While there are those who will lament the loss of duration hedging, ESMA’s recently published opinion levels the playing field for UCITS share classes across the EU.
ESMA has, at last, concluded its multi-year assessment of UCITS share classes. Our suspicions from last year were confirmed and ESMA has in fact changed the rules for UCITS share classes in its final opinion. The purpose of the assessment was to harmonize divergent approaches to UCITS share classes that have emerged across EU Member States. The most significant revision is the disqualification of duration-hedged share classes for UCITS. However there are other changes UCITS managers will have to address as well.
ESMA retains its four high-level principles, initially outlined in April 2016:
- Common investment objective: Share classes of the same fund should have a common investment objective reflected by a common pool of assets.
- Non-contagion: UCITS should implement appropriate procedures to minimize the risk that features specific to one share class could have a potentially adverse impact on other share classes.
- Pre-determination: All features of the share class should be determined before it is set up.
- Transparency: Differences between fund share classes should be disclosed to investors when they have a choice between two or more classes.
New Hedging Rules
As expected, the final opinion confirms that ESMA considers only currency-risk hedging to be compatible with the common investment objective principle at the share class level. Any other hedging strategy should be set up in a separate fund or sub-fund. This means duration-hedged share classes are no longer allowed within a UCITS.
Beyond hedging restrictions, ESMA has introduced two new requirements for share classes.
- 95% Minimum Hedge Threshold
Hedged UCITS share classes are required to hedge at least 95% of the share class value at all times. In practice, UCITS largely adhere to this guideline already, but the opinion formally codifies it.
- UCITS Stress Tests
Stress tests must be conducted to quantify the impact of losses on all investor classes of a fund. In particular, stress testing is designed to ensure hedging does not lead to losses for investors in other share classes.
Instrument types or operational elements of a hedging program are not considered part of the pre-determination principle in the final opinion. This change is a welcome change to the original, as many UCITS managers were concerned that the original proposal was too prescriptive. Asset managers should now review the relevant language contained in their prospectus to ensure that it is in-line with the predetermination principle.
ESMA’s opinion is not binding and must be reviewed by the local regulators of EU Member States. It is widely expected that regulators in Ireland and Luxembourg, the two biggest UCITS fund domiciles, will adopt the principles in full and incorporate them into local UCITS regulations.
ESMA has acknowledged that some existing share classes, such as duration-hedged share classes are not compatible with the new share class rules. However, ESMA has also granted a grace period for such share classes. All existing hedged share classes may continue to operate for now. The following transitional provisions give impacted asset managers time to make any required changes.
Share classes that do not adhere to the opinion should be closed:
- for investment from new investors by 30 July 2017
- to all additional investment by existing investors by 30 July 2018
For UCITS funds that do not adhere to these final rules, these funds will need to decide if they want to move investors in non-compliant share classes into new sub-funds or shut the share classes. These decisions will largely be driven by the size of impacted share classes and whether it is economically viable to establish a new sub-fund.
While asset managers currently operating duration-hedged share classes will not be too pleased, ESMA’s final decision was not unexpected. ESMA’s opinion brings a level of certainty and consistency to UCITS share class rules and levels the playing field across the EU. The new share class requirements may just be the beginning. In its 2017 work program, ESMA highlight several areas of regulation it seeks to harmonize across the EU, including investor protection for cross-border services. So, the industry may want to steel itself for a series of incremental regulatory fixes.