January 30, 2013 - In a summary document that concludes three years of research on better management of non-financial risks within the European fund management industry – conducted with the support of CACEIS – EDHEC-Risk Institute is putting forward a series of proposals to limit these risks which emerged during the 2007-2008 crisis and undermined the quality of the UCITS label.
For EDHEC-Risk Institute, the sophistication of UCITS is one of the principal causes of a rise in non-financial risks. These risks are not the direct result of positions taken by funds on financial markets and for which they receive a reward proportional to their exposure, but rather produced by the operation of the value chain of the collective investment management industry itself.
This analysis also leads to the conclusion that current regulation (AIFMD, UCITS V, MiFID II, IMD II, PRIPS and EMIR), even if it does contain some very positive elements in terms of investor protection against non-financial risks, will not really solve the problem. On the contrary, such security-related discourse pushing for restitution of assets guaranteed by the depositary, which in reality would only relate to a portion of these assets, would give less sophisticated investors, particularly retail investors, a false sense of security, thus leading them to select their funds without taking into account any of the associated non-financial risks. On the other hand, the emphasis put on the depositary's obligation to return assets (AIFMD and UCITS V) does not directly encourage other stakeholders in the value chain to contribute to the improvement of information and to manage non-financial risks better.
In order to deal with this, and add a new dynamic to the UCITS label, EDHEC-Risk Institute recommends the implementation of regulation and promotion of better practices with regard to non-financial risk. These proposals can be categorised into three major themes.
The first recommendation relates to the reinforcement of information on non-financial risks, particularly with a requirement for the Key Investor Information Document (KIID) to contain a description of gross risk exposure and how to manage these risks, as well as a synthetic indicator of the fund's net risks. In the same vein, the duty to advise, as prescribed within MiFID, would be reinforced with respect to non-financial risks.
The second recommendation aims to increase the responsibility of all actors within the fund management industry. This new system of shared responsibility breaks with the idea that depositaries can protect investors from all non-financial risks, which are often taken by fund managers. It will lead to the creation of incentives to better manage non-financial risks by associating the level of required regulatory capital with the level of residual non-financial risk taken by the major players in the value chain. In this perspective, EDHEC-Risk Institute does not favour the idea of extending the Investor Compensation Scheme Directive (ICSD) to UCITS: its excessive cost and failure to effectively take risks into account lead, at best, to a lack of accountability among actors and, at worst, to opportunistic risk-taking (moral hazard).
Lastly, with what is probably the flagship proposal of this study, EDHEC-Risk Institute recommends that as a reaction to the sophistication of UCITS, made possible by the evolution in regulations (UCITS III, EAD) and exploited to the absolute limit by NewCITS, a level of sophistication which potentially exposes investors to greater non-financial risks, a new label of "Restricted UCITS" be created. This would establish a UCITS category with a scope for investment that is limited to what the depositary can actually hold and thus return without difficulty, thereby ensuring that the depositary would be able to benefit from a total guarantee. This "Restricted UCITS" label would allow UCITS funds, which would rightly benefit from a secure image, to be marketed not only to European retail clients, but also on a global platform.
