June 2011

INSIDE VIEW: Risk and reward in the new age of Ucits

Mouse_trapFund categorisation is anything but easy, yet it is more important now that Ucits products must produce a risk-reward indicator. Rudolf Siebel and Michael Pirl, of the German trade body BVI, discuss what action to take.

The European investment fund industry is actively preparing for a new age of transparency. By 1 July, 2012, all Ucits funds need to replace their simplified prospectus with a new Key Investor Information Document, or Kiid for short. The industry welcomes the Kiid as a major step towards better informed prospective investors.

Going forward, investors can put several Kiids side by side and may easily compare the content of various Ucits because, for the first time, the presentation of past performance, charges and risk of a Ucits will be fully standardised throughout Europe. A new synthetic risk and reward indicator (SRRI) will be used in all Kiids. On July 1, 2011, the European Securities and Markets Authority (Esma, previously Cesr) guidelines will provide more insight into the calculation of the SRRI.

There are several ways to calculate the SRRI, which depend on the classification of a fund into one of five categories. This also determines the scope, composition and structure of its Kiid. For example, the Kiid of a structured fund will be three pages long and have an exclusive additional feature in terms of a scenario analysis estimating potential losses under different market conditions, while usually the Kiid is only two pages. In market funds and life cycle funds, to give another example for the purpose of calculation of the SRRI, a performance history shorter than five years has to be completed by the data of a representative portfolio model or benchmark.

A valid and easy to use fund classification scheme is becoming of utmost importance to the industry which needs to produce tens of thousands of Kiids in the near future.

As a service to the industry, BVI issued recommendations on how to classify funds according to the five categories under the SRRI rules. Adherence to the recommendation is entirely voluntary and there is no intention to make them mandatory. The text is available in English, French and German at www.bvi.de.

The main advantage of the recommendations is to provide a decision tree on how to categorise a fund into one of the five groups. This a genuine task for the fund sponsor, it requires a case by case approach, including fund data analysis and SRRI calculation.

The BVI recommendations should be useful in determining the possible scenarios for SRRI calculations, and will help to avoid overblown and expensive methods. The fund sponsor retains the full freedom to deviate from the recommendations and to use other criteria if necessary. The need will arise mainly with new funds because the recommendations require a minimum of 36 months’ data history.

Now we describe how Ucits fall into one of the five Esma fund categories under the BVI recommendations: absolute return funds; total return funds; life-cycle funds; structured funds; and market funds.

Absolute return funds
These are defined as Ucits, the risk and reward profile of which is largely independent of traditional asset classes (such as equity, bonds without default risks) and the objective of which is the generation of a positive active return (risk adjusted surplus returns) in the predominant number of scenarios. Risk budgeting is used to maintain a defined floor but there is no formal guarantee requirement. Other value protection strategies may be used. In our view, absolute return funds include highly variable/highly flexible balanced funds and multi asset strategies, provided that they are backed by high-frequency timing across asset classes and the exposure to traditional markets is limited in the long-term average, which is more than the Cesr single example of a multi-asset class strategy.

Total return funds
These are defined as Ucits, the risk and reward profile which is largely dependent on traditional asset classes (equities, AAA bonds) and/or exotic asset classes and which apply dynamic rules. In the dominant number of scenarios the fund target is based on active returns (risk adjusted surplus returns), while complying with time horizon adjusted risk. Typically, total return strategies try to achieve a minimum return target which is related to a period or a point in time. Standard guaranteed products (no/low active risks, convex basic profile) with no significant degree of path dependency and no volatile changes in risk profile are also total return funds. Other examples of total return funds are dynamic value protection funds based on constant proportion portfolio insurance (CPPI)  or variable proportion portfolio insurance (VPPI) strategies, and fixed-income funds with a fixed-term date and target return.

Life cycle funds
We widely agree with Esma’s definition of life cycle funds, but we submit that shifts in asset allocation may occur from equities to bonds and vice versa. Therefore, we include in this category all funds marketed as “target date saving” and “pension solution” and any portfolio that shows a rule based gradual shift between asset classes such as long-term balanced funds with a maturity target, provided that rule-based shifts take place over the entire life of the fund.

Structured funds
These typically show asymmetrical and potentially rapidly changing risk and reward profiles, a limited term, and often use exotic derivatives. There is a defined payoff profile depending on different market situations. Esma, however, does not view strongly path-dependent strategies with discretionary elements, such as CPPI strategies, as structured funds. Esma reduces this category to sophisticated guaranteed funds: with significant path dependency and a large range of sudden changes in the risk and return profile. However, in specific cases, a prima facie “structured fund” that exhibits a risk and reward profile close to a total return product could be reclassified as such.

Market funds
In real life, this category will cover the majority of the fund universe (approximately 75%). It will be the “default option” as any fund will be included which does not meet the criteria for the other categories. Market funds – dependent on the management style which can be either index based, close to index or discretionary – follow the development of one or more reference markets. Main market equity funds, fixed-income funds, mixed funds, money market funds, bond funds, as well “traditional” balanced funds will be in this category. Also included are funds which show a distinct negative market exposure (through short positions or negative duration). In conclusion, the risk-based approach reflected in the Cesr guidelines 2010/10/673 provides a good baseline for a scientific fund categorisation. Our interpretation extends the authorities approach. Its value-added is the consistent classification of guaranteed funds, and a more reasoned distinction between absolute return and total return strategies. We hope to see going forward more research leading the way to a widely accepted fund categorisation method which is based on three elements; relative return, absolute return, and total return, as well as a general convergence of methodology and terminology. BVI’s recommendations on SRRI calculation are an important step in this direction. A number of European fund associations have expressed support for our initiative. We hope that this new way of thinking will be reflected in Esma’s guidelines as soon as the Kiid rules are revised in light of MiFID 2 and PRIPs (packed retail investment products) initiative.

Rudolf Siebel is managing director and Dr Michael Pirl is vice-president research and market analysis at BVI, the German investment and asset management association

©2011 funds europe