Recognising that there are different national practices regarding the types of share class that are permitted by UCITS, ESMA issued an opinion on 30 January (“Opinion”) setting out what it considers are the common principles to be observed by UCITS when operating multiple share classes. We examine the scope of the opinion and the likely impact it will have on UCITS.
ESMA is of the opinion that share classes which employ derivative-based hedging strategies, which are aimed at mitigating certain risks such as interest rate hedging or duration hedging, are not compatible with the requirement that all share classes of a UCITS have a common investment objective. Although ESMA’s Opinion is addressed to national regulators, it is expected that the Central Bank of Ireland will adopt the Opinion as part of its supervisory practices.
To ensure a harmonised and consistent approach across the EU, ESMA sets out four high-level principles that UCITS are required to observe when setting up different share classes:
1. Common investment objective
Share classes of the same UCITS should have a common investment objective which is reflected by a common pool of assets. In analysing the requirement that share classes should have common investment objective, ESMA notes that the use of derivative overlay strategies by a share class may lead to a share class having a risk profile that is not in line with the overall investment objective of the UCITS. Due to the different risk profiles that may be established in respect of individual share classes, ESMA stated that:
“[ESMA] is of the opinion that hedging arrangements at share class level are not compatible with the requirement for a fund to have a common investment objective. ESMA holds the view that UCITS which aim at protecting the investor from certain types of risk should be set up as separate funds or sub-funds.”
Accordingly, ESMA has determined that hedging arrangements that apply derivative overlay strategies at share class level are not compatible with the requirement for a UCITS to have a common investment objective. A very important exception applies to currency risk hedging, which ESMA considers is compatible with the principle of a common investment objective.
ESMA advises UCITS to use appropriate procedures to minimise the risk where one share class could have an adverse impact on other share classes of the UCITS. In order to ensure that derivative exposure does not lead to risk of contagion, also known as spill-over, to other share classes, ESMA recommends that:
- Derivatives should not lead to a payment or delivery obligation which is greater than the value of the relevant share class;
- The UCITS management company should put in place operational and accounting segregation to identify the assets and liabilities of each share class on an ongoing basis;
- Share classes should be subject to stress tests;
- The derivative overlay should be implemented in accordance with a detailed, pre-defined and transparent hedging strategy.
In further defining risk controls, ESMA recommends that:
- That the exposure to a counterparty (to be calculated in respect to the net asset value of the share class) comply with the limits laid down in Article 52 of the UCITS Directive;
- Over-hedged positions do not exceed 105% of the share class NAV;
- Under-hedged positions do not fall short of 95% of the share class currency exposure;
- The UCITS keep hedged positions under review on an ongoing basis; and
- The UCITS put in place procedures to rebalance hedging arrangements on a regular basis to ensure compliance with permitted levels.
In order to allow investors gain a full overview of the features attributed to a share class, ESMA considers that a UCITS should not allow any discretion in relation to hedging arrangements that apply to the relevant share class. Consequently, ESMA has determined that all of the features of the share classes should be pre-determined before the UCITS is established.
When investors have a choice between two or more classes, ESMA is of the opinion that the differences between share classes of a UCITS should be disclosed. In addition, ESMA recommends that UCITS comply with the following operational principles:
- Information about existing share classes should be provided via the fund prospectus as part of the details of the types and main characteristics of the units;
- In regard to the share classes with a contagion risk, the UCITS management company should provide a list of share classes in the form of readily available information which should be kept current; and
- The stress test results should be made available to national competent authorities on request.
ESMA recognises that its Opinion will impact UCITS with hedged share classes that do not comply with the new principles. In order to mitigate the impact on such UCITS, ESMA proposes a transitional arrangement whereby UCITS should be closed for investment (i) by new investors within six months of publication of its Opinion, and (ii) for top-up investment by existing investors within 18 months of publication of its Opinion.
Irish-authorised UCITS currently comply with detailed requirements in relation to currency hedged share class. However, the Opinion should be reviewed by UCITS to ensure that the new principles, particularly in relation to stress testing, availability of information in relation to share classes that carry a risk of contagion and counterparty exposure limits, will be complied with.