On 18 July 2019, the Central Bank of Ireland (the "Central Bank") issued a press release and a letter to industry (the "Industry Letter") on its thematic review of closet indexing by UCITS. However, some of the key supervisory issues identified by the Central Bank are relevant for all UCITS boards and managers ("Boards").
Closet indexing or closet tracking, also known as "index hugging", refers to portfolios which are described as being actively managed, when in reality the fund stays close to or tracks a benchmark.
In 2016, the European Securities and Markets Authority ("ESMA") raised concerns that closet tracking may prejudice investors as they are not receiving the service or risk/return profile they expect based on the fund’s disclosure documents while potentially paying higher fees compared to those typically charged for passive management.
Against this background, in a speech made by Derville Rowland on the 4 December 2018, Ms. Rowland confirmed that the Central Bank was undertaking an analysis on 2,000-plus Irish domiciled UCITS funds that report to be "actively" managed with the Central Bank's key priority being "to ensure that investors are not disadvantaged by funds operating in a manner that is not consistent with the way in which they have presented their objectives, policies and charges in the fund documentation".
It should also be noted, ESMA updated its UCITS Q&As (the "ESMA Q&As") on 29 March 2019 to clarify the benchmark disclosure obligations for UCITS. ESMA stated that each key investor information document ("KIID") should indicate whether the relevant UCITS’ strategy is active or passive. For those UCITS which are active, they must disclose whether they are managed with reference to a benchmark and, if so, the degree of autonomy the manager has relative to the benchmark. In determining whether or not a UCITS is passively or actively managed, ESMA has indicated that a wide variety of circumstances can imply that a UCITS is being managed by reference to a benchmark. For example, instances where a manager has issued marketing material showing fund performance relative to a benchmark may indicate that a UCITS is in fact not fully actively managed. These KIID disclosure obligations are aimed at preventing closet-tracking and ESMA has stated that disclosures should be consistent across all fund documentation (i.e. offering documents, KIIDs and marketing material), and, where required, updates should be made as soon as practicable or by the next KIID update. Please refer to our previous client update for further details.
Thematic Review Outcome
Following the Central Bank's detailed analysis of 2,550 Irish authorised UCITS which were classified as actively managed as at March 2018, it identified 182 UCITS which required further review (less than 8% of the funds analysed).
To date the Central Bank has completed follow up engagements with 62 of the 182 UCITS and will continue its engagement with the remaining UCITS over the coming months. It has identified that 57 of those 62 UCITS did not provide their investors with sufficient or accurate information about the UCITS' investment strategy in the prospectus or KIID.
The Central Bank has highlighted a number of key findings in the Industry Letter which Boards must consider and address as required:
- Transparency: Investors must be given sufficient and accurate information about the fund's investment strategy in the prospectus and the KIID(s), thereby meaning that they are able to make an informed decision on whether to invest in the UCITS.
- Governance: The Industry Letter emphasised the importance of governance and controls by Boards (including sufficient review and oversight).
With regard to index-tracker issues, the Central Bank drew particular attention to the following:
- Cases where multi-manager UCITS consistently delivered a performance similar to an index. This raised the question as to whether the diversification benefits of the multi-manager approach versus passive investing were being achieved by those UCITS over time. Where UCITS are using a multi-manager approach, the Board should consider whether this results in a strong correlation with an index to an extent that active management fees may not be appropriate;
- Scenarios where UCITS have a target to outperform a benchmark that is less than the fee charged to certain share classes in the UCITS meaning that even if the UCITS provides a return at the upper end of its projections, investors in these share classes will not realise a positive return against the benchmark, as the fee charged will cancel out any outperformance achieved; and
- Instances where the past performance section of the KIID did not include relevant benchmark disclosures thereby not permitting investors to determine from the KIID whether the UCITS represents good value relative to its benchmark
The Central Bank has stated that Boards must actively consider the contents and findings in the Industry Letter as they carry out their role and that they should review and revise prospectuses and KIID accordingly, if required.
Disclosure requirements: When considering the accuracy of the content of fund documents, the Central Bank has stated that Boards must ensure that:
- Prospectuses and KIID are in compliance with all applicable legislative requirements and all relevant guidance (including the ESMA Q&As and the Industry Letter);
- Marketing material or other documentation provided to investors is consistent with information contained in the prospectus and KIID;
- If the UCITS is managed in a constrained manner to a benchmark, this constraint is clearly disclosed in the KIID and the prospectus; and
- Where the UCITS is being managed with a performance target, this is disclosed in the KIID and prospectus in order to assist investors in making an informed decision.
The Central Bank has advised that any necessary updates to prospectuses and KIID(s) should be submitted by 31 March 2020.
Governance and annual review: More generally, the Central Bank has stated that Boards should consider annually1 whether the UCITS has delivered on its stated objective and whether it remains a viable and suitable investment for investors. This review should be documented and should assess: (i) the UCITS performance; (ii) fee structure and (iii) investor base.
In addition, the fees charged on all share classes within each UCITS should be reviewed to assess whether they are appropriate for the targeted level of outperformance of the UCITS against its benchmark.
The Industry Letter should be carefully considered by Boards and, if necessary, acted upon. In particular, Board procedures, fee structures, investment policies, prospectuses and KIIDs should be reviewed and, where necessary, amended, to ensure compliance with the Industry Letter requirements.