On 6 April 2016, the European Securities and Markets Authority (ESMA) published a new discussion paper on the use of share classes in UCITS funds, following its first paper on the topic in December 2014. See our briefing on the December 2014 ESMA discussion paper.
In the 2014 paper, ESMA considered using an examples-based approach to set out the types of share class which would fit – or not - with the UCITS structure. With this second discussion paper, ESMA has moved towards proposing a principles-based approach focussing on investor protection. High-level principles will be supplemented, as necessary, by a set of operational principles.
From a UK perspective, the biggest impact is likely to be on the operation of hedged share classes, which is a common theme running through each of the principles.
ESMA are seeking feedback on whether and how share classes would work under this revised approach. The consultation period ends on 6 June 2016.
Principles to follow when setting up different share classes
ESMA has identified four high-level principles to be followed when issuing different share classes in a UCITS.
1. “Common investment objective”
Share classes of the same fund should have a common investment objective reflected by a common pool of assets.
ESMA considers that if the characteristics of UCITS share classes do not modify the performance of the investment, then they continue to share a common investment objective with the rest of the fund. There are several of these types of share class, each providing investors with different features (for example, retail/institutional shares, different currencies, or different means of investment).
The key point of this principle involves a share class where there is a question of modified performance or modified risk profile. ESMA recognises that this is an issue where a share class is distinguished by its use of a derivative overlay aimed at hedging risk.
ESMA explicitly states that currency risk hedging within a share class is compatible with the principle of a common investment objective. However, it is of the view that the use of other derivative overlays could lead to a share class having a risk profile which is no longer in line with the objective of the fund (reiterating the view put forward in response to the December 2014 paper that a common investment objective requires a common risk profile).
As other types of derivative overlay are not permitted in the UK, any restriction on this type of share class would not have an impact on UK UCITS.
UCITS management companies should implement appropriate procedures to minimise the risk that features that are specific to one share class could have a potentially adverse impact on other share classes of the same fund.
ESMA is concerned that the use of derivative overlays may cause a disadvantage to investors in other share classes because any derivative used becomes part of the common pool of fund assets. As such, there is a potential counterparty and operational risk for all investors in the fund.
Although ESMA acknowledges there is no evidence that any such cross-share class loss has been suffered in a UCITS, and that any risk can be mitigated, ESMA is concerned that the prospect of a risk remains and so considers it paramount that any such risk be monitored appropriately and borne only by the investors in the appropriate class.
To deal with this, ESMA has proposed a number of operational principles. These are a minimum standard to be applied by share classes with any type of derivative overlay:
- the notional of the derivative should not lead to a commitment to deliver or receive securities with a value that cannot be serviced by that portion of the fund which is represented by the share class;
- the management company should put in place a level of operational segregation to ensure a clear identification of assets, liabilities and profit and loss to the respective share classes on an ongoing basis;
- stress tests should be implemented to quantify the impact of losses on all share classes due to share class-specific assets;
- the management company should be able to evidence, ex ante, that the implementation of a derivative overlay will lead to a share class which better aligns with the specific risk profile of the investor; and
- the derivative overlay should be implemented according to a detailed, pre-defined and transparent hedging strategy.
In addition to these operational principles, ESMA recommends that:
- exposure to counterparties is in line with existing UCITS limits;
- over-hedged positions do not exceed 105% of the NAV of the share class;
- under-hedged positions do not fall short of 95% of the NAV of the share class (unless explicitly stated in the investment strategy);
- hedged positions be kept under review; and
- a procedure be incorporated to reset the hedging arrangement on a regular basis and is not carried forward from month to month.
Interestingly from a UK perspective, ESMA states that currency risk hedging (which is permitted in the UK) could be operated in line with these principles but that other strategies such as duration risk or volatility risk hedged classes (which are not permitted in the UK) are unlikely to be compatible.
As such, it may not be necessary to amend the strategies implemented for UK funds as a result of the principles but UK managers will need to consider their operational policies and procedures.
All features of the share class should be pre-determined before it is set up.
ESMA considers that this principle is required to allow investors to gain a full overview of the rights and features which will be attributed to their investment.
Any discretion on the part of the UCITS management company regarding the features of a share class, particularly regarding hedging arrangements, would be in contravention of the pre-determination principle.
In share classes with hedging arrangements, this pre-determination should also apply to the kinds of risks which are to be hedged out. Otherwise, there could be a potentially adverse effect on shareholders, as they would lack information about the hedging arrangements in place and their potential effect on the fund.
ESMA is of the view that if a share class is created in an existing fund, the new share class should not affect the features and characteristics of the fund for the investors already invested in other classes.
Differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes.
ESMA notes that the existence and nature of all share classes should be disclosed to all investors, whether they are participants in the share class or not.
Particularly with regard to hedged classes, both new and existing investors should be informed about the creation of such classes in a timely manner, including updates in periodic reports.
ESMA has suggested the following operational principles – which are considered a minimum requirement:
- information about existing share classes should be provided via the fund prospectus;
- where share classes have a contagion risk, the UCITS management company should keep a list of share classes in the form of readily available information;
- stress test results should be made available to the relevant national authority on a regular basis.
Impact on existing share classes
ESMA recognises that the current approach to share classes throughout the EU is so divergent that the introduction of a framework for the use of share classes could have a considerable impact if existing arrangements would contravene the principles.
As a result, ESMA is seeking feedback on what kind of transitional provisions would be necessary.
ESMA has not yet taken any decision on the type of instrument it may issue on the topic of share classes but it is probable that this will be in the form of an ESMA opinion addressed to EU institutions or national competent authorities.
ESMA is seeking responses to the discussion paper by 6 June 2016.
Although the impact in the UK will not be as far-reaching as in other member states, as the UK permits only currency risk hedging at share class level, it is important for operators to consider this discussion paper.
To the extent that you operate any hedged share classes, you may wish to take this opportunity to comment, particularly as the operational principles mentioned above could impact on your currency hedging and potentially be burdensome to implement.