BVI interpretations of ESMA’s risk-based approach
As the Ucits IV Directive comes into force in July, product providers must be careful how fund information is offered to private investors, according to Rudolf Siebel and Michael Pirl of the German Fund Association
Undoubtedly, 1 July will bring one of the most significant changes to the European investment fund industry.
With the Ucits IV directive coming into force, a number of new regulations have to be implemented, especially in the way fund information is offered to private investors.
One of the most important aspects will be the replacement of the simplified prospectus with the Key Investor Information Document (KIID).
This requires the use of a volatility-based synthetic risk and reward indicator (SRRI).
The structure, content and layout of the KIID are different depending on the category of a fund.
The European Securities and Markets Authority (ESMA) assigns Ucits to five categories: market, absolute return, total return, life-cycle and structured.
It is important to ensure correct fund classification in accordance with the ESMA guideline exCESR 10/673.
The SRRI is expressed on a seven-stage scale: ‘one’ denotes low risk and ‘seven’ high risk.
The CESR guidelines must be implemented before 1 July 2012.
Most of the industry is working towards creating the KIID and the SRRI automatically.
However, little attention has been paid to the scientific foundation of the guidelines.
ESMA offers some explanatory text and examples, but fund classification in the context of the SRRI calculation remains a difficult issue.
The problems of assigning a fund to one or other of the categories defined by ESMA include how one defines the difference between absolute return and total return funds, and how one separates structured funds from other categories, especially from total return.
Generally, greater precision is needed in the definitions of the ESMA fund categories and in how to ensure homogeneity within them.
ESMA’s approach is a quantitative one, which seems to be inspired by the academic discussion of risk and reward profiles.
For the first time, a risk-based approach (RBA) has become standard in legal fund classification throughout Europe.
The investment fund industry therefore appreciates the SRRI as a valuable, straightforward tool that will achieve more transparency for investors.
In principle, an RBA, rather than a holdings-based approach (HBA), provides resilient, replicable and consistent results.
These are pre-conditions for a well-performing, stable and reliable classification system. In the past, there was a preference for an HBA.
It remains useful as a supplementary or even indispensable tool to categorise funds at inception, or where there is incomplete data history.
But a qualitative scheme will never have the power, soundness and universality of a calculated approach.
Consequently, any interpretation of the ESMA guidelines should be based on academic research in the context of recent findings of capital markets theory and strategic asset allocation.
BVI, the German fund and asset management association, has contributed to this debate, with text available at www.bvi.de in English, French and German.
The benefits of an RBA are not restricted to the result.
The data needed to calculate the RBA-based SRRI are easy to obtain as they are usually available for other reasons, such as regular internal performance analysis.
It is relatively easy to run the recommended calculations on correlations between fund returns and benchmark returns (beta or a similar figure such as RVR), distribution types of curves plotting fund returns against returns of a risky asset (symmetrical, convex, concave, or convex-concave), skewness and kurtosis, and tracking error, among others.
Combining these measures gives an insight into the risk and reward profile of a fund.
The BVI has suggested additional definitions and test criteria for the allocation of a fund to the five ESMA categories.
The risk and reward profile is predominantly affected by a largely static factor exposure in the meaning of the ‘relative return’ approach of the strategic asset allocation.
Its object is single index benchmarks or (quasi) static mixed benchmarks.
Other features will be largely stable beta exposures, wide structural stability of the relative risk, typically measured by tracking error and without explicit limitation of the absolute risk, meaning there will be neither any absolute upper limits for losses nor any capital protection mechanisms.
The risk and reward profile is independent of all systematic risks (market neutrality) and serves to generate positive active returns (risk-adjusted surplus returns), thus reflecting a pure active strategy.
The benchmark will be a short-term safe investment, free of default risks and therefore a border case of the strategic asset allocation, since the active risks dominate the benchmark risk.
As a general rule, guaranteeing the achievement of positive risk-adjusted surplus returns is not feasible.
Target returns above the safe investment can be achieved only within the scope of ‘defined’ probabilities.
The term ‘target return’, which should be avoided in the context of absolute return, is to be distinguished from the term ‘minimum return’, the use of which makes sense (risk limit as supplementary feature).
In the past, contradictions occurred in the use of the terms ‘absolute return’ and ‘total return’.
To avoid this, the objective should be to focus on ‘genuine’ absolute return products in the industry, and to clear the way for a broadly accepted definition of such fund concepts.
This differentiation should be reflected also in standards for naming funds. For example, absolute return funds will include highly variable/highly flexible balanced funds and multi-asset strategies, provided that their average exposure to traditional markets is limited in the long term.
This goes beyond what CESR gives as a single example of a multi-asset class strategy.