Assets invested in UCITS funds hit a record high in June of this year, pushing past the €10 trillion mark across more than 90 countries. Despite their continued growth, UCITS have faced several regulatory headwinds including scrutiny on liquidity issues, delegation rules in a Brexit context, and so-called “closet trackers.” An added gust is a recent ESMA consultation focused on how UCITS performance fee models operate that includes suggestions for changes to the current framework.
One of the reasons UCITS are so successful is that the ruleset has a robust, transparent, and standardized framework for investor protection, risk management, and corporate governance standards. Allied to these safeguards, UCITS have relatively broad investment mandates that can operate within the confines of its rules. UCITS are generally seen as the international gold standard of cross border fund structures and the only one that has had the passporting success grow well beyond its own borders.
With all that said, it is not uncommon for the UCITS rules to go through revisions. Sometimes this comes in the form of a complete overhaul as in the case of UCITS 3, where investment permissions were expanded, UCITS 4 where both the passporting and governance frameworks were bolstered, or UCITS 5 where asset safekeeping and depositary obligations were more strictly codified. Other times, the changes are more targeted in nature and the changes affected through guidance (e.g.: Share Class Rules or Efficient Portfolio Management).
UCITS performance fees under the spotlight
The latest area of regulatory scrutiny comes in the shape of European Securities and Markets Authority (ESMA) consultation on guidelines on performance fees. The consultation seeks to harmonize how UCITS funds calculate, disclose, and pay performance fees where practices are fragmented across EU Member States. Not all UCITS incorporate performance fees into their remuneration practices, but recently, as asset managers focus more on expense ratios, they have reduced their fixed management fees and shifted to return-based incentives such as performance fees or fulcrum fees in order to better align the incentives of managers with their investors. This trend is also driving ESMA to look for a greater degree of harmony on fee methodologies.
The consultation paper follows a pan-EU review where through the course of 2018, ESMA compared various national practices for UCITS performance fees and found certain discrepancies. This review built on previous work by IOSCO who published their good practice for fund fees, and country-level regulatory initiatives conducted by German, Irish, and UK regulators.
Another impact of this regulatory scrutiny is the increased use of technology. Funds that were using spreadsheets to calculate performance fees are exploring new methodologies – both in house and with third party servicers – to automate and track these functions. Additionally, managers increasingly need to be able to explain and justify each complex fee calculation to their fund boards, regulators, external auditors, and investors.
ESMA Chair Steven Maijoor, prior to the release of the consultation paper, said differing practices between Member States create “undue risks of regulatory arbitrage and inconsistent levels of investor protection” – the very issues UCITS are trying to mitigate. Rather than introduce new, heavy regulation, ESMA is hoping to solve for this with updates and recalibration.
What’s in ESMA’s consultation paper?
The paper cover’s five distinct areas:
1. Guiding principles on calculations
The current UCITS fee rules are based on certain principles explicitly laid out with the current regulations and bolstered by general appreciation of the IOSCO principles. As is often the case with rules containing broad discretions, this approach has resulted in fragmentation of methods across respective UCITS domiciles. ESMA’s proposals seek to remove these discretions with more explicit and prescriptive ruleset which should in turn drive greater harmonization. Operationally, the recommendations shouldn’t change much for managers, since UCITS performance fees already self-impose a rigid calculation processes to ensure their accuracy. With that said, all UCITS should undergo a review process to ensure they accord with the new guidelines.
The guidelines state that the calculation method should include at a minimum:
- Reference indicator such as an index, a high-water mark, or a hurdle rate
- Stated crystallization period
- Performance reference period
- Performance fee rate
- Computation frequency
- The methodology should always be aligned with the investment strategy and be a reasonable incentive for the asset managers while being aligned with investors’ interest.
2. Alignment of fee models and prospectus language
This guideline focuses on the fact that when it comes to performance fees, the methodology of calculation is normally disclosed to investors through prospectus language. The language is then interpreted and calculated using numeric formulae. The consultation paper suggests that currently, it is possible for a disconnect to arise between the prospectus language and how the fee is calculated and as such ESMA want UCITS funds to ensure fee models are aligned with funds’ investment policy.
To ensure such alignment, UCITS should consider the following:
- Suitability of the chosen calculation model, for example, a benchmark agnostic fund like an absolute return strategy should use HWM or a hurdle rather than a chosen benchmark in order to match the funds risk return profile;
- If calculating a performance fee to a stated benchmark, it should be an appropriate benchmark, for example, a US equity fund should not ever benchmark itself to a totally uncorrelated reference benchmark such as Japanese Bond index;
- If using fulcrum fees, the performance fee should be based on the same benchmark to determine excess performance. While the industry is interested in the use of fulcrum fees, in practice, we haven’t seen a large shift to use this model. Fulcrum fees are difficult to disclose under UCITS Key Investor Information Documents (KIIDs) and many managers are taking a “wait and see” approach.
- Excess performance must always be calculated net of costs, never on gross performance.
3. Prescribed frequency for Performance Fee Crystallization and Payments
ESMA suggest that the UCITS performance should be assessed and paid on the basis of the investors holding period. ESMA also suggest that the crystallization period should be at least one year, and generally run until December 31st each year, or else to the UCITS’ financial year end if not calendar year end.
4. Circumstances where a fee should and should not be payable
ESMA request that performance fees should only be applied once the fund has absolute performance; as such, a fund must recover any underperformance or loss within the performance reference period before any performance fee becomes payable.
If a fund pays out a performance on negative returns (fund has gone down but has still beaten its stated hurdle or benchmark on relative basis), there must be a prominent disclosure notice to its investors provided in its marketing and legal materials that this is a possibility.
5. Investor Disclosures
The disclosure of performance fees to investors should always occur in advance, and visible within the UCITS Key Investor Information Document (KIIDs) and Prospectus. Disclosures should also be posted in the financial statements of the UCITS.
In terms of financial statement disclosure, both the annual and semi-annual reports of the UCITS should indicate the impact of the fees over the crystallization period for each relevant share class by clearly showing:
- The actual amount of performance fees charged
- The percentage of fees charged based on the share class net asset value
ESMA also impose more rigid obligations on UCITS management companies to ensure that the performance fee model utilized offers a reasonable incentive for the manager to perform but that the funds’ risk return trade off does not entice a manager to take undue risks and always remain aligned to their investors’ best interests.
The ESMA consultation remains open for feedback until 31 October and regulators hope to finalize the guidelines in early 2020. It is anticipated that once final guidance is released, UCITS funds will have a year to align their procedures and documentation with the ESMA guidelines. Given performance fees are such a vital stream of revenue to many UCITS managers, it would be prudent for asset managers to reviewing these guidelines and provide feedback to ESMA on whether the proposals are reasonable, proportionate, and fit for purpose.
The article was authored in conjunction with BBH Vice President Greg Ranieri.