The introduction of UCITS III paved the way for UCITS to pursue alternative type investment strategies. Following the implementation of UCITS III in 2002, the Committee of European Securities Regulators (CESR) (now the European Securities and Markets Authority (ESMA)) clarified the range of eligible assets for UCITS, and domestic regulators, including the Irish Central Bank, have recognised the increased investment scope of UCITS.
These developments, in combination with the adoption of UCITS IV in 2009, have provided for the introduction of a range of complex, alternative type strategies within UCITS in recent years, including the use of a long-short equity strategies.
Although not permitted to take direct uncovered short positions, a UCITS can pursue a long/short equity strategy, achieving the short exposure component of this type of
investment strategy synthetically through the use of financial derivative instruments (“FDI”). Global exposure (leverage) and counterparty exposure restrictions apply to synthetic short positions, as discussed further below.
In the example depicted in the diagram below, the long equity portfolios comprised of direct investments in equities or equity related securities and the portfolios are comprised of a combination of cash/liquid instruments and derivative positions referenced to the return of the shorted positions. The cash/liquid element is used as cover or collateral for the derivative positions, as required for UCITS IV risk management purposes. The FDIs themselves provide the desired exposure to returns linked to the downside performance of specific equities. Swaps, options, stock futures and contracts for difference (CFDs) are the more typically used FDIs for this purpose.
Cash and cash equivalents
Contract for purchase/sale of economic performance of reference assets
Counterparty/or Exchange Traded FDIs
Underlying reference assets
Overview of Use of Financial Derivative Instruments for Performance Purposes
The Central Bank’s UCITS Notice 10 sets out high level rules on the use of FDIs by UCITS, including a summary of permitted FDI, cover requirements and risk management requirements. This is complemented by the Central Bank’s Guidance Note on FDIs that contains detailed provisions for the use of FDI by UCITS. The following is a brief summary of the Central Bank’s conditions for the use of FDI for performance purposes (and not just for efficient portfolio management) by UCITS.
Conditions for the Use of FDI
UCITS may invest in any type of exchange traded or OTC FDI for investment purposes subject to the following conditions:
•e rt rre s r cs,csstferrefe g(Incsre c):
(i)aSesst(. rrescrs,y tsrs,sn cce st sc,sshcrt ss,I(tte rrsfSce
21 and the Central Bank’s Guidance Note 2/07)) including financial instruments having one or several characteristics of those assets;
•eIotseeSo rskschtcdtrse sse(.nsreon srsscrcyoch e S ct e a rt sr);
•reaSrs o a l rrn sp r ss n r I hsrcrcrscs,esss
held by the UCITS must comply with the UCIT Regulations (the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011).
Positions may create long or short exposure to the underlying asset and may result in leverage to the portfolio.
Counterparty Exposure Limits
UCITS are required to limit their exposure to any single counterparty to 5% of net asset value. This can be extended to 10% where the counterparty falls within the category of certain credit institutions. Counterparty exposure must include all exposures to the counterparty (i.e. exposures related to OTC FDI and any other exposure to the counterparty). The counterparty exposure can be controlled through the receipt by the UCITS of acceptable collateral.
Position Cover Requirements
Where a UCITS has an obligation/commitment under a derivative contract including synthetic short positions, the UCITS is required to have either cash or securities to settle its obligation under the derivative. Where the derivative is cash settled, the UCITS must hold liquid assets
cshrytrs)s cr.resclryfe rgssts rrdrs, eStdergsstt lsrscydsssre e rgsstcsssfyd d cescrsr e S csrstesrecne ycrdtge rgsstdsrerdn e’ rss.
Risk Management Process
In accordance with the requirements of the Central Bank, UCITS are required to implement a detailed risk management process (“RMP”) that sets out how the UCITS will monitor and manage risk relating to the use of FDI. UCITS may apply either the “Commitment Approach” or alternatively use an advanced risk measurement methodology such as the Value-at-Risk model (“VaR”), as further described below.
“sophisticated” or a “non-sophisticated” user of FDI, and this categorisation determined the appropriate risk management methodology the UCITS should adopt. Sophisticated users of FDI would apply the VaR model, whereas non-sophisticated users of FDI would apply the Commitment Approach. Although such categorisation is no longer required, if a UCITS uses FDI as a material part of its investment strategy or uses FDI in a sophisticated manner, as opposed to using FDI only for efficient portfolio management, the Central Bank will expect the UCITS to monitor and manage risk by using the VaR model.
When using the Commitment Approach, each sub-fund within an umbrella-type UCITS must ensure that its global exposure does not exceed its net asset value. Therefore, under the Commitment Approach a sub-fund of a UCITS may not be leveraged in excess of 100% of its net asset value. In other words, the gross exposure of a UCITS sub-fund should not exceed 200% of such fund’s net asset value. Given the hard limit on leverage exposure under the Commitment Approach, a UCITS implementing an investment strategy that takes on significant market exposure will need to use an advanced risk management methodology such as VaR.
VaR is a methodology that is used to estimate the risk or probability of loss in a portfolio. It is based on statistical analysis of simulated or historical price trends and volatilities and is designed to predict the likely scale of losses that might be expected to occur in a portfolio over a given period of time. VaR is used by UCITS that use FDI for complex investment strategies.
The VaR model (absolute VaR) must adhere to the following requirements:
•a m g rd f e ;
•a m srcl srn rd fer(sf, renersfrctsct cs n rce );
•srs s crrd t t t rry(osssseyct f lsnrt r,crrcsdcrt);
•ckgfeRla lssclrcssoce cl ro rrs o e R rc.
It is the responsibility of the UCITS to select an appropriate methodology to calculate global exposure. The selection should be based on an assessment by the UCITS of its risk profile resulting from its investment policies (including its use of FDI). A UCITS should generally use an advanced risk measurement methodology (supported by a stress testing program) such as VaR to calculate global exposure where:
•tsncxst srschrrsta rl rtfe’ stc;
•t s re n a e sre o c;r
•ectrchst y cre e t rkfe r.
Although the governing body of the UCITS is required, as part of overall governance, to provide oversight of the risk management function, in practice the decision on the appropriate risk measurement methodology is for the investment manager’s risk manager (in consultation with the portfolio manager) to determine. In considering the appropriate risk measurement methodology, the risk manager should consider:
•chdsrreg occtestr, e cy f I d e rnferotle crsdfre ss;
•e s n re sre retrh d r s s n e csrs f e st sr;d
•rlcsrsschs ecsdse fcgh e rt rk srt .
Typically, UCITS that use FDI to generate investment returns in a long-short strategy use the VaR model. The VaR model allows for a greater degree of leverage, and we have observed a number of UCITS whose gross exposure exceeds 500% of the UCITS net asset value.
Use of Prime Brokerage
Global prime brokers are providing solutions for UCITS that utilise long-short strategies by means of “synthetic prime brokerage” products. Although UCITS are not permitted to take direct uncovered short positions (as noted above) or to borrow stocks for the purposes of short selling (or, for that matter, to appoint a “prime broker” to facilitate cash financing and short sales coverage or to act as custodian, clearing or settlement agent), synthetic prime brokerage is an alternative solution that enables UCITS products to take positions in equity and fixed income derivatives that provide exposure to underlying securities that they would otherwise be prohibited from investing in directly.
In this model, FDIs are deployed as a substitute for borrowing equities to achieve a short position, or as a substitute for equity financing to achieve leverage on the long side. By entering into a FDI, such as forwards, futures, CFDs or swaps, the UCITS (or its “prime broker”) may economically sell the performance of an underlying reference asset and profit if the underlying reference asset decreases in value. The FDI may provide the economic position of being long or short securities, and because the UCITS does not hold the underlying securities, there is no custody, clearing or settlement attached to the trade. However, counterparty exposure limits and position cover requirements as well as limits on global exposure continue to apply to such synthetic short positions, as discussed above.
Head of Investment Funds d: +3531 614 5080
d: +3531 614 5261