ESMA publishes an Opinion on UCITS share classes

On 30 January, ESMA published an Opinion in respect of its work on harmonising the use of UCITS share classes across the EU (see our elexica article on ESMA’s Discussion Paper of December 2014).

The views expressed in the Opinion are important for any UCITS manager running different share classes.

Although the Opinion is not binding on national competent authorities in the EU, such as the FCA, it is highly likely that they will follow its stance. Equally, while the provisions of the Opinion are not directly applicable to UCITS managers until implemented by their regulator into the local rules, it is sensible for managers to consider preparing to comply with them in the near future - not least bearing in mind the relatively short transitional period allowed (see below).

In particular, Managers looking to establish new trading and collateral arrangements for currency hedges at share class level to comply with the uncleared margin rules may wish to take account of ESMA’s views at this stage.

Managers of UCITS which use a derivatives overlay at share class level other than currency risk hedging will need to consider what restructuring might be needed.

Key elements of share classes

The UCITS Directive recognises the possibility of UCITS offering different share classes, but there is no formal definition of a share class and no details as to their scope, including the level of customisation. As a result, different interpretations have developed in different EU jurisdictions, a situation which ESMA is keen to now rectify.

Following its earlier consultations, ESMA’s final view is that UCITS managers should follow four high-level principles when setting up different share classes, namely:

• Common investment objective: Share classes of the same fund should have a common investment objective reflected by a common pool of assets. ESMA considers that hedging arrangements at share class level - with the exception of currency risk hedging - are not compatible with the requirement for a fund to have a common investment objective.
• Non-contagion: UCITS management companies should implement appropriate procedures to minimise the risk that features specific to one share class could have a potentially adverse impact on other share classes of the same fund.
• Pre-determination: All features of the share class should be pre-determined before the fund is set up.
• Transparency: Differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes.

Furthermore, share classes should not be set up to circumvent the UCITS rules, particularly around diversification, derivative eligibility and liquidity.

Looking at each of the four high-level principles in more detail:

Common objective

ESMA noted that currently there are several types of UCITS share classes available in the EU which provide different features. Some are so-called “technical share classes”, set up from an administrative or accounting perspective. These differentiate between, for example, retail and institutional investors, or between level of management fee/minimum investment amount, voting rights etc. ESMA takes the view that these types of share classes do, indeed, share a common objective.

The other type of share class identified by ESMA are “overlay share classes”, which use financial derivative instruments at share class level with a view to mitigating one or more risk factors in the common pool of assets. ESMA’s view is that, with the exception of currency risk hedging (see below), share classes with an overlay feature cannot be said to have a common objective as the risk profile created by the overlay may create a risk profile and, therefore, an investment objective, which is no longer in line with the investment objective of the fund.

In ESMA’s view (acknowledging that not all EU Member States share a single currency), currency hedged share classes are required to support the single market - ensuring that investors can participate in the same performance of the common pool of assets, but obtaining that exposure through a different currency.

Non-contagion

While ESMA is, therefore, supportive of currency hedged share classes, given the lack of asset segregation at share class level, it considers that any additional risk introduced to the UCITS through the overlay must be mitigated and monitored and borne only by the investors in the relevant share class.

Equally, any rise in administrative costs due to the need for additional risk management should be borne by investors in the relevant share class and not generally. In this regard, ESMA considers that the accounting methodology of the fund must ensure that profit and loss on the overlay is applied only to the relevant share class.

To reduce contagion risk, ESMA suggests that the following operational principles be observed:

• the notional of the derivative should not lead to a payment or delivery obligation with a value greater than the value of the assets attributable to the share class
• the ManCo should put in place a level of operational and accounting segregation which ensures that there is a clear identification of the value of assets and liabilities, as well as P&L, in the relevant share class on an ongoing basis (and at least as frequently as the fund itself)
• stress tests should be implemented to quantify the impact of losses caused by the derivatives overlay that exceed the value of the relevant share class on all other classes of investor, and
• there should be a detailed, pre-defined and transparent hedging strategy.

To ensure that the above principles are met, ESMA requires the ManCo at a minimum to:

• Ensure that the exposure to any counterparty of a currency hedging transaction is in line with the limits in Article 52 of the UCITS Directive in respect of the NAV of the relevant share class. This means that the risk exposure to a counterparty to currency risk hedging transaction at share class level must not exceed 5% of the NAV of the share class or 10% where the counterparty is an approved bank. Managers will need to consider whether this might impact the number of potential counterparties that a UCITS uses for its share class hedging.
• Over-hedged positions must not exceed 105% of the NAV of the share class and underhedged positions must not fall short of 95% of the NAV of the share class which is to be hedged against the risk.

The level of over/under-hedging must be kept under review (at least at the same valuation frequency as the fund itself), and a procedure should be incorporated to rebalance the hedging arrangements on a regular basis.

Pre-determination

ESMA takes the view that all features of a share class should be pre-determined before the share-class is established, although the ManCo should have full discretion as to the type of derivative instrument used for currency overlay purposes.

The Opinion raises one potentially important concern. Current market practice is that fund rules and prospectus language will typically allow ManCos and their delegates the discretion to hedge without, however, being under an obligation to do so. Often it will be desirable to retain operational discretion to hedge or not to hedge depending upon the ManCo/investment manager’s view of prevailing circumstances.

A strict reading of the ESMA Opinion would appear to require the ManCo to disclose a firm intention to hedge “systematically” to provide clarity for investors ahead of them investing - and to disclose the potential contagion risk inherent in class level currency hedging. The obvious consequence of this would be that classes currently in issue with such ‘permissive’ wording might need to be closed and replaced with more definitive and binding hedging obligations in line with the transitional provisions outlined below. The impact for the industry is potentially very significant.

The stance which national competent authorities, such as the FCA, the CSSF and CBI, take will be key here - these authorities are not obliged to follow the Opinion and may, instead, choose to adopt it in part only. It will be seen in due course whether lobbying of these regulators on this point on behalf of the industry helps find a workable solution to this potential problem.

Transparency

ESMA suggests the following three operational principles should be followed to ensure a common level of transparency across all investors:

• Information on share classes should be included in the fund prospectus as part of the details of the types and main characteristics of units.
• Where a share class uses a currency overlay strategy that introduces contagion risk, the ManCo should provide an up-to-date list of share classes in the form of readily available information.
• The results of the stress tests should be available to national competent authorities upon request.

Transitional provisions

ESMA is aware that these principles will have an impact on investment fund markets in countries where share classes can currently be set up which do not comply with them.

To mitigate the impact of this, ESMA’s Opinion proposes that share classes which do not comply with the provisions should be closed for investment:

• by new investors within six months of publication of the Opinion, and
• for additional investment by existing investors within 18 months of publication.