On 30 January 2017, the European Securities and Markets Authority (ESMA) published an opinion setting out common principles for setting up and operating share classes within UCITS funds.
The opinion paper follows ESMA’s previous discussion papers on share classes, issued in 2014 and 2016. We provided an update on the 2016 paper in April.
The UCITS Directive is silent on the definition and scope of share classes, so national practice diverges greatly as to the types of share classes which are permitted – ranging from no share classes to sophisticated classes which potentially have different investment strategies. ESMA is of the view that a common framework is required to protect investors and ensure a harmonised approach.
The opinion, which is addressed to national regulators, focuses on four high-level principles which must be followed when setting up and operating share classes in a UCITS. These principles closely follow the proposals of the 2016 paper, so there should be little of surprise for the industry.
Nevertheless, all hedged share classes will be impacted and so it is important that management companies take notice. Further, although the ESMA opinion applies only to UCITS, it remains to be seen whether the FCA will extend its application to non-UCITS.
In addition to the principles, ESMA states that share classes should never be set up to circumvent the rules of the UCITS Directive, particularly those on diversification, derivative eligibility and liquidity.
Principle One: Common investment objective
Share classes of the same fund should have a common investment objective reflected by a common pool of assets.
ESMA is of the view that share classes of a fund have a common investment objective where their characteristics do not modify the performance of the investment.
To this end, ESMA accepts that different types of share classes exist to provide different features to holders:
ESMA considers that these “overlay” share classes are not compatible with a common investment objective. ESMA is concerned that using derivative overlays in a share class could lead to that class having a risk profile which would no longer be in line with the investment objective of the fund. As a result, where a management company wishes to provide investors with protection from risks, separate funds should be set up, not separate share classes.
In ESMA’s view, the only exception to the above principle is currency hedging. This is seen as a way to support the single market by ensuring that investors across the EU are able to fully participate in the same fund, even if their exposure is obtained through a different currency to the fund’s base currency.
Impact for UCITS
This principle will have no impact in the UK, where the only derivative overlay currently permitted at share class level is for currency hedging.
As the rules differ across the EU, management companies will need to review their share classes in each jurisdiction to identify whether any classes operate a derivative overlay for purposes other than currency hedging.
As further detailed below, these classes will ultimately need to be closed to new investment unless changes can be made to bring them into compliance.
Principle Two: 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.
Given the lack of segregation between share class assets, the derivatives used in currency overlays become part of the common pool of fund assets. This could disadvantage other investors by introducing counterparty or operational risks in the fund that otherwise would not exist and potentially lead to contagion for other classes.
To minimise the risk of contagion and to appropriately manage the overlay, ESMA has set out operational principles that should be followed, as a minimum standard. Again, these follow the proposals set out in the 2016 discussion paper and are summarised below:
To ensure that the operational principles are met, management companies should (at share class level):
ESMA considers that the principles outlined above should be a minimum standard and that all additional administrative costs should be borne only by the relevant share class.
Impact for UCITS
Management companies with currency hedged share classes will need to follow the operational principles set out above. This will mean, at least, a review of current hedging arrangements and possibly the introduction of new processes and procedures to capture ESMA’s minimum requirements.
Principle Three: Pre-determination
All features of the share class should be pre-determined before the share class is set up.
ESMA considers that this principle is required to allow investors to gain a full overview of the rights and features which will be attributed to their investment, and that this pre-determination should also apply to any currency risk which is to be hedged out.
However, ESMA has been clear that they do not intend for pre-determination to limit either the discretion of the management company as to the type of derivative instrumentsused, or its operational implementation.
Impact for UCITS
Management companies should consider their procedures for setting up share classes and ensure that the features of any new share class are settled in advance of launch. These features should be recorded as part of the product governance processes used by compliance, risk and product teams and be clear enough to form an effective audit trail.
Principle Four: Transparency
Differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes.
ESMA considers it important that the existence and nature of all share classes of a fund are disclosed to all investors and, in particular, that both new and existing investors in a fund should be informed in a timely manner about the creation and existence of currency hedged share classes.
To ensure a common level of transparency, ESMA sets out operational principles as summarised below, and which ESMA considers to be the minimum requirements:
Impact for UCITS
Prospectuses already set out available share classes, but management companies should:
Timing and impact on existing share classes
ESMA appreciates that national practices are so divergent that the impact throughout the EU will differ. To mitigate the impact on investors in share classes which will now be non-compliant, those share classes should be allowed to continue; however, they must:
Clearly, no new share classes which would be non-compliant with the above principles should now be set up.