e. it should not be left to the ManCo's discretion whether the relevant risk is to be hedged. However, ESMA does not think this requirement limits the discretion of the ManCo as to the type of derivative instrument used to hedge the currency risk, nor its operational implementation.
Transparency
Differences between share classes of the same fund should be disclosed to all investors whether they are participants in the share class or not. Share classes with derivative overlays introduce counterparty and operational risk, so new and existing investors should be informed about the creation and existence of such share classes in a timely fashion, including updates in periodic reports. ESMA considers that the minimum requirements are:
- the information about existing share classes should be provided via the fund prospectus as part of the details of the types and main characteristics of the units
- in regard to the share classes with a contagion risk, the UCITS ManCo should provide a list of share classes in the form of readily available information which should be kept current
- the stress test results should be made available to national regulators on request.
What is the impact on existing share classes and what are the transitional provisions?
ESMA is of the view that share classes that do not comply with the principles should be allowed to continue. However, such share classes should be closed for investment by new investors within six months of 30 January 2017 and for additional investment by existing investors within 18 months of 30 January 2017.
UCITS ManCos should consider whether their existing share classes comply with the above principles and if not what they would need to do to make them compliant within the relevant timescales.
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