The UCITS Directive (2009/65/EC) recognises the possibility for UCITS to offer different share classes to investors, but provides no detail as to the permitted scope of these share classes. As a result, there is no common legal or regulatory framework for establishing share classes throughout the EU. Therefore, to ensure a harmonised approach across the EU, ESMA issued an opinion on 30 January 2017 to the Member State national regulators emphasising the four high-level principles it believes should be followed in setting up different share classes. In addition to these principles, ESMA also believes that share classes should never be set up to circumvent the rules of the UCITS Directive, particularly those on diversification, derivative eligibility and liquidity.
ESMA’s four high-level principles are:
Common investment objective
Share classes of the same sub-fund should have a common investment objective reflected by a common pool of assets. The opinion clearly expresses ESMA’s view that hedging arrangements at share class level, save for currency risk hedging, are not compatible with the requirement for a sub-fund to have a common investment objective. Accordingly, the only hedging that a share class may engage in is currency risk hedging. ESMA characterises such hedging as a means to level the playing field for EU-wide investors, by allowing them to invest in sub-funds while mitigating the currency risk.
UCITS should implement appropriate procedures to minimise the risk of features particular to one share class potentially having an adverse impact on other share classes of the same sub-fund.
Any additional risk introduced to a sub-fund through the use of a derivative overlay for a given share class should be mitigated and monitored appropriately and in the event of its realisation should only be borne by the investors in the relevant share class. At the level of the share class with a derivative overlay, ESMA requires that a UCITS should:
- Ensure that the exposure to any counterparty of a derivative transaction is in line with the limits laid down in Article 52 of the UCITS Directive in respect to the net asset value of the share class;
- Ensure that over-hedged positions do not exceed 105% of the net asset value of the share class;
- Ensure that under-hedged positions do not fall short of 95% of the portion of the net asset value of the share class which is to be hedged against currency risk;
- Keep hedged positions under review on an ongoing basis, at least at the same valuation frequency as the sub-fund, to ensure that over-hedged or under-hedged positions do not exceed/fall short of the permitted levels stated above; and
- Incorporate a procedure in said review to rebalance the hedging arrangement on a regular basis to ensure that any position stays within the permitted position levels stated above and is not carried forward from month to month.
All features of a share class should be pre-determined before the share class is set up, this pre-determination should also apply to the currency risk which is to be hedged out systematically. However, this requirement should not be interpreted as limiting the discretion of the UCITS as to the type of derivative instrument to be used to hedge the currency risk, or its operational implementation.
Differences between share classes of the same sub-fund should be disclosed to investors when they have a choice between two or more classes. The following operational principles, considered to be minimum requirements, should be observed by a sub-fund with share classes to ensure a common level of transparency vis-à-vis all its investors:
- Information about existing share classes should be provided via the UCITS prospectus as part of the details of the types and main characteristics of the shares;
- Regarding share classes with a contagion risk; the UCITS should provide a list of share classes in the form of readily available information which should be kept current; and
- The stress test results should be made available to national competent authorities on request.
ESMA states that share classes established prior to the publication of the opinion and which do not comply with the high-level principles set out above, will be allowed to continue to operate. However, these share classes should be closed for investment by new investors within six months (July 2017) of publication of the opinion, and for additional investment by existing investors within 18 months (July 2018) of publication of the opinion.
Contributed by Niall Crowley