Risk Management for UCITS funds: a long and slow but irreversible process

The Committee of European Securities Regulators (CESR) has recently (August 2008) released its Consultation Paper on Risk Management Principles for UCITS funds. Although it is true that the European legislation in that field is rather limited, Luxembourg has had its own legislation in place since August 2007: the 07/308 CSSF Circular provides rules of conduct to be adopted by UCITS funds with respect to the use of a method for financial risk management, as well as the use of derivative financial instruments. But what kind of risks are the UCITS funds facing? Do the current regulatory requirements capture all risks? Are there different approaches between the CSSF and the CESR? Let’s try to elaborate some answers.

Scope of the 07/308 CSSF Circular.
Although UCITS funds are exposed to a multitude of risks, the Circular exclusively deals with the global exposure (restricted solely to the market risk), the counterparty risk, the concentration risk and the valuation risks arising from OTC derivatives. The other risks (mainly operational risk, settlement risk and legal risk) are not directly addressed in the Circular and “must be the subject of adequate supervision at the UCITS funds level”.

Scope of the CESR consultation paper.
The CESR paper deals with financial risks (market, credit [a.o. concentration], counterparty and liquidity risks) and certain operational risks (those that also affect investors’ interests by their direct impact on the fund’s portfolio).

Market risk limits in the current regulation: a license to kill (limits)?
Both the CSSF and the CESR have defined a market risk limit system consistent with UCITS funds’ investment strategy and covering all risks to which a limit can be applied. The CESR goes further than the CSSF. The risk management policy has to define procedures that, in the event of breaches to the risk limit system of the UCITS funds, result in a prompt (use of triggers / exceptional warnings) correction of the portfolio and provide for the timing of this. Unfortunately, it is unclear how to specifically proceed in case of a breach of these limits. Neither the CSSF nor the CESR propose an appropriate escalation procedure.

Appropriate escalation procedures could be set as follows. Based on the assessment of the risk profile, a maximum internal limit shall be defined:
- The first internal warning level could then be set to 75% of this maximum internal limit. In case of breach, the investment manager shall be informed and asked for explanation,
- The second internal warning level could be set to 85% of the maximum internal limit, whereas in case of breach the investment manager as well as the conducting persons have to be informed. The investment manager has to explain the breach and the conducting persons may force the investment manager to reduce the risk exposure within a certain time frame,
- When breaching the maximum limit (third internal warning level), the investment manager, the conducting persons and the board of directors have to be informed. The board has to decide what actions have to be undertaken within what time horizon.

If the maximum internal limit is set below the applicable regulatory threshold, this escalation process prevents the UCITS fund to breach a regulatory limit. This procedure would consequently provide all relevant stakeholders with clear rules of conduct. Nevertheless, if a regulatory market risk limit is breached, the UCITS fund should define beforehand how to escalate. As the regulation does not define a clear process, it is up to the UCITS funds to do so. Minimum action which should be taken would be to inform the external auditor and provide them with the specificrisk exposure and the action plan which has been decided upon by the board.

Liquidity: far from WaterWorld.
Generally speaking, the liquidity of an asset reflects its capacity to be converted into cash quickly and without any price discount. But as far as UCITS funds are concerned, liquidity is also the ability for a UCITS fund to meet, at a reasonable cost, its obligations (redemptions or debt reimbursement) as they become due. The 07/308 CSSF Circular simply states that the UCITS funds shall ensure that its global exposure is calculated according to the time available to liquidate the positions. The CESR is more explicit about liquidity and mentions (without any explanation) methods to foresee and measure it.

Unfortunately, for liquidity risk, the market does not have a well developed measurement tool like Value at Risk (VaR) for price variation risk. Some theoretical essays exist trying to mirror the market risk assumptions to liquidity risk assumptions. But the models behind are much more complex as liquidity does not follow a normal distribution, which prevents liquidity VaR models from being easily applied.

Nevertheless, there are a few techniques which could help capture any tendency for illiquidity and which could prepare the UCITS funds to react in a more efficient way:
- Liquidity on instrument level. The more illiquid an asset is, the wider the bid offer spreads (We suggest monitoring all bid-offer spreads for UCITS funds’ investment instruments. When reaching a predefined limit, these instruments should be put on a watch list. Moreover, liquidity stress tests could be performed: by defining a liquidity ratio for all instruments or instrument classes and then stressing this ratio, the tests could simulate a potential loss of the portfolio when instruments or instrument classes become illiquid. These tests could also show how much illiquidity a portfolio could bear before the investment manager is unable to follow his initial strategy. The liquidity ratio should rely on different factors such as the outstanding volume of shares compared to the owned shares, the trading volume per day, the time to sell a certain amount of an instrument on the market, etc. ,
- Liquidity on UCITS funds level. If a UCITS fund is facing large redemptions, the fund may be subject to liquidity risk although the market and/or the instruments in which the fund has invested are not subject to illiquidity at all. This kind of illiquidity risk is highly linked to reputational risk. If investors suddenly lose their trust in the market (other suggestion replace “trust in the market” by “confidence”), they will try to redeem their shares. If too many investors do so, the UCITS funds may be forced to sell instruments which are core to sustain the fund’s strategy in order to satisfy the outstanding redemptions. Again, creating a dedicated stress test scenario resulting in an amount of redemptions the UCITS funds may bear without modifying their core strategy, would be key.

These methods for sure can only help in understanding a given portfolio’s sensitivity to certain liquidity movements. Nevertheless the market will inevitably have to develop further more sophisticated methods in order to measure and control the liquidity risk.

Conclusion. There is a clear tendency to enhance Risk Management within the UCITS funds and to emphasize the importance of dealing with risk when addressing the fund management, valuation or compliance issues. Being informed and sensible about potential threats and not only sticking to the fulfillment of regulatory requirements should make the difference, for UCITS funds… and investors.