ALFI UCITS IV implementation project – KID Q&A Document

Q. CESR’s guidelines on the selection and presentation of performance scenarios in the KID for structuredUCITS (CESR/10-1318, Box 2, paragraph 4.) state that “the examples used in favourable and unfavourablescenarios shall be based on reasonable assumptions about future market conditions and price movements”.How can a practitioner decide what is reasonable in the context of the long-running global financial crisis,when there is so much uncertainty and so little consensus about the future?A. There can be no easy answer to this question. To the extent that the UCITS relies upon a counterparty to provide aguarantee, we think that it would be reasonable to exclude the failure of that counterparty from the illustration of theunfavourable scenario provided that the counterparty risk is nevertheless disclosed as one of the specific risks in therisk section of the KID and that the UCITS or its management company has contracted the guarantee diligently andensured that the counterparty is a good credit risk. Thereafter, it may be possible to say that if the UCITS offers acapital guarantee, the unfavourable scenario should ensure that the effect of that guarantee is demonstrated and thatthe favourable scenario is not indefensibly optimistic. In all other cases, the detail of scenarios is a matter for thepractitioner to decide in its sole discretion, taking account of the features of the payoff formula and the need toillustrate the performance of the product without creating a mis-selling risk. We note that Art 36(5) of the EURegulation 583/2010 requires the performance scenarios to use "reasonable and conservative assumptions aboutfuture market conditions and prices," (ALFI's emphasis) and that the potential for substantial losses must be illustrated,even if the probability of that outcome is low.Q. CESR’s guidelines on the selection and presentation of performance scenarios in the KID for structuredUCITS (CESR/10-673, Box 2, 7.) state that “the scenarios shall represent information which is complementaryto and consistent with the information in other sections of the KII”. Should the performance scenarios beupdated when the SRRI has changed?A. Art 22(3) of EU Regulation 583/2010 requires, "a review [of the KID to] be carried out prior to or following anychanges regarded as material to the information contain in the [KID]." A change to the SRRI category would be such achange and the consequent review of a structured UCITS' KID should include a review of its performance scenarios. Itis for the practitioner to decide whether it needs to update the performance scenarios; the change of the SRRI doesnot create a direct obligation to do so.Q. CESR’s guidelines on the selection and presentation of performance scenarios in the KID for structuredUCITS (CESR/10-1318, Box 2.8) say, “When relevant, the scenarios shall be updated: … Where marketconditions have changed significantly since the launch of the UCITS; … At least on a yearly basis; ….” Whatare significant changes of market conditions?A. The CESR guidelines do not provide a definition for “significant changes of market conditions.” Changes in riskfactors which could impact the payoff of the specific product (and that have already been identified within the design ofthe scenarios) should be monitored and may require the scenario to be updated. For example, if some option conditionhas been realised, one or more scenarios which represented it as a potential future event may need to be revised inthe light of it having been realised. The definition, implementation and documentation of this monitoring process is forthe management company to decide in its own discretion.Q. CESR’s guidelines on the selection and presentation of performance scenarios in the KID for structuredUCITS (CESR/10-1318, Box 3.3) state the following: “The illustrative returns in the various scenarios shall bedisplayed as an annualised rate of growth (with an appropriate explanation). However, the [capitalised/gross]rate of growth may also be shown.” Should inflation or the time value of money also be taken into account forfunds whose maturity date is still sufficiently far away?A. We do not think that it would be sensible to include the time value of money into the illustration. Average retailinvestors would probably not understand the concept and it may reduce the comparability of the fund with otherstructured funds whose KIDs might not be prepared on that basis.ALFI KID Q&A, Issue 1314, 11 April25 September 2012 Page 46