By way of providing us with some light reading over Christmas, the European Securities and Markets Authority (ESMA) has issued a Discussion Paper on Share classes of UCITS . ESMA has identified differing national practices on the use of share classes by UCITS ranging from very simple share classes (e.g. with different levels of fees) to much more sophisticated share classes (e.g. with potentially different investment strategies). ESMA is therefore proposing to establish a common understanding of
- what constitutes a share class of UCITS, and of
- the ways in which share classes may differ from each other.
The Discussion Paper sets out ESMA's views on what constitutes a share class, including how to distinguish share classes within sub-funds of UCITS. The paper sets out possible approaches to the extent of differentiation between share classes that should be permitted and poses 14 questions on the topic. It requests responses by Friday 27 March 2015. ESMA will take into account the possible impact on current market practices and the feedback from stakeholders when developing its final position on the use of share classes by UCITS.
Share Class Principles
ESMA proposes the following principles (Share Class Principles) for use in assessing the legality of different share classes:
- Share classes of the same sub-fund should have the same investment strategy.
- Features that are specific to one share class should not have a potential (or actual) adverse impact on other share classes of the same sub-fund.
- Differences between share classes of the same sub-fund should be disclosed to investors when they have a choice between two or more classes.
ESMA opines that UCITS management companies which seek to offer different investment strategies to investors should create a separate sub-fund for each strategy.
ESMA has identified the following non-exhaustive list of types of share class that they consider would be compatiblewith the Share Class Principles:
- Share classes that differ according to the maximum or minimum investment amounts, or values of holdings allowed to be retained;
- Share classes that differ in terms of the type of investor (e.g. institutional investors vs. retail investors);
- Share classes that differ according to the types of charges and fees that may be levied and their amount (on-going charges, subscription and redemption fees, performance-related fee);
- Share classes that differ according to the currency in which they are denominated;
- Share classes that differ according to the allocation of revenues to investors (by capitalisation or distribution, either subject to or exempt from withholding tax);
- Share classes that differ according to their characteristics: registered or bearer;
- Share classes that differ in terms of voting rights; and
- Share classes that provide currency hedging when share classes are denominated in different currencies from the base currency.
ESMA has identified the following non-exhaustive list of types of share class that they consider would not appear to be compatible with the Share Class Principles:
- Share classes that are exposed to different pools of underlying assets. For example, a sub-fund that offers two share classes, one tracking the Eurostoxx and one tracking the S&P 500.
- Share classes whereby the same underlying portfolio is swapped against different portfolios of assets (i.e. the final exposures of the share classes are different).
- Share classes that offer differing degrees of protection against some market risks such as interest rate risk or volatility risk.
- Share classes that are exposed to the same pool of assets but with different level of capital protection and/or payoff. For example, a sub-fund offers two share classes. One share class protects 80% of the initial NAV and delivers 100% of the performance of an index after a fixed term (5 years) and the other share class protects 100% of the initial NAV and delivers 50% of the performance of the same index after the same 5 year term.
- Share classes that differ in terms of leverage.
For share classes which are denominated in different currencies from the base currency, ESMA is of the view that currency hedging at the level of a share class is compatible with the principle of a common investment strategy. This is because such hedging arrangements are intended to ensure that investors receive as nearly as possible the same results of the investment strategy, even though their exposure is obtained through a different currency. Nevertheless, currency hedging should only be possible if it cannot have an adverse impact on the unit-holders of the other share classes of the sub-fund or UCITS and the costs of the hedging should only be borne by the unit-holders of the hedged share class.
Interest rate hedging
Unlike currency hedging, ESMA believes that interest rate hedging performed at the level of share classes does not comply with the principle of having the same investment strategy, because it modifies the investment strategy of the share class. For example, a share class that reduces the duration of the portfolio should not be considered as compatible with the principle of a unique investment strategy because investors in that class are not exposed to the same interest rate risk as investors in the other classes of the fund.
In the event that the final ESMA position remains as proposed, this would lead to changes in approach in Ireland. In turn this may impact on certain Irish UCITS which may need to examine their arrangements at share class level, particularly UCITS involved in interest rate hedging at share class level.