Analysing UCITS III risk

The introduction of UCITS III has not led to a marked increase in fund volatility over the five years from 2002 to 2006. These are the results of a European Commission study.

When analysing the risks of UCITS funds before and after the UCITS III Directive which allowed use of a wider range of assets, especially derivatives, there is no significant difference in quantitative market risk (as expressed by the volatility). That being said, there is an increase in qualitative risks (or operational risks).

For sure, all asset classes of funds (with the exception of real estate) have experienced one year of negative returns between 2002 and 2006. But this is the case for funds launched both before and after the 2002 directive.

These are the headline results of the study performed by PricewaterhouseCoopers and entitled: ‘Investment funds in the European Union: Comparative analysis of use of investment powers, investment outcomes and related risk features in both UCITS and non-harmonised markets’ . Published in February 2008, it evaluates the investment outcomes (performance and related risks) of UCITS and non-UCITS funds over the five past years. The study takes also stock of how UCITS managers have used the new investment possibilities offered by UCITS III directive (much wider range of eligible assets, use of derivatives for hedging and leveraging purposes, new types of investment strategy allowed such as index-based investing, fund of fund strategies).
One of the main results is that the increased use of derivatives has been matched by neither greater volatility, nor better performance nor higher level of leverage in comparison with other analysed funds.

Volatility unchanged

Of the 380 UCITS funds from nine countries surveyed, even those that used derivatives intensively showed no greater price volatility than those that did not. The 150 non-harmonised, or non-UCITS, funds were less volatile, but this may have been due to less regular valuation, which has the effect of smoothing returns. While UCITS funds are valued daily, non-harmonised funds are often valued as infrequently as once a month.

The portfolio composition of funds analysis shows an effective use of the wider investment powers introduced by the UCITS III directives and the use of derivatives also seems to be more intensive both in terms of derivatives lines but also of the range of derivatives type. The proportion of funds that extensively uses derivatives (defined as more than 200 lines) remains however limited. It can also be noted that UCITS funds present a higher degree of sophistication than for non-harmonised funds.

The study examines also the risks associated with the use of enlarged investment powers such as leverage risk, valuation risk, liquidity risk and counterparty risk. The survey finds that fund managers develop strong risk management procedures before launching new, more complex products. Asset managers consider the suitability of their funds for retail investors as well as the risk management process they need before launching such funds. However, some operational risks specific to OTC derivatives did appear to have grown.
Another area for improvement is the liquidity analysis which is not always done for authorized products as shown in the graph below.



Legal differences

The study identified some differences in individual countries’ legal frameworks governing UCITS, which could impact portfolio compositions, and showed that supervision has yet to be harmonised completely. From a regulatory perspective, regarding the greatest variation related to the 10 % basket of unlisted investments, France appeared to have the most flexible approach to this, with Luxembourg a close second.


Regarding derivatives, the authors of the study observed differences in the following areas:
• Definition of sophisticated funds and their distinction from non-sophisticated funds
• Commitment approach used for calculating the global exposure to derivatives for non-sophisticated funds
• Parameters imposed by regulators for calculating Value-at-Risk
• Potential leverage limitation for sophisticated funds
• Method for calculating counterparty risks for OTC derivatives

According to respondents, however, this lack of harmonisation does not lead to regulatory arbitrage.

Looking forward

The results of the study showed how UCITS III has affected fund risks during the legislation’s first five years. Clearly, the UCITS III framework provides a flexible environment and allows managers to implement innovative strategies.
The results also showed a marked increase in the creation of sophisticated funds in 2007, following the publication of the Eligible Assets Directive, which clarifies UCITS III rules. Yet, how this will change the risk picture in the future still remains to be seen.


En bref

L’introduction de la directive UCITS III n’a pas engendré d’augmentation marquée de la volatilité des fonds au cours des 5 années allant de 2002 à 2006. Ce sont les résultats d’une étude réalisée par PricewaterhouseCoopers pour la Commission européenne et publiée en février 2008. Son objectif : évaluer les rendements d’investissements (performance et risques associés) des fonds coordonnés et non coordonnés au cours des 5 dernières années ainsi que de mesurer l’utilisation faite par les gestionnaires des nouvelles possibilités d’investissement offertes par la directive UCITS III.
L’étude montre un recours plus important aux produits dérivés dans la composition des portefeuilles des fonds, qui n’est néanmoins suivi ni d’une plus grande volatilité, ni d’une meilleure performance.
Une analyse des risques encourus avant et après l’introduction de la directive révèle que les fonds coordonnés qui font beaucoup appel aux produits dérivés ne présentent pas un niveau de risque de marché plus élevé. Par contre, les risques opérationnels ont augmenté. L’étude montre néanmoins que les gestionnaires, soucieux de leur responsabilité vis-à-vis des clients retail, développent de solides procédures de gestion des risques avant de lancer de nouveaux produits complexes.
Par contre, depuis 2007 et la publication de la directive sur les actifs éligibles, qui clarifie certaines dispositions de UCITS III, on note la création plus importante de fonds sophistiqués. L’impact sur les risques encourus reste encore à analyser.