Derivative reporting and disclosure review
Derivatives can introduce particular risks into funds and it is important that investors are aware of these risks.
UCITS funds that use derivatives need to report their use to us. Managers of these funds will also need to provide investors with information on the derivative-related risks present in these funds.
Leverage disclosure
We reviewed a sample of 19 funds that used derivatives for investment purposes. We looked at whether derivative leverage was being appropriately disclosed in the key investor information document (KIID), annual report and prospectus.
In many cases we found that investors are not receiving adequate information about leverage. ESMA (CESR) guidelines[1] (PDF) set out expectations for disclosing the level of leverage being deployed, the risk this presents and the limits for leverage.
Only 11 out of 19 funds described the risk of leverage in their prospectus, while only five disclosed the expected leverage level. The actual level of leverage was disclosed in the annual report of only one fund and only two KIIDs provided clear descriptions of the risk associated with leverage.
We focussed on leverage disclosure, but other risks also associated with derivative use means firms should:
- consider their disclosure of derivative risks more broadly to ensure they are clear, fair and not misleading
- ensure investors are clearly informed of important risks
- decide whether leverage represents a material risk to the fund and if so, whether it should be disclosed in the KIID
Derivative risk management process reporting
Fund supervision relies on detailed and accurate data to focus our work on the most relevant funds. Derivative risk management process (DRMP) reporting is an important step in this approach.
Our review found that the majority of firms do not submit details of their derivative risk management process (DRMP) to us.
You have to submit DRMP details to us at least annually (see COLL6.12.3R). These should be submitted to us at [email protected].
Valuation and liquidity oversight review
Poorly performed valuation and liquidity management have the potential to cause considerable harm to investors.
Valuation and liquidity management is more difficult in some types of fund, including funds that invest directly in properties.
Property valuation is difficult as properties are rarely bought and sold, so a market price is often not available. The time it takes to sell a property and the lack of demand in some market conditions can make physical property a particularly illiquid asset.
Our review of seven funds and three depositaries therefore focused on direct property funds to explore trustee and depositary oversight of valuation and liquidity management.
Property valuation oversight
We found that all trustee and depositaries relied on a single standing independent valuer for the valuation of physical properties.
One trustee/depositary compared changes in property valuations to changes in a relevant benchmark, which provided a form of independent check on valuations.
Another depositary/trustee did not perform additional checks on valuations, which is being followed up by supervision.
Trustees and depositaries are required to take reasonable care to ensure that all scheme property (including real property) is appropriately managed, including its valuation (COLL 6.6.4R (1)).
This will include some form of check of valuations to ensure they are accurate (e.g. comparing valuations against a relevant benchmark or checking a sample of valuations).
Liquidity monitoring oversight
Depositary and trustee monitoring of liquidity varied greatly across the property funds in our review.
One firm gathered detailed monthly information on liquidity including the level of liquid assets and an assessment of the risk of large redemptions by looking for concentration within the investor population. This trustee/depositary also monitored long-term redemptions to identify any consistent outflows that might cause liquidity issues.
Another firm performed no liquidity monitoring and so did not meet its requirements. This firm has since implemented liquidity monitoring.
Liquidity monitoring is important for all funds. For alternative investment funds, depositaries must verify the effectiveness of processes and procedures that the alternative investment fund manager (AIFM) is responsible for (see AIFMD Level 2 Regulations Article 92 and Level 1 Regulations Article 16).
Trustee/depositaries should therefore perform liquidity monitoring in proportion to the liquidity risk in the fund, particularly for less liquid funds. This oversight provided by trustees/depositaries directly contributes to the protection of investors.
Trustees and depositaries reporting agreement
We have agreed with trustees and depositaries that they will regularly report to us fund breaches and summaries of visits to authorised fund managers.
We will use the information provided by trustees and depositaries with other data to build our understanding of the UK authorised investment fund landscape.
This reporting does not alter authorised fund managers’ obligation to directly inform us of significant events.
This agreement is the result of a working group made up of the Depositary and Trustee Association, Investment Association and us.