ESMA high level principles approach
In the opinion, ESMA outlines four high-level principles which UCITS must follow when setting up different share classes with a view to define the concept of “UCITS share class” and set boundaries between share class and compartment.
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. Also there is some concern that the use of derivative overlays within a share class could lead to that class having a risk profile, and therefore an investment objective, which would no longer be in line with the overall investment objective of the fund.
Thus, ESMA states that UCITS which aim to protect investors from certain types of risk though the use of derivative overlays, should set up separate sub-funds rather than separate share classes (with the exception of currency risk hedging).
ESMA states that UCITS management companies should implement appropriate procedures to minimise the risk that features specific to one share class (such additional risk introduced to a fund as result of the use of a share class currency hedge) could have a potentially adverse impact on other share classes of the same fund - referred to in the opinion as non-contagion risk or spill-over risk.
In order to ensure that derivative use within share classes does not lead to contagion risk, ESMA proposes minimum operational procedures with exposure limits for the mitigation and monitoring of risks associated with share class hedging (although it recognises that such risks cannot be fully eliminated).
A summary of these operational principles are:
- The notional of the derivative overlay should not lead to a payment or delivery obligation with a value exceeding that of the share class;
- Accounting segregation should be operationally in place to allocate the hedging contracts and their profit and loss, both realised and unrealised, to the Net Asset Value (“NAV”) of each Share Class;
- The UCITS management company should implement stress tests to quantify the impact of losses on all investor classes of a fund that are due to losses relating to share class-specific assets that exceed the value of the respective share class;
ESMA is aware that daily subscriptions and redemptions lead to conditions where it is difficult to attain a perfect hedge within a fund or share class. To nonetheless ensure that the above operational principles are met, the UCITS management company should, at the level of the share class with a derivative overlay:
- Ensure that the exposure to any counterparty is line with the limits laid down in the UCITS Directive
- Monitor that hedging positions are at all times within 95% of the net asset value of the share class which is to be hedged against currency risk and 105% of the net asset value of the share class; and
- Hedging positions should be reviewed on an ongoing basis (at least at the same valuation frequency as the fund) to ensure that positions stay within the permitted levels outlined above.
ESMA considers that all features of the share class should be pre-determined before the fund is set up. This is to enable investors to obtain a full overview of the rights and/or features attributed to their investment. This should also apply to any currency risk which is being hedged out.
Further, ESMA introduces a number of minimum transparency requirements. These are:
- Differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes.
- UCITS management companies should provide a current, readily available and consultable list of share classes with a contagion risk, which should be kept up to date
- Upon the request of NCAs, UCITS management companies must provide stress test results.