A short but important ESMA Discussion Paper was issued at the end of December entitled "Share classes of UCITS". It seems to go to the question "What is a sub-fund?" as much as "What is a share class?"
It all used to be very simple with single UCITS funds with a single pot of assets and a basic selection of share classes – essentially only income and accumulation options. With the popularity (and indeed now predominance) of umbrella funds with a number of sub-funds and the proliferation of share classes, it seems from the ESMA Discussion Paper that some products being established in the market place now have lost some of the basic notions of a UCITS retail investment fund.
To set out the essential intended basic features of a UCITS umbrella:
- the product is the sub-fund;
- the sub-fund has an investment strategy and a single pot of assets,
- the sub-fund then offers its investors exposure to returns on that pot of assets,
- with the investors' interests in those returns being calculated by reference to proportionate interest accounts assessed by reference to the respective rights attached to their shares on the various share classes, and
- it should not be possible for one share class to operate so as to have an adverse impact on the investors in another share class.
For relatively straightforward differential share class features, the "no adverse impact" on other shareholders should not prove to be a challenge.
Typically there may be a number of different share classes with different features. Most features are typically concerned with eligibility - the type of investor or minimum investment levels - and so consequent charging structure, the variety of charging structures (e.g. performance fee or not) and differences on income allocation policies are the most common. These have little scope for one share class to prejudice another share class.
For UK authorised funds, you may, quite rightly, assert that all of the above is clearly already recorded in COLL 3 and, when hedged unit classes were added, particular paragraphs were added in COLL 3.3.5A and 3.3.5B accordingly. However, this is clearly different from the case in some other EU fund domiciles.
The examples of the share classes which are not thought to be compatible for share classes of a sub-fund of a UCITS, set out in Paragraph 10 of ESMA's Discussion Paper would be unlikely to arise in the UK. Those set out as not being compatible with the relevant UCITS principles in the ESMA Discussion Paper include:
- share classes that are exposed to different pools of underlying assets,
- share classes where the same underlying portfolio is swapped against different portfolios of assets,
- share classes that differ in terms of leverage,
- share classes that offer differing degrees of protection against some market risks, such as interest rate risk or volatility risk, and
- share classes that are exposed to the same pool of assets but with a different level of capital protection and/or pay off.
One key question for you to consider is whether the ESMA view is right that they can, on the one hand, sympathise with currency hedged share classes and so consider they are allowable (with add on costs of the currency hedging for the amount of the relevant hedged share class) but, on the other hand, think that interest rate hedging performed at the level of share classes is not appropriate. Should not a similar "add on feature" approach be supportable?
Another key question is whether, given the analysis in ESMA's paper, it needs to be emphasised that the product is indeed the sub-fund with its investment portfolio. With the emphasis on share classes, for example in the KII documents and now in this paper, they may be unhelpful?
Nonetheless, given the costs of running multiple sub-funds/share classes, it is important that the conclusions reached on the ESMA Discussion Paper are pragmatic, although not add to the risks of UCITS funds. Most of the "offending" share classes would appear to be established outside of the UK but it is important that UK managers, which normally operate UCITS in two or three of the EU's fund domiciles, indicate why they should wish to have different share classes and what should and should not fall within the permissible and impermissible categories.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.