Asset Management & Investment Funds: EU & International Developments – May 2022

ESMA statement on the implications of Russia’s invasion of Ukraine on investment fund portfolios.

The European Securities and Markets Authority (ESMA), issued a Public Statement on the implications of Russia’s invasion of Ukraine on investment fund portfolios. The statement aims to promote convergence in the way market participants and national competent authorities (NCAs) respond to these adverse events and to provide clarity to fund managers.

The statement helpfully recalls some general principles that can be derived from EU law that are of relevance to the management of investment fund portfolios impacted by the Russian invasion of Ukraine. It provides overarching messages to fund managers, including high-level guidance on:

  • the appropriate action in case of exposures to Russian, Belarusian and Ukrainian assets, given valuation and liquidity uncertainties
  • the process fund managers should follow when evaluating these assets
  • whether and where fund managers may consider using liquidity management tools (LMTs), such as side pockets or similar arrangements, to segregate these assets

ESMA expects fund managers of investment funds with exposures to assets facing liquidity issues to assess whether a fair value of these assets can still be determined and adapt the valuation without undue delay. Fund managers are advised to avoid a one-size-fits-all approach whereby all assets facing liquidity issues are by default written down to zero without giving due consideration to the specificities of each individual asset.

As regards side pockets, ESMA highlights that side pockets might also come with potential risks. It remains the responsibility of the fund manager to perform a comprehensive analysis to ascertain, whether and which of the permissible side pocket arrangements could be implemented in any particular situation and under what circumstances and conditions, carefully weighing the advantages and disadvantages for all investors wishing to subscribe, redeem or remain invested in the fund.

For UCITS, the analysis should demonstrate that the liquid part of the UCITS portfolio is sufficiently diversified to operate in accordance with the UCITS risk diversification requirements. In case the risk profile or the constitutional documents of the UCITS need to be changed, these changes should be reflected in the prospectus of the UCITS accordingly.

The statement is relevant to UCITS management companies and self-managed UCITS, AIFMs and internally-managed AIFs subject to the AIFMD, EuVECA managers and EuSEF managers.

European Commission responses to SFDR/ Taxonomy queries

The European Commission (EC) provided answers to a number of questions in relation to the applicability of the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation (TR).

Topics covered include:

  • principal adverse impact (PAI) disclosures
  • financial advisers and recommendations of financial products
  • the transparency of the integration of sustainability risks and rules for financial products that are no longer made available
  • good governance practices, including financial products investing solely in government bonds
  • the scope of Articles 5 and 6 of the Taxonomy Regulation

We highlight some of the key points for Irish fund management companies and investment funds here.

ESMA's overview of planned consultation papers 2022 includes for Q2/Q3 a review of PAI indicators in the context of SFDR.

ESMA guidance for NCAs on the integration of sustainability risks and disclosures

ESMA published a Supervisory Briefing to ensure convergence across the European Union in the supervision of investment funds with sustainability features, and in combating greenwashing by investment funds.

This briefing aims to help combat greenwashing by establishing common supervisory criteria for NCAs to effectively supervise investment funds with sustainability features. NCAs are encouraged to be proportionate in their supervision, to create checklists based on the information to be provided, and are provided with lists of minimum requirements. The briefing includes:

  • guidance for the supervision of fund documentation and marketing material
    • verification of the compliance of the pre-contractual disclosures
    • verification of the consistency of information in the fund documentation and marketing material: presentation of disclosures; principles-based guidance on fund names; sustainable investment policy and objectives; investment strategy
    • verification of the compliance with the website disclosures’ obligations
    • verification of the compliance with the periodic disclosures’ obligations
    • additional supervisory actions
  • integration of sustainability risks by AIFMs and UCITS managers
  • regulatory action in case of breaches

ESMA report on the Common Supervisory Action on costs and fees for investment funds

ESMA published a report on the Common Supervisory Action (CSA) on costs and fees for investment funds that was carried out with NCAs during 2021. ESMA highlights the importance of supervision in ensuring investors are not charged with undue costs, considering its high impact on investors’ returns.

The CSA report presents the main results:

  • there is room for improvement on the application of the ESMA supervisory briefing on the supervision of costs in UCITS and AIFs, particularly for smaller management companies
  • some questions arise concerning compliance with delegation rules where portfolio managers i.e. delegates, exercise significant influence or even decide the level of costs
  • divergent market practices exist as to what industry reported as “due” or “undue” costs
  • some NCAs discovered conflicts of interest at UCITS managers, in particular in case of related-party transactions
  • in some instances there is a lack of policies and procedures on efficient portfolio management and lack of clear disclosures as required under the ESMA Guidelines on ETFs and other UCITS issues
  • widespread use of fixed fee splits arrangements for securities lending continues, with unfavourable results for retail investors

On the topic of investor compensation, ESMA stresses the importance of ensuring that investors are adequately compensated in all cases where they were charged with undue costs or fees, and also in cases where there were calculation errors that resulted in a financial detriment for investors.

ESMA invites NCAs to consider enforcement actions in the cases where a significant regulatory breach was identified, particularly bearing in mind that the area of costs and fees is a priority due to the high relevance for investor protection.

ESMA's Verena Ross speech at the Irish Funds Annual Global Funds Conference 2022

Verena Ross, ESMA chair, spoke to the Irish Funds Annual Global Funds Conference 2022 on key priorities for EU retail fund investors. The speech focussed on PRIIPs, costs and fees of investment funds and sustainability.

PRIIPs

  • ESMA recommends a broad review of the PRIIPs framework.  Some issues require amendments to the Level 1 text
  • ESMA recommends meaningful consumer testing to calibrate any changes appropriately
  • performance and past performance information in the PRIIPs KID is a key topic 
    • ESMA recommends replacing the current requirement in the PRIIPs regulation for ‘appropriate performance scenarios’ to be shown for all products, with the wording ‘appropriate information on performance’. This would allow more flexibility on the nature of the information provided in the performance section of the KID, and avoid the systematic need to build forward-looking performance scenarios based on modelling, which are not really appropriate for investment funds
    • ESMA recommends allowing past performance to be included in the PRIIPs KID
  • ESMA recommends allowing different approaches between different types of products - provided there remain key comparable elements
  • ESMA recommends that the opportunities provided by digital disclosure are harnessed, for example by allowing information to be presented in a “layered” format

Costs and Fees

  • CSA showed room for improvement in the application of the ESMA supervisory briefing on the supervision of costs in UCITS and AIFs. This was particularly the case for smaller entities which have in place less formalised pricing processes compared to entities managing larger amounts of assets
  • NCAs should address the topic of costs of smaller funds
  • ESMA stressed the importance that UCITS managers perform an independent analysis of the fee structures once those have been established and avoid overreliance on the assessment made by the delegated portfolio manager
  • ESMA stressed the importance of ensuring that investors are adequately compensated in all cases where they were charged with undue costs or fees, and also in cases where there were calculation errors that resulted in a financial detriment for investors
  • ESMA stressed the importance of disclosures. ESMA favour the creation of online calculator tools allowing retail investor to calculate the costs and fees of funds distributed across the EU

Sustainability and greenwashing

  • ESMA acknowledges that the sustainability disclosure framework is incomplete and imperfect at this time
  • The ESAs will shortly publish a statement clarifying several areas of the RTS that have been unclear to market participants
  • ESMA also plans to issue a comprehensive set of formal Q&As after the delegated regulation is published in the Official Journal on the practical application of the rules, covering the SFDR disclosures and the additional taxonomy-related product disclosures 
  • ESMA emphasised that the purpose of Article 8 disclosures is to highlight any kind of environmental or social characteristics promoted by such products – however small it might be.  It is therefore very important that investors do not take the mere presence of an Article 8 disclosure as an indication of sustainability per se. investors need to review the disclosures to determine the actual sustainability characteristics and to what extent the product applies those characteristics in reality in the product’s investment strategy
  • The ESAs will work with NCAs to reduce “over-disclosure” by investment funds under Article 8, to avoid misleading disclosures to investors about the greenness of a product.
  • ESMA supports future legislative efforts to create clear criteria for financial products making sustainability disclosures. For instance, a comprehensive solution could be to introduce sustainability labels for financial products, in order to help generate much needed clarity for retail investors.

Updated ESMA Q&As - ESMA’s guidelines on performance fees in UCITS and certain types of AIFs

ESMA announced that it issued updated Q&A's

  • on the application of the AIFMD
  • on the application of the UCITS Directive

The update to ESMA's Q&A relate to ESMA’s guidelines on performance fees in UCITS and certain types of AIFs

  • The Q&A concerning the performance reference period for the benchmark model has been updated with additional examples aimed at further clarifying the mechanism of compensation of underperformances.
  • A new Q&A on the performance reference period for the hurdle rate model has been added. The new Q&A confirms that the principle in paragraphs 40  and 41 of the Guidelines on performance fees that the length of the performance reference period (if this is shorter than the whole life of the fund) should be set equal to at least five years does apply to the hurdle rate model. The Q&A points out that paragraph 42 of the guidelines clarifies that the only exception to the application of the five-year performance reference period is “the fulcrum fee model and other models which provide for a symmetrical fee structure”.

ECON draft report on proposals for amendments to AIFMD and UCITS Directive

On 18 May 2022, the European Parliament's Economic and Monetary Affairs Committee published its draft report on the proposed Directive amending the AIFMD and UCITS directive as regards delegation arrangements, liquidity risk management, supervisory reporting, provision of depositary and custody services and loan origination by AIFs. The draft report contains a draft European Parliament legislative resolution which lists suggested amendments to the proposed Directive on topics including: 

  • delegation and supervisory reporting
  • LMTs
  • loan origination funds
  • depository services  
  • transparency, data collection and disclosure

PRIIPs KID

The ESAs issued a joint supervisory statement regarding the 'What is this product?' section of the KID for PRIIPs. This will provide helpful guidance for industry. The ESAs identified a range of poor practices in how PRIIP manufacturers describe products under this section. Most issues relate to a general lack of clarity in the text. The supervisory statement provides an overview of these issues and sets out the ESAs' expectations in each area to ensure that information is presented to retail investors in an adequate, clear and accessible manner. Some of the main issues identified include:

  • the use of overly broad, general categories when specifying the type of product
  • poor practices regarding the overall clarity of the language and layout of the text, including as a result of automation in creating such texts
  • insufficient information regarding capital protection levels and potential losses for the investor
  • imprecise descriptions of early termination features
  • lack of clarity concerning the nature and timing of the coupon payments
  • limited information about the specific nature of the underlying assets to which investors are exposed
  • inadequate description of any leverage factors and the risks related to them
  • undifferentiated and abstract descriptions for the 'intended retail investor'

For each of the issues identified, a description is provided of some of the current practices observed, with reference to specific examples drawn from KIDs that are included in an annex, followed by the ESAs expectations regarding how to improve the clarity and comparability of KIDs.

The supervisory statement is addressed to the NCAs.

Also, the ESAs furnished technical advice to the European Commission on the review of the PRIIPs Regulation. This will form part of the Commission’s work to develop a strategy for retail investments and to make appropriate adjustments to the PRIIPs legislative framework. The ESAs recommend appropriate consumer testing before proposals are made to change the PRIIPs Regulation. Recommendations include:

  • harnessing the opportunities of digital disclosure, such as by allowing information to be presented in a “layered” format
  • not extending the scope to additional financial products at this stage, but further specifying the existing scope
  • allowing different approaches for different types of products where this is necessary to ensure the appropriate understanding of retail investors
  • allowing more flexibility on the information provided in the performance section of the KID including the indication of past performance
  • changing the rules for multi-option insurance products to better facilitate comparison between different investments
  • introducing a new section in the KID to give prominence to sustainable objectives

 

ESMA Consultation on RTS/ ITS for the notifications for cross-border marketing and cross-border management of AIFs and UCITS 

ESMA opened a consultation on implementing technical standards (ITS) and regulatory technical standards (RTS) to specify the information to be provided and content and format of notification letters to be submitted to national competent authorities (NCAs). These will be submitted by UCITS, UCITS management companies and AIFMs intending to undertake cross-border marketing or cross-border management activities in host Member States, as well as the procedure for the communication of the notification file by the relevant home NCA to the host NCAs of the Member States where cross-border marketing or cross-border management activities will take place.

This consultation paper includes the draft ITS and RTS at Annex IV. The consultation closes on 9 September 2022. ESMA expects to publish a final report by the beginning of 2023.

​ESMA study on the relatively lower ongoing costs, and better performance, of ESG funds compared to other funds, between April 2019 and September 2021

ESMA published a study looking at the potential reasons behind the relatively lower ongoing costs, and better performance, of ESG funds compared to other funds, between April 2019 and September 2021.

ESMA recently determined that ESG equity UCITS, excluding ETFs, were cheaper and better performers in 2019 and 2020 compared to non-ESG peers.

ESMA looked at some of the potential drivers behind this relative cheapness, and outperformance, of ESG funds, and found several differences between the two categories of funds:

  • ESG funds are more oriented towards large cap stocks
  • ESG funds are more oriented towards developed economies (both these factors correlate with lower ongoing costs)
  • funds targeting institutional clients, passive funds and more recent funds are associated with lower costs (this confirmed previous findings)
  • the analysis highlights some differences in sectoral allocation between ESG and non-ESG funds. ESG funds are for instance more exposed to the healthcare and technology sectors

Even after controlling for these differences, ESG funds remain statistically cheaper and better performing than non-ESG peers. Further research is needed to identify the other factors driving these cost and performance differences.

2021 update of ESMA Guidelines on stress test scenarios under the MMF Regulation

​ESMA issued its 2021 update of its guidelines on stress test scenarios under the MMF Regulation​​ with translations.

The updated elements of the guidelines, (which appear in red in the text) apply from 4 July 2022. The other parts of the guidelines already apply.  The parts in red concern the liquidity discount factor to be used in calculations, credit spreads, interest rate yield shocks, FX shocks.

Proposed regulation on digital operational resilience

The EU Council and the European Parliament reached a provisional political agreement on the proposed regulation on digital operational resilience for the financial sector (DORA). The Council published a press release. The European Parliament also published a press release. 

The new rules aim to ensure a robust framework that boosts the IT security of the financial sector. The efforts required from financial entities will be proportional to the potential risks. Almost all financial entities will be subject to the new rules. Critical third-country ICT service providers to financial entities in the EU will be required to establish a subsidiary within the EU so that oversight can be properly implemented.

The EU Council and European Parliament need to approve the provisional agreement before going through the formal adoption procedure.

EBA advice on non-bank lending

The EBA published a final report setting out its technical advice to the European Commission on non-bank lending, in response to a February 2021 call for advice on digital finance and related issues. The report identifies the specific risks related to the provision of credit by non-bank lenders and sets out proposals to address them.

European Commission call for evidence on retail investment legislative package

The European Commission published a call for evidence as part of its retail investment strategy. The aim of the strategy is to improve market outcomes and increase consumer participation in capital markets. The document is accessible on the Commission webpage.

European Commission consultation on use of benchmarks administered in a third country

The European Commission published a consultation paper to seek views on possible improvements to the functioning of the BMR, specifically relating to the rules applicable to non-EEA benchmarks and the impact on market participants of the full entry into application of the third-country regime from 1 January 2024. The targeted consultation is aimed in particular at benchmark administrators (located both in the EU and in third countries), EU supervised entities that use benchmarks, and businesses and investors that are end-users of benchmarks for investment, hedging or other purposes. The consultation closes on 12 August 2022.

European Commission proposal for distance financial services contracts

The European Commission published a legislative proposal that it has adopted, for a directive concerning financial services contracts concluded at a distance. The proposed directive will repeal the Distance Marketing Directive and transfer the framework for consumer protections relating to financial services distance contracts to the Consumer Rights Directive. The EU Council and the European Parliament will now consider the proposal.         

Wolfsberg FAQs on negative news screening

The Wolfsberg Group published frequently asked questions (FAQs) on negative news screening (NNS).

The FAQs set out considerations for financial institutions when establishing their NNS framework.

  • applying NNS as part of a risk-based approach to AML/CTF
  • documenting a risk-based approach to NNS, taking into account the legal and regulatory requirements in the jurisdiction(s) in which the financial institution operates
  • ensuring that NNS processes are both effective and efficient
  • providing guidance on assessing the reliability of NNS sources and the materiality of NNS results as well as the configuration of screening systems, alert management, and associated governance

Please speak with your usual contact in the Asset Management & Investment Funds team if you would like more detail on this topic. 

Date published:   2 June 2022