For the past two years, the European Securities and Markets Authority (“ESMA”), Europe’s main securities regulator, has had UCITS share classes in their sights. It has issued two discussion papers on the topic and has now finalised its work with the issue of its final opinion on - "Share classes of UCITS" issued on 30 January 2017 (the “Opinion”). The Opinion is available to read here »
ESMA's Views on the Key Elements of Share Classes
The Opinion sets out the high-level principles which ESMA considers should be followed when setting up different share classes
- Common investment objective: share classes of the same fund should have a common investment objective which is realised through investment in a common pool of assets;
- Non-contagion: UCITS management companies should implement procedures to minimise the risk that features specific to one share class could adversely impact other share classes in the same fund;
- Pre-determination: all features of the share class should be pre-determined before the share class is established;
- Transparency: differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes; and
- Anti- circumvention: share classes should never be set up to circumvent the rules of the UCITS Directive particularly those on diversification, derivatives eligibility and liquidity.
Duration Hedging and Volatilty Hedging - Early Fallers!
The Opinion acknowledges that there are currently a number of types of UCITS share classes available in the EU which provide investors with different features in relation to their investment. One category of share classes (which ESMA categorise as “technical share classes”) differentiate between groups of investors (e.g. retail vs. institutional investors) or means of investment (e.g. variations relating to management fees, minimum investment amounts, voting rights and currency). ESMA consider that these technical share classes satisfy the principle of a common investment objective.
Other categories of share class (which ESMA categorise as “overlay share classes”) utilise derivative based hedging arrangements aimed at mitigating one or more of the risk factors attributable to the common pool of assets in which all share classes in a fund invest. It is this category of share class which the Opinion focuses on.
The discussion papers signalled that duration hedged and volatility hedged share classes may not be compatible with the high-level principles that are set out in the Opinion. The Opinion states that in ESMA’s view hedging arrangements at share class level are not compatible with the requirement for a fund to have a common investment objective. ESMA express the view that UCITS classes which aim at protecting the investor from certain types of risk should be set up as separate funds. The only type of hedged share classes which are considered by ESMA to satisfy the principle of a common investment objective are currency hedged classes.
It is clear from the Opinion that duration hedged share classes will be the big loser. According to Morningstar data quoted by Ignites (Ignites Europe, 31 January 2017) there are as many as 222 duration hedged classes with $10bn in assets managed by managers. The European Fund and Asset Management Association (“EFAMA”) has come out strongly against the Opinion and has been quoted in Ignites (Ignites Europe 6 February 2017) as saying that it believes that the Opinion is a “step too far” and is urging reconsideration on the basis that investors in these classes will be required to redeem and invest in new funds. Its essential argument is that culling share classes will lead to more funds and smaller funds.
Currency Hedging Clears the Final Hurdle
ESMA consider that currency risk hedging is compatible with a common investment objective on the basis that it enables investors from EU member states with differing currencies to “participate to the maximum extent possible in the same performance of the common pool of assets as other investors”, provided that the hedges meet certain conditions aimed at reducing contagion risk.
In Ireland, currency hedged share classes are the norm of most UCITS and the Central Bank of Ireland (the “Central Bank”) has well established guidelines on share class hedging. In addition to currency hedging, the Central Bank has specifically permitted interest rate hedging share class level. It has also additionally been open to proposals for the use of derivatives at class level to provide for differing levels of participation in the underlying portfolio or differing levels of capital protection. These types of hedging, however are less prevalent in the Irish market than currency hedging.
Hedged share classes are also common in Luxembourg with a greater prevalence of duration hedged classes. The Commission de Surveillance du Secteur Financier has not, to date, imposed formal requirements regarding these share classes.
The conditionality that ESMA is proposing to apply to the use of currency hedged classes with a view to achieving its principles of non-contagion, pre-determination and transparency are remarkably similar to the rules that have been in place in Ireland and Luxembourg for many years. In Ireland the only additional requirements imposed to ensure that under-hedged positions do not fall short of 95% of the proportion of net asset of the share class, which is to be hedged against currency risk a requirement that many managers voluntarily adhere to in practice and to ensure that counterparty exposure is calculated at share class level. This latter requirement will need to be considered against the UCITS Directive which requires counterparty exposure to be calculated at fund level.
Going forward, for UCITS at least, class currency hedging will be the only permitted form of overlay.
Getting in Line - the Transitional Provisions
It is expected that the Opinion will have immediate effect and that the establishment of hedged share classes apart from currency hedged classes will no longer be permitted. However, it should also be noted that many managers provide that they “may but are not obliged to” undertake class currency hedging. This is in contrary to the principle of pre-determination; as detailed in the Opinion which gives rise to a number of questions such as whether the current optionality will continue to be permitted e.g in circumstances where the terms of the hedge may be disadvantageous. Managers may no longer have discretion on whether to hedge or not and may be required to undertake uneconomic hedges.
Fund documents, risk managements processes and hedging agreements will need to be reviewed to ensure compliance with the provisions of the Opinion, particularly the principles relating to non-contagion.
For those non-compliant classes that are currently in existence, notably the large cohort of duration-hedged share classes, ESMA will not require immediate closure or redemption from such classes, but it will require that they be closed to new investors from 30 June 2017 (being six months from the date of the Opinion) and closed to additional investment by existing investors from 30 June 2018 (being 18 months from the date of the Opinion). We will also have to wait and see how regulators will apply the new requirements to existing currency hedge share classes.
Managers impacted by the change will need to consider how they give clients the benefit of hedging going forward. The establishment of parallel funds or feeder funds are the more obvious solutions. However, this could also lead to the consideration of alternative options outside of the UCITS regime through the establishment of alternative investment fund structures within and outside the EU. In Ireland and Luxembourg, such structures include the Irish Qualifying Investor Alternative Investment Funds structures, the Luxembourg Specialized Investor or Reserved Alternative Fund structures. In the UK and other European jurisdictions, non UCITS structures are also available