17 December 2012

Rita Laura D'Ecclesia: Improving the European Commission's PRIPs proposals

UCITS IV KID

The UCITS IV KID is not a valid benchmark for the PRIPs KID. The information required in the UCITS document is incorrect, incomplete and often misleading for three reasons.

First, the synthetic risk-return measure is based on volatility data that is "downward flattened". This is because the depth of the series of returns that is normally used is for a long time horizon (five years), and typically weekly returns are analysed. This results in a risk rating that systematically underestimates the risk of the product and distorts the riskiness of the investment at the subscription date.

Second, the KID requires the representation of possible outcomes (performance scenarios) done by a ‘what-if' deterministic method. Consequently, the provider of the fund is required only to present the product payout according to three hypotheses (market neutral, favourable and unfavorable).

This approach cannot be considered scientific or fair. In an uncertain world, risk is, by definition, measured using probability theory, which simply cannot be replaced by deterministic methods. The ‘what-if' approach provides incomplete information on potential returns since it gives no information on the probability of each outcome. The provider can then show only three of a possible infinity of outcomes, each selected at his convenience without giving any useful information on the likelihood of its occurrence, while the retail investor could be led to think the three scenarios cover all possible outcomes and perceive them as equally probable.

Third, the UCITS IV KID provides no indication of the optimal investment time horizon, which is crucial information for retail investors.

Performance scenarios

The proposal introduces performance scenarios when they are relevant for the nature of the product. This is still too vague, since despite not insisting on a ‘what-if' approach, it fails to suggest any other methodological approach.

Hopefully, the details can be defined in the Regulation's implementing measures. I would suggest performance scenarios should be applied to all PRIPs rather than just some. By definition, PRIPs are packaged products with varying degrees of sophisticated financial engineering, so a representation of the performance scenarios is useful. The July proposal states that all PRIPs "seek to address a simple need relatively: capital accumulation that beats the risk-free rate", and that is the common denominator to all PRIPs.

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