On July 1, 2010 the European Commission introduced a new programme of legislative changes with respect to the investment funds known as UCITS (Undertakings for Collective Investment in Transferable Securities). These legislative changes are popularly known as UCITS IV. The focus of this article will be the changes introduced by virtue of Commission Regulation (EU) No 583/2010 (the Regulation). This Regulation concerns the fund disclosure documentation to be issued to investors in UCITS and in particular the new methodologies being introduced regarding the calculation and presentation of risk information in relation to all UCITS funds.
The Key Investor Information Document (KID)
The driving force behind the concept of a KID is to cut away the complexity of fund industry terminology from documentation presented to retail clients and replace it with easy to understand language. This will allow an investor to better assess the essential elements of a UCITS. The concern in the past was that investors were unable to properly evaluate the suitability of their investments due to complex language in the fund documentation being provided to them. The new rules, as set out in the Regulation, aim to establish a harmonised set of guidelines to be followed by UCITS in order to provide retail investors with information which will be easy for them to understand. One of the most significant aspects of this new approach is the way investors will be informed as to the risk and reward profile of the investment.
Synthetic Risk and Reward Indicator (SRRI)
A SRRI is in essence a number between 1 and 7 which will allow investors assess the risk applicable to a potential investment in a UCITS. A numeric value of 1 will mean a low risk/low reward investment while a 7 on the scale will indicate the investment carries a high level of risk but an equally high level of potential return. The European Commission carried out extensive research on investor preferences before deciding on the use of a SRRI. This research revealed investors were more confident in their ability to compare the relative risks associated with different funds when it was presented on a numeric scale.
The simplicity of the numeric scale belies a complex set of calculations. The calculation of the SRRI will be based on the volatility of a UCITS past performance. Volatility in this context relates to fluctuations in the net asset value (NAV) of the UCITS. This will be calculated on the basis of the weekly performance of the fund or if this data is unavailable, the monthly returns of the fund. For new UCITS, the management company will need to base the SRRI calculation on a representative portfolio model and simulate the projected volatility.
CESR has published guidelines to accompany the introduction of the Regulation. These guidelines set out the algorithms to be used in the calculation of the volatility of the UCITS and the appropriate risk class applicable to that level of volatility. The guidelines include different algorithmic formulae for the calculation of SRRI for absolute return funds, total return funds, life cycle funds and structured funds. The calculation of a SRRI for these funds will incorporate a "value at risk" (VaR) computation in most cases due to the nature of the investment strategies involved.
Fund managers will be required to re-assess the risks attaching to a UCITS on an ongoing basis and revise the KID to take account of any material changes in the risk profile of the fund. Logically, the responsibility will fall on administrators/investment managers to provide software that can process the information on the SRRI based on weekly or monthly performance data as applicable. While fund managers which currently generate VaR reports may not find the production of an SRRI too onerous, fund managers of vanilla funds with no complex reporting obligations at present may find their systems need significant overhauls with all the added expense this may generate.
Another implication is the volume of reporting which may be required. All the sub-funds in an umbrella structure will need to produce a SRRI and potentially some share classes within a sub-fund may require a SRRI e.g. hedged versus un-hedged share classes. For funds sold predominantly to institutional investors the reporting requirements might be regarded as particularly onerous given that non-retail investors may have little need for a SRRI indicator when assessing risk. The material in this article is for general information only. Professional legal advice should always be sought in relation to any specific matter.