Investment funds and the PRIIPs regulation
Closed-ended and open-ended investment funds are categorized as PRIIPs under regulation (EU) No 1286/2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs), if they are available to retail investors. Investment funds available to retail investors are thus affected by the requirement to provide Key Information Documents (KIDs) as of 1 January 2018.
However, UCITS that were authorised pursuant to Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to UCITS, as amended, are exempt from the obligations under the PRIIPs Regulation until 31 December 2019, as such investment funds are already obliged to provide a UCITS KIID (Key Investor Information Document) under Directive 2009/65/EC. The ultimate aim is, however, to stipulate that one standard document be provided to retail investors for all investments distributed, including UCITS.
The impact of PRIIPs on investment funds and asset managers – an analysis of the Q&A published by the ESAs on 4th of July 2017
The commission delegated regulation from March 2017, raised several questions in relation to the methodology and information to be included in KIDs.
On 4th of July 2017 the ESAs published the first set of Questions and Answers (Q&A) related to the Key Information Document (KID) requirements for Packaged Retail and Insurance-based Investment Products (PRIIPs) to clarify on issues relating to e.g. market risk assessment and classification, methodology for assessing credit risk, performance scenarios, and the methodology for calculating costs. Many of the clarifications directly concern investment funds. Important points are summarized below.
Market Risk Assessment and Categorisation of PRIIPs
What is it about?
For the purpose of determining market risk, PRIIPs are divided into four categories depending on the structure of the PRIIP, where standard unit linked products with at least monthly pricing normally fall under category 2 (as opposed to structured products).
The KID for PRIIPs contains a Summary Risk Indicator (SRI). The indicator is a combination of a Market Risk Measure (MRM) ranging from 1 to 7 and a Credit Risk Measure (CRM) ranging from 1 to 6.
For PRIPs falling under MRM-category 2, a Value-at-Risk (VaR) measure in return space at a confidence level of 97,5% should be calculated based on the number of trading days in the recommended holding period, using the Cornish-Fisher expansion. The VaR is the percentage of the amount invested, that is returned to the retail investor, and the return over each period is defined as the natural logarithm of the ratio of the price at the market close at the end of the current period to the market close at the end of the preceding period. The VaR shall be calculated from the moments of the observed distribution of returns during the past five years (with possible exceptions), the minimum frequency of observations being monthly.
The VaR calculated is used to calculate the VaR-equivalent-volatility (VEV) at a 97,5% confidence level. The PRIIP is then assigned to one of seven MRM-classes in accordance with the VEV calculated. In the case only monthly price data is available, the MRM class assigned shall be increased by one additional class.
Points of clarification by the ESAs
- A voluntary inclusion of a PRIIP into a specific category in relation to market risk assessment is not permitted. Investment funds are thus to be categorised in accordance with their pay-off structure and availability of historical data;
- For investment funds, the historic availability of price data relates to the frequency of the calculation of the NAV, not the frequency of redemption rights;
- A determination as a category 1 PRIIP overrules the other categories; thus where a PRIIP satisfies the conditions for a category 1 PRIIP it shall be classified as a Category 1 PRIIP irrespective of whether it also meets the conditions of another category;
- The determination of the PRIIPs’ category addresses the PRIIP itself, and depends on the pay-off structure and the availability of data. Classification is thus contingent on the linearity or non-linearity of the pay-off structure and the availability of historical data of the PRIIP portfolio as a whole, and not on the underlyings as such;
- When insufficient price data for the PRIIP are available, data of an appropriate benchmark or proxy should be used, and such a PRIIP should not be assigned to a different category, unless no appropriate benchmark or proxy exists;
- The availability of historical data is per se not sufficient when the representability of the historical data changes in relation to the PRIIP. For example, the portfolio composition of life cycle funds changes substantially over time usually becoming more defensive by switching from equity to fixed income assets. In this case, the actual fund data history is not used for the VEV calculation, and instead the maximum of points 14 (a) (ii) and (iii) of Annex II to the Commission Delegated Regulation 2017/653 should be used.
Methodology for assessing credit risk
What is it about?
A PRIIP or its underlying investments or exposures shall be taken to entail credit risk where the return of the PRIIP or its underlying investments or exposures depends on the creditworthiness of a manufacturer or party bound to make, directly or indirectly, relevant payments to the investor.
Where the credit risk is entailed solely at the level of underlying investments or exposures, the credit risk shall not be assessed at the level of the PRIIP itself but instead at the level of these underlying investments or exposures on a look-through basis. Where the PRIIP is a UCITS or an AIF, the UCITS or AIF itself shall be taken to entail no credit risk, whereas the underlying investments or exposures of the UCITS or AIF shall be assessed where necessary.
A PRIIP shall be allocated a credit risk measure (CRM) on a scale ranging from 1 to 6.
Points of clarification by the ESAs
- In certain situations the credit risk of a PRIIP needs to be assessed at the level of the underlyings to determine the CRM. In this case either a look-through or a cascade assessment shall be performed. For example, in the case of fund of funds it is necessary to look-through the different levels of funds to identify the underlying credit risk exposures. In the case of an investment fund, credit risk may need to be assessed in relation to the underlying investments or exposures, for example in the case of exposures to non-exchange traded derivatives and noncleared OTC derivatives, where these are not fully and appropriately collateralised and amount to 10% or more of the total assets or value of the PRIIP.
Performance scenarios
What is it about?
The KID shall include four performance scenarios, showing a range of possible returns, namely: a favorable scenario, a moderate scenario, an unfavorable scenario and a stress scenario. The scenario values under different performance scenarios shall be calculated in a similar manner as the market risk measure, and scenario values shall be calculated for the recommended holding period.
Points of clarification by the ESAs
- For products with a fixed end date, the remaining time to maturity should be used to demonstrate the performance scenarios.
Methodology for the calculation of costs
What is it about?
Costs to be disclosed in the KID for investment funds include one-off costs, recurring costs, and incidental costs.
Points of clarification by the ESAs
- Subscription fees are to be presented gross of any taxes, such as VAT, financial transaction taxes and stamp duties;
- Calculation of costs should take into account the costs incurred in underlying funds or other underlying PRIIPs. However, where the underlying investments are PRIIPs producing KIDs, it will only be necessary to obtain cost information from the KIDs;
- For investment funds, where the investment to be made is unknown at the date of creation or investment in the fund, best estimates in relation to investment costs, adopting as proxies either a comparable PRIIP or a peer group, are to be applied;
- When computing performance fees for new funds, the relevant fund return shall be estimated using the return of a comparable fund or a peer group.
Our recommendation
Reviewing the PRIIPS regulation (as amended), and related commentary, it appears evident that the requirements stipulated for investment funds in relation to the methodology and information requirements pertaining to KIDs are not always crystal clear. Proper and timely action from fund managers is thus necessary to be able to accurately understand and comply with the PRIIPs regulation coming into force at the beginning of 2018.
Timeline for the implementation of PRIIPs for investment funds
The final recommendations regarding the PRIIPs Regulation were published on 8th of February 2019 by the ESA. The ESA decided to initiate a revision of the PRIIPs Regulation to be undertaken in 2019, including to launch a consultation on the draft Regulatory Technical Standards.
For further information on how we can assist you in properly implementing PRIIPs requirements for fund managers, do not hesitate to contact us per E-Mail or via our Contact form.
Latest update: 11.02.2019