ALFI UCITS IV implementation project – KID Q&A Document

Q. It may be hard to tell apart absolute return funds and total return funds. How should a practitioner do thatfor the purposes of applying CESR's SRRI methodology?A. We think that a combination of quantitative and qualitative techniques may be used to establish the classification ofthe fund. Absolute return funds have a tendency to be neutral with respect to systemic market risks whereas totalreturn funds depend on those risks for their returns. From another perspective, absolute return funds may be expectedto have a low correlation with a relevant index or basket of indices whereas a total return fund may be expected to bemore correlated. The investment company's or management company's decision on the fund classification should becarefully documented and applied consistently across its fund range.Q. Could two absolute return funds that are the same in all respects except that one is guaranteed and theother is not have different SRRI classifications?A. No.Q. Take an example of two absolute return funds with identical portfolios and NAV history but only one ofwhich is guaranteed. In what circumstances could the guaranteed fund have a higher SRRI classification thanthe fund without a guarantee?A. The guaranteed fund would have a higher SRRI classification if its risk limit is higher, since the SRRI for anabsolute return fund is a function of "the greater of the actual annualized volatility and the volatility that is consistentwith the risk limit adopted by the UCITS" (CESR/10-673, Box 5, para 2).Q. In CESR/10-673 Box 6, total return funds are defined by reference to reward objectives. How can thisreward objective be defined? Is it relative (e.g. maximum participation on index given some restrictions) orabsolute (e.g. 5% p.a.)?A. We think that a definition of reward objectives is equally acceptable in absolute terms or in relative terms. However,as the relative strategy increasingly replicates faithfully not only the performance but also the fluctuation of a givenbenchmark (that is, as the reward objective tends towards the performance of the benchmark + 0%), so it is morelikely that the condition “flexible investment in different financial asset classes” is not fulfilled. In that case, practitionersshould consider classifying the fund as a market risk fund.Q. The SRRI methodology for total return funds requires the practitioner to compute "the annualized volatilityof the returns of the pro-forma asset mix that is consistent with the reference asset allocation of the fund atthe time of the computation." Does this mean that the practitioner must use the fund's reference allocation orits actual allocation and must the computation be based upon a line-by-line analysis of the portfolio or couldit be based upon suitable indices? For example, if the fund's pro-forma asset mix is equities, bonds andalternatives and a suitable index exists for each, could those indices be used with appropriate weights tocalculate the annualised volatility of returns?A. The concept of a "reference asset allocation" is not defined in CESR/10-673 and is not clearly understood within thecontext of the SRRI methodology but we understand it to mean the portfolio that the fund may be expected to holdunder certain conditions. We think that paragraph 2(a)(ii) of Box 6 means that the practitioner should base thecomputation on the actual asset allocation (i.e., the actual portfolio), since that is what will produce an SRRI that isrepresentative of the fund "at the time of the computation."The practitioner may base the computation at Para 2(a)(ii) of Box 6 on the price history of each security in the portfolio.However, it may be more efficient and equally valid to use indices with appropriate weights, provided that each indexis an acceptable proxy for the relevant component of the fund's portfolio at the time of the computation. It must beemphasised that we consider that this approach can only be valid if it conforms to the principles of CESR's guidelines.For example, the mere fact that an index does not have a full 5-year price history would be enough to invalidate it forthese purposes. It may also be possible to derive the annualized volatility from the fund's VaR model, provided that itis suitable (for example, see page 11 of CESR/10-673). Parametric VaR models are unlikely to be suitable.Q. According to CESR/10-673 Box 6, total return funds require a pro-forma asset mix. Is it necessary to repriceoptions (with less than five years history) in order to be reflected in the volatility calculation of the pro-formaasset mix?A. Yes, if the options are likely to have a material impact on the SRRI. The assessment of materiality could rely on theoption weight within the portfolio, but should also take account of risk features (small weights within the portfolio do notnecessarily imply small contributions to risk).If the options are considered likely to have a material impact on the SRRI, the following limitations should be kept inmind as they are repriced:Historical time series of implied volatilities may not be available for all instrumentsALFI KID Q&A, Issue 1314, 11 April25 September 2012 Page 43