On 30 January, 2017 the European Securities and Market Authority (ESMA) issued an opinion addressed to local regulators on the share classes of undertakings for collective investment in transferable securities (UCITS) and their sub-funds, which may have an impact on the set-up of some funds and, particularly, on their distribution.

ESMA’s opinion (ESMA34-43-296) addresses the issue that share classes of the same UCITS and/or their sub-funds, in the case of an umbrella set-up (commonly referred to as UCITS), can vary in different EU countries and are not regulated by a common EU framework.

While all UCITS investors invest in a common and ring-fenced pool of assets, ESMA highlights the fact that share classes attribute different rights or features to sub-sets of investors, although there is no legal segregation of assets between the share classes.

The opinion lists a number of reasons for setting up share classes but highlights the risk that investors face as there is no segregation of assets between share classes.

Technical recommendations

According to ESMA’s interpretation, the UCITS Directive provides for the segregation of assets between sub-funds.

As UCITS can be sold to retail investors throughout the EU, ESMA sets out in its opinion four high-level principles which UCITS should follow when setting up different share classes.

Common investment objective

Share classes of the same UCITS should have a common investment objective reflected by a common pool of assets.

ESMA considers that the UCITS’ common investment objective also requires a common risk profile. Consequently, hedging arrangements at share class level – with the exception of currency risk hedging – are not compatible with the requirement for UCITS to have a common investment objective.

The use of a derivative overlay in a hedged share class introduces potential counterparty and operational risk for all investors in the UCITS. This could lead to a risk of spill-over to other share classes, some of which might not have any derivative overlays in place.

ESMA considers UCITS management companies should implement appropriate procedures to minimise the risk that may arise by:

  • Ensuring that the payment or delivery obligation value does not exceed the share class value.
  • Applying a level of operational and accounting segregation, which ensures on an ongoing basis a clear identification of the value of assets and liabilities and of profit and loss (realised and unrealised) in the respective share classes, at the very least, at the same valuation frequency of the UCITS.
  • Implementing stress tests to quantify the impact of losses on all investor classes of UCITS that are due to losses relating to share class-specific assets.
  • Having a detailed, pre-defined and transparent hedging strategy.

In its hedging strategy, the management company must always ensure that:

  • It is in compliance with Article 52 of the UCITS Directive.
  • It does not exceed limits for over-hedging (105%) and under-hedging (95%).
  • Positions are monitored according to the valuation frequency of the UCITS and rebalanced when required.

Pre-determination

All the share class features should be pre-determined before setting up a UCITS in order to allow the potential investor to gain a full overview of the rights and/or features attributed to his investment.

Differences between share classes should be fully disclosed to investors in the offering document.

Management companies should provide a readily available and consultable list of share classes with a contagion risk, which should be kept up to date.

Upon the request of national competent authorities, management companies must provide stress test results.

Grandfathering

ESMA proposes that share classes that do not comply with the opinion’s recommendations, should be allowed to continue operating. However, in order to achieve a level playing field across the EU, non-compliant share classes should be closed:

  • For new investors, within six months as of the opinion’s publication date.
  • For additional investment by existing investors, within 18 months of the opinion’s publication date.

Enforceability

While ESMA may, in accordance with Article 29(1) of the EU Regulation (EU) No 1095/2010 of the European Parliament, issue such opinions to foster a common level playing field, it must be noted that such opinions are not binding. Therefore, over the coming months, it will be necessary to monitor the position that the different national regulators take in respect of the opinion.