The European Securities and Markets Authority (ESMA) has been busy. In just four weeks, it issued a report (PDF 2.5MB) on the performance and costs of retail investment products, draft guidelines (PDF 377KB) on liquidity stress testing in funds and a report with the other two European Supervisory Authorities (ESAs) on the PRIIP KID. Each of these brings important news for fund managers and are in addition to ESMA’s supervisory convergence (PDF 334KB) and risk assessment (PDF 465KB) work programmes for 2019, and various outputs on Brexit, MiFID II and other issues.
The most immediate issues for asset managers are the PRIIP KID recommendations, mitigating Brexit risks and the transition to risk-free rates, followed close behind by the guidelines on liquidity stress testing. The ongoing debate on costs and charges within investments funds also requires close attention by fund managers.
More generally, when taken as a whole, ESMA’s recent publications demonstrate that its role is now focussing much more on supervisory convergence and market monitoring, having been absorbed in recent years on writing Level 2 rules, especially under MiFID II.
At the end of last year, the ESAs consulted to a very short timetable on a narrow range of issues relating mainly to the performance scenarios. The industry, distributors and commentators have expressed concern for a year or more that the prescribed methodology is leading to overly-rosy potential return disclosures. The ESAs’ report recommends no rule changes but that (as originally envisaged by the co-legislators) a fuller review should be undertaken, including more consumer testing. As a temporary fix, it recommends an additional risk warning:
“Market developments in the future cannot be accurately predicted. The scenarios shown are only an indication of some of the possible outcomes based on recent returns. Actual returns could be lower.”
Given the Level 2 Regulation specifies the narrative that must be used in the KID, it is not clear how this statement can be added without the Level 2 Regulation being amended – or, indeed, how to fit in yet further text into an already crammed three-page document – but legal niceties are outweighed by concerns about misleading consumers.
Separately, it has been agreed that the original timeline for the UCITS exemption from the PRIIP KID should be reinstated, so UCITS will not have to produce the PRIIP KID until after the full review. Meanwhile, though, PRIIP KID type data will continue to be required for UCITS held within wrapper products, such as unit-linked and with-profits insurance contracts.
Performance and costs of investment funds
The European Commission has mandated the ESAs to provide recurrent reports on the costs and performance of retail investment products. ESMA’s first such report covers UCITS, retail Alternative Investment Funds (AIFs) and Structured Retail Products (SRPs), considering each of these products against member state of domicile and underlying assets.
UCITS make up three-quarters of the market and are described as “the most transparent market in terms of cost and performance disclosure”. Retail AIFs have not been as transparent as UCITS, and SRPs even less so, but the PRIIP KID is beginning to change that. The report finds that there is a high degree of heterogeneity between member states, including for UCITS (e.g. in relation to performance fee disclosures). This makes comparative analysis difficult, but ESMA notes that in the period 2018 to 2017, ongoing costs had the greatest impact on fund performance. Overall costs remained broadly stable, but costs in money market funds halved in the period 2008 to 2011.
Key findings include that there is no significant sign of liquidity mismatch for 100%-retail funds and that actively-managed funds outperform passive funds on gross returns, but underperform net of costs. The ESAs’ reports will likely set the broader context for the Commission’s review of the costs and charges section of the PRIIP KID and cost disclosures under MiFID II and the UCITS KIID.
Draft guidelines on liquidity stress testing in investment funds
In April 2018, the European Systemic Risk Board (ESRB) published recommendations on liquidity and leverage risks in investment funds, one of which was that ESMA guidance should include:
(a) The design of liquidity stress testing (LST) scenarios;
(b) The LST policy, including internal use of LST results;
(c) Considerations for the asset and liability sides of investment fund balance sheets; and
(d) The timing of and frequency for individual funds to conduct LSTs.
In response, and as part of its supervisory convergence role, ESMA is consulting until 1 April on 14 principles-based guidelines for fund management companies and depositaries, relating to provisions in Article 16 AIFMD, Article 47 AIFMR and Article 40 UCITSD.
ESMA notes that liquidity risk in investment funds has crystallised infrequently and has largely been contained, but an event could have a considerable impact on investors. LST is only one tool in managing fund liquidity, which the great majority of fund managers already employ. The guidelines recognise that a variety of methods can be used to build LST models and do not adopt a one-size-fits-all approach. They cover all UCITS and AIFs, including money market funds, exchange-traded funds and leveraged closed-ended AIFs.
Fund managers will need to review their current LST policy and process, and ensure they are embedded in their product governance process.
ESMA’s 2019 Work Programmes
ESMA is mandated to take an active role in building a common supervisory culture among the national regulators (NCAs). In 2019, it will focus on:
In the detail, each of sustainable finance, SME growth markets, fintech, prospectuses, derivatives, central securities depositaries, delegation and closet tracking is mentioned, as well as seven thematic activities: intermediaries and investor protection, secondary markets, investment management, market integrity, post-trading, corporate finance and corporate reporting - a long “priorities” list.
In addition, under its remit to monitor and assess market developments, ESMA will:
Questions for CEOs to ask: