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January 2020

In the last edition, we noted that the European Commission and ESMA had already set out their agendas for 2020 and beyond, which include a number of topics impacting asset managers and investment funds.

Specific proposals and supervisory activity are now beginning to emerge, in new or expanded areas of rule-making. Over the next three years, firms will need to implement many new rules and respond to an increasing number of supervisory edicts.

Throughout 2020, asset managers will wish to keep a close eye on the reviews of MiFID II and MiFIR, the market abuse requirements and other capital markets rules. Fund management companies will also have a keen interest in the MiFID II review, as regards the product governance and fund distribution aspects, together with the reviews of the UCITS Directive and AIFMD. Meanwhile, the heated debate about how to make the PRIIP KID fit-for-purpose continues.

We comment below on three specific areas of current activity. They underline the overarching message for asset and fund managers of all types: the way in which the industry operates is under continued and deepening regulatory scrutiny, across all aspects of the business.

Environmental, social and governance (ESG)

Unsurprisingly, consideration of ESG factors - in particular, climate change and other climate-related risks - is at the forefront of agendas. The Commission's package of legislative proposals have all been adopted, including the Taxonomy Regulation, which defines the criteria for an activity to be regarded as environmentally-sustainable. The three ESAs are charged with producing various technical regulatory standards (RTS) to underpin the Disclosure Regulation (which is about more than disclosure). The RTS will apply to UCITS, all forms of AIFs, occupational pension funds, asset managers, fund intermediaries and insurance intermediaries.

Further information has emerged on what an EU ecolabel for funds will look like. The European Commission's Joint Research Centre (JRC) has issued its Second Technical Report (PDF 3.9 MB). It now proposes mandatory criteria for determining whether retail financial products (investment funds, insurance-based investment products and savings accounts/deposits) can use the ecolabel. It will apply to the service provided by the fund management company, rather than to the fund itself, but can feature on the fund's promotional material.

A particular focus of the JRC's recent work has been to find a balance between allowing too many funds to claim green status and excluding too many of the more than 400 existing funds that are currently advertised as green or sustainable. The JRC suggests that:

  • bond funds be at least 70%-invested in bonds that comply with the Green Bond Standard
  • equity funds be subject to a “three-pocket” approach (see below)
  • mixed funds should apply the above two criteria to the underlying assets
  • funds of funds should be at least 90%-invested in funds that have been awarded the ecolabel
  • feeder funds must be invested in a master that has been awarded the label
  • the use of derivatives should be in line with the fund's environmental investment policy and restricted to either hedging purposes or increasing exposure to underlying assets on a temporary basis

It is not clear how the last criterion would work for funds invested only in derivatives and cash, where the derivatives do not (all) relate to specific assets. The proposals for equity funds may also be difficult to operate, especially for open-ended funds.

For more details on the Commission's new European Green Deal and other developments, look out for the January edition of Horizons.

The three-pocket approach to equity funds

At least 60% of the fund's portfolio must be invested in companies whose economic activities comply with:

  • at least 20% of the fund's portfolio must be invested in companies that derive at least 50% of their revenue from green economic activities (as defined by the new Taxonomy Regulation)
  • the remaining 0%-40% must be invested in companies deriving 20%-49% of their revenue from green economic activities

The remainder of the portfolio must be invested in companies deriving less than 20% of their revenue from green economic activities but not undertaking any excluded activities, or other assets or cash.

Systemic risk

Liquidity management of open-ended funds and the use of leverage in AIFs are also high on the agenda. Although different topics from a technical perspective, they tend to be grouped by policy-makers under the systemic risk heading. ESMA's second statistical report on the EU AIF market is the latest paper to call out these issues. In particular, it notes that AIFs with higher proportions of retail investors are more vulnerable to liquidity issues, and consequently the investors are themselves more vulnerable. It calls out the hedge fund sector as having increased its use of leverage, although it notes that large cash buffers offer some security.

Given a small number of recent liquidity issues in the open-ended funds market, national regulators are reported to have been asked to take a closer look at all such funds, especially UCITS. We await information on their findings, which - together with the finalised IOSCO framework (PDF 113 KB) for monitoring leverage and the ESRB's recommendations of 2018 on both liquidity and leverage - are likely to form the basis of proposals by the European Commission for rule amendments.

Costs, charges and performance

The main activity in this area is supervisory. ESMA's work programme includes achieving greater convergence and consistency of national regulators' (NCAs') supervisory approaches and enforcement activities, further to the findings in its first Annual Statistical Report (PDF 3.4 MB) on the performance and costs of retail investment products.

In addition to continued co-ordination of NCAs' work on “closet indexing”, ESMA is finalising its guidelines on performance fees, on which it consulted last year. Some NCAs - Germany and Ireland, for example - have already introduced more restrictive requirements.

ESMA's draft guidelines cover the structures and methodologies of performance fees and the circumstances in which they can be paid. One issue that has received much comment is in what circumstances it should be possible to change a “high watermark” (above which performance fees kick in), especially the ability to lower it. Consumer representatives and a number of fund managers have said that high watermarks should be changed rarely and only in very specific circumstances (such as when there is a change to the fund's investment strategy or objectives, or a restructuring). Others disagree, but seem unlikely to win the argument.

Questions for CEOs

  • Are we fully briefed on all the new ESG rules that are coming into force and what they may mean for our business and our clients'/funds' portfolios?
  • Are our current liquidity stress testing policy and process in line with latest regulatory expectations? Is liquidity stress testing fully embedded in our product governance process, for each fund?
  • What is our process for setting management and other charges within funds and for the containment of other costs? What is our policy and operation of performance fees?
  • In practice, how does the board exercise its independent challenge of our decisions in relation to such matters?