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Peter Ainsworth, Managing Director, EM Applications

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Comment: New UCITS rules on VaR will hurt investors

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At a time of high market volatility, the latest consultation by the Committee of European Securities Regulators (CESR), which closed on 31May 2010, would allow UCITS funds to be twice as risky as the riskiest equity markets, says Peter Ainsworth (pictured), Managing Director of EM Applications, a supplier of investment risk solutions to asset managers and securities firms.

These new rules pose significant risks for investors and could severely damage the reputation of UCITS funds, a globally trusted regime. Furthermore, the range of Value at Risk (VaR) calculated during a year will be at odds with the risk figure published in the “Key Information Document”. In a period when many investors are relying on UCITS funds as a safe investment choice, this is confusing and misleading.
 
Following the credit crunch CESR has been reviewing the rulebook on the use of VaR for UCITS funds.  Its latest consultation proposes to let funds use a “Relative VaR” measure with a maximum ratio of two. This means a UCITS fund would be permitted to have twice the risk of, e.g., a technology or emerging markets index. Think of the losses made by some technology funds in 2000-2003, double them, and it’s hard to believe that this is deemed suitable for the investing public.  Ironically, investor protection is a key purpose of the UCITS rules and they have, over the years, become a trusted standard not just in Europe but around the world, leading many investors to consider a UCITS-branded fund a safe choice.  
 
In recent weeks even mainstream developed market indices have seen daily moves of the order of five per cent, implying a UCITS fund with a relative VaR of two would be changing in value by as much as 10 per cent in one day.  Clearly, a fund where the investor could lose 10 per cent of their capital in one day is not a safe investment. Allowing very high risk funds to operate under the UCITS cover has the potential to undermine investors’ trust in UCITS funds, leading to a reduction in overall investment levels and widespread economic damage.
 
The forthcoming UCITS IV “Key Information Document” (KID) is designed, i.a., to facilitate investors’ understanding of the risk of different funds. It will include a single number between 1 and 6 to indicate a UCITS fund’s risk level. However, the risk will be measured over the past five years and will not consider current market conditions or the current make-up of the UCITS investment portfolio.  Consequently, the KID’s risk indication will be very different from the VaR measure, which is calculated to estimate the risk over the next month and takes the current investment portfolio into account. As managers must report the highest and the lowest VaR in the funds’ annual reports, investors will notice that their fund’s actual risk is quite different to that set out in the KID. This will confuse investors and further undermine their confidence in the reliability of UCITS.
 
EM Applications is critical of CESR’s proposals.  The firm compares the situation with one where the EU might be trying to reduce road accidents but is doing so by limiting the number of gears in a car, banning fourth and fifth gear, but not limiting the speed (revolutions per minute) of the engine.
 
The only effect of this would be to make cars less efficient, burning more fuel and wearing out engines faster, without any impact on speed – the factor that contributes to accidents, as drivers can simply push their engines harder.  What’s more, in communicating how fast a car can go, the maximum speed of another, older model of car, is published. Clearly, if it is speed that contributes to risk then it is speed (VaR) that should be regulated, not gearing (Relative VaR). What investors need to know is how fast the car can go (VaR limit), not how fast an older model could go (KID risk indicator).
 
Controlling risk and communicating the magnitude of potential losses to investors are crucial for the future success of the UCITS brand. If the rules allow a fund to be twice as risky as a high risk index, it is certain that somebody will launch such a fund. It is equally certain that, at some point, investors will suffer catastrophic losses. Combined with different risk measures being used by the manager and communicated to the investor, it’s a recipe for letting investors down and damaging the reputation of the UCITS brand.

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