The publication of the ESMA Discussion Paper on UCITS Share Classes on 6 April 2016 marks an important step towards the development of a common regulatory approach on the regulation of UCITS share classes in the EU.
The Discussion Paper builds on the first edition of the ESMA paper on the subject (published in December 2014) and sets out a principles-based framework for the establishment and operation of share classes of UCITS funds.
It is expected that the Discussion Paper will ultimately culminate in the publication of ESMA guidelines on UCITS share classes, which national regulators in the EU will be expected to apply.
ESMA has identified four core principles that define a share class. These are:
- Common investment objective: As share classes are different types of shares belonging to the same fund, they must share a common investment objective realised through investment in a common pool of assets.
- Non-contagion: The counterparty and operational risks associated with the use of derivatives in hedged share classes should not disadvantage investors in other share classes. ESMA set out operational principles to be observed in respect of share classes with a derivative overlay including operational segregation of assets and liabilities of the class to ensure that the use of derivatives at share class level does not result in any losses incurred through the use of derivatives "spilling-over" to other share classes.
- Pre-determination: All features of a share class should be pre-determined. In explaining this principle, ESMA placed a particular emphasis on hedged share classes stating that the risks to be hedged out should be determined in advance and that there should be no discretion to the UCITS management company with regard to hedging mechanisms.
- Transparency: The existence and nature of all share classes should be disclosed to all investors in the fund. In view of the counterparty and operational risks associated with the use of derivatives, the establishment of hedged share classes should be notified to existing investors in other share classes in a timely fashion.
The discussion paper envisages that the final ESMA guidelines will contain transitional provisions in respect of share classes that do not comply with the above requirements.
The principles set out in the Discussion Paper are, for the most part, in line with the current regulatory treatment of share classes in Ireland. As such, the manner in which share classes are defined is likely to accord with most industry participants’ understanding of what constitutes a share class.
As anticipated, hedged share classes received a considerable amount of attention in the Discussion Paper. Significantly, ESMA has specified that UCITS limits on counterparty exposure to derivative transactions should be observed at share class level.
The Discussion Paper also specified that over-hedged positions should not exceed 105% of the net asset value of a share class, reflecting the current requirement applied by the Central Bank of Ireland. The Discussion Paper develops this principle further by providing that under-hedged positions should not fall short of 95% of the net asset value of the share class unless such an under-hedged position is explicitly anticipated in the strategy of the share class.
Likely demise of interest rate hedged and volatility hedged share classes
Perhaps the most interesting aspect of the Discussion Paper is ESMA’s continued stance against interest rate hedged and volatility hedged share classes, a view which was also expressed in the December 2014 edition of the paper.
ESMA appears to base its objection to interest rate hedged and volatility hedged share classes on the concern that the derivative overlay would mean that these classes do not share a common risk profile, and therefore do not have a common investment objective, with other classes in the fund. ESMA goes on to clarify that currency hedged share classes meet the common investment objective requirement and justifies this by stating that creation of currency hedged share classes supports a single market as not all EU member states share a single currency.
Those anticipating the publication of this Discussion Paper probably did not expect that it would draw on a political argument to support its propositions, particularly in the context of currency hedged share classes – the cohort of share classes which never seemed to be under scrutiny in the first place. One wonders if ESMA simply found that its justification for the proposed ban on interest rate hedged and volatility hedged share classes (that they do not share a common risk profile with other classes) did not sit particularly well with currency hedged share classes (which remove the currency risk of the portfolio relative to the currency of the class) and, therefore, felt compelled to justify the continued existence of currency hedged share classes on policy grounds.
The Discussion Paper offers industry participants another opportunity to make submissions to ESMA to demonstrate that interest rate hedged and volatility hedged share classes can be operated within the principles-based framework proposed by ESMA. It remains to be seen whether there is sufficient appetite in the industry to go to the trouble of trying to convince ESMA to change its mind. Given ESMA’s repeated assertion of its objection to the idea of interest rate hedged and volatility hedged share classes, it appears that these types of strategies are more likely to be confined to stand-alone UCITS funds rather than share classes in future.
The deadline for receipt of comments on the discussion paper is 6 June 2016. Following consideration of the feedback, ESMA expects to take further steps on share classes of UCITS by the end of 2016.