Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

2. Key Topics on the European Regulatory Agenda

Payoff simplicity should be understood as the “average retail investor’s” ability to understand the sources of performance and the systematic character of the exposure to these sources. By disregarding the nature of the payoff generated by the fund to focus on its structure or the instrument it holds to generate the said payoff, regulation would create a false sense of security vis-à-vis “simple”, “plain-vanilla”, or “mainstream” products, which in fact can include large, and more worryingly, hard to predict extreme risks 46 – again, this would exacerbate adverse selection and moral hazard phenomena (Amenc, Ducoulombier, Goltz, Tang, 2012). We consider it key to recognise the difference between passive UCITS that track a financial index and other funds. With the former, investors choose a linear and constant exposure to an index, which should be managed in a transparent and systematic manner and boasts a published track record. 47 With the latter, the payoff depends on risk-taking and portfolio management models that may be neither systematic nor transparent. A multiclass fund engaging in global tactical asset allocation will have a non-linear track-record, which will be difficult to explain or replicate, and a higher risk to underperform its benchmark in case its tactical bets turn out to be wrong. Likewise, a fund that tries to outperform its benchmark by taking risks of different economic nature than those implicit in its benchmark will exhibit a performance that will be hard to understand or replicate when the investor performs its due diligence.

The recent debate on the purported risks of ETFs saw a number of providers very successfully peddle to the mainstream media and a number of regulators the idea that physical-replication ETFs were simple products while synthetic-replication ETFs were complex products. We consider this structural or instrumental approach to complexity to be misguided; complexity should be defined in relation to the payoff: if the investor cannot easily relate a fund’s payoff to a benchmark or indicator that is simple and observable, then this fund should be considered complex and should not be sold without advice. Interestingly, the focus on the payoff is very clear in the regulator’s approach to structured UCITS as demonstrated by the specific transparency requirements outlaid in the regulation implementing the key investor information provisions of UCITS (Commission Regulation (EU) No 583/2010) and the related CESR guidelines (CESR/10-1318). The “objectives and investment policy” section of the KIID must include an explanation of how the structured product formula works or how the payoff is calculated and it must be accompanied by illustrations showing the circumstances in which the formula may generate a low, a medium, or a high return 48 ; the presentation should be fair, clear and not misleading and made in a way that is likely to be understood by the average retail investor. The recent debate on the risks of ETFs has given the regulator the opportunity to reject the idea of creating distinctions between UCITS on the basis of structural or instrumental differences that were not relevant from a risk point of view

46 - As well as possibly overlooked financial risks as illustrated at the early stage of the debate on the purported risks of ETFs, see Amenc, Ducoulombier, Goltz, Tang (2012). 47 - In Amenc and Ducoulombier (2012) and Ducoulombier (2012), we make proposals regarding the transparency of indices, index governance and the auditability of index committee decisions. 48 - Based on reasonable and conservative assumptions

about future market conditions and price movements.

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An EDHEC-Risk Institute Publication