On 22 July 2011, ESMA issued a discussion paper setting out policy orientations on possible guidelines for structured UCITS. The discussion paper also addresses UCITS exchange traded funds and the Asset Management and Investment Funds Group has produced a separate update in relation to the discussion paper as it applies to exchange traded funds, please click here to access our update.
The rapid development of the UCITS product as a powerful global brand has been accompanied by extensive evolution, post UCITS III and the Eligible Assets Directive (2007/16/EC), in the investment strategies of the UCITS product and the relative complexities of those strategies. The discussion paper is part of ESMA’s review of the impact which structured UCITS may have on investor protection and market integrity. Having reviewed the regulatory regime to which structured UCITS are subject, ESMA believes that the existing requirements are not sufficient to take account of the specific risks associated with these products, particularly as UCITS, including structured UCITS, are categorised under MiFID as non-complex products and are generally available to retail investors.
Structured UCITS are UCITS which use financial derivative instruments, in most cases a total return swap, to provide a predefined payout to investors based on the return of the assets underlying the swap. The strategy is generally comprised of a swap with a single counterparty, such counterparty providing collateral to reduce counterparty exposure to permissible levels. As part of the strategy, the UCITS will generally invest in a portfolio of assets and will pass those assets or the return on them to the counterparty in exchange for a return based on an underlying portfolio. The underlying portfolio may be a straightforward basket of assets, but increasingly such portfolios are based on more complex hedge fund type strategies including long/short equity, commodity and absolute return strategies.
In the discussion paper, ESMA identifies the possibility that it may seek to introduce measures to require warnings to be issued to retail investors in relation to investment in such products or even to go as far as limiting the distribution of them to such investors. ESMA raises the issue of whether structured UCITS should be classified as ‘complex’ and seeks views as to the criteria to be applied to determine complexity. This proposal is consistent with the view expressed by EMSA’s predecessor, the Committee of European Securities Regulators (“CESR”), in 2010 in its response to the European Commission’s Request for Additional Information in relation to the review of MiFID, where it stated that there was a case for treating structured UCITS as complex financial instruments for the purposes of the MiFID appropriateness test.
In addition to these general issues, ESMA’s paper also sets out a number of more specific issues in relation to structured UCITS, including the following:
(i) as referred to above, in many cases the investments of the structured UCITS are passed to the swap counterparty or the return on them is paid to the counterparty and therefore, save in the case of default of the counterparty, the UCITS will not generally have economic exposure to such assets. While recognising that queries have been raised as to extent to which such investments may not need to comply with the UCITS diversification requirements, ESMA indicates that it is not clear that the UCITS Directive would permit such an interpretation and has suggested that both the UCITS’ investments and the underlying portfolio of the swap to which the UCITS will actually be exposed must comply with the UCITS diversification rules;
(ii) ESMA also considers that the role of the counterparty in respect of the total return swap should be subject to specific safeguards. ESMA proposes that the offering documents for those structured UCITS which allow an element of counterparty discretion in terms of the UCITS portfolio should include disclosure in respect of the extent of the counterparty’s control over the investment policy and any limitations imposed. ESMA further suggest that, in such instances or where the counterparty has any discretion in relation to underlying swap portfolio, the agreement with the counterparty should be deemed to be an investment management delegation arrangement. The counterparty will therefore, in such cases, be treated as an investment manager of the UCITS and disclosed as such. In arriving at this proposal, EMSA points to the difficulties which can arise when a UCITS seeks to resolve investment breaches where the swap requires counterparty approval for a change in the UCITS’ portfolio or the UCITS is specifically required to purchase the portfolio assets from the counterparty; and
(iii) ESMA suggests that disclosure be included in the offering document regarding the underlying strategy, the counterparty and the permitted collateral which may be received from counterparties. ESMA also proposes that the annual report for the UCITS include disclosure in relation to the underlying exposure, the counterparty and the collateral received from the counterparty.
In the context of its review of structured UCITS, ESMA also raises questions for stakeholders in relation to strategy indices, being indices which aim to replicate a quantative or trading strategy. Such indices are generally developed and operated by the index provider rather than the UCITS and may include proprietary applications and models developed by the index manager. The discussion paper proposes that protections be put in place in relation to the use of strategy indices and principally proposes the following with regard to the existing eligibility criteria for financial indices as set out in the UCITS Directive:
(i) the index must be sufficiently diversified
EMSA suggests that, in the case of an index replicating UCITS, the prospectus should (where applicable) inform investors of the intention to avail of the increased diversification limits permitted under the UCITS Directive and where the UCITS has exposure to a single component representing 20% to 35% of the overall index this should also be specifically disclosed. In each of these circumstances, ESMA propose that the exceptional market conditions which justify this investment should be disclosed.
In addition, ESMA proposes that rather than merely being concerned with the components of the index complying with the UCITS Directive limits, the impact of each component on the return to investors should be considered and should be within the limits.
(ii) adequate benchmark
In assessing the UCITS Directive requirement that an index represent an adequate benchmark for the market to which it refers, ESMA suggest that, in order to fulfil this requirement, the index should have a clear single objective and that the universe of components and the basis of selection should be clear to investors.
Eligible indices for UCITS are required to rebalance periodically using publicly available criteria. In reviewing this requirement, ESMA notes that strategy indices which rebalance daily or intra-day are unlikely to satisfy the UCITS Directive requirements in respect of replication and transparency and suggests that the frequency of rebalancing should not be such as to prevent replication by investors. ESMA further suggests that the rebalancing frequency and its impact on costs should be disclosed in the prospectus.
(iii) published in an appropriate manner
ESMA suggests that the provision of summary disclosures in relation to the objective and calculation methodologies for indices is not sufficient and that the full calculation methodology, which is often proprietary to the index sponsor, should be disclosed to enable investor replication. ESMA further notes that the publication obligation requires that relevant information should be easily accessible, including details of the performance, index constituents, calculation and re-balancing methodologies. ESMA therefore suggests that a strategy index which involves proprietary information on composition which the index provider does not wish to disclose will not be an eligible index for a UCITS.
ESMA further proposes that the additional CESR guidelines in respect of the eligibility of hedge fund indices should be applied to all financial indices to ensure that indices do not include discretionary elements in methodologies and that indices provide adequate transparency and disclosure. This proposal envisages that all indices would, among other requirements, be required to have pre-determined rules and objective criteria in relation to selection and re-balancing, backfilling will not be permitted, payment for inclusion in an index will not be acceptable and the UCITS must carry out due diligence on the quality of the index.
Finally, in order to prevent conflicts of interest which may arise where the manager/investment manager of the UCITS, the counterparty and the index provider are part of the same group, ESMA proposes that the UCITS should have a documented conflicts of interest policy to deal with this, details of which should be disclosed in the prospectus. In addition, ESMA suggest that independent assessment and valuation should be available in respect of the index.