There are specific UCITS rules relating to what will be acceptable as a permitted financial index underlying a financial derivative instrument. The requirements are that the index:
- must be sufficiently diversified;
- must represent an adequate benchmark for the market to which it refers;
- must be published in an appropriate manner; and
- must be managed independently from the management of the UCITS.
The Central Bank has issued a specific Guidance Note addressing those requirements in detail, as explained below.
(i) Prior Approval Required
It will be necessary to submit the relevant index to the Central Bank for prior approval if (a) the index is comprised of ineligible assets or (b) the index is comprised of eligible assets but it would not be possible for the UCITS to invest directly in such underlying assets without breaching the UCITS risk spreading limits (assuming the UCITS does not wish to apply a look through approach). With any such submission it will be necessary to demonstrate to the Central Bank that the index meets the four prerequisites listed above, and explained further below.
(ii) Sufficiently Diversified
The general rule relating to diversification of a UCITS portfolio is the 5/10/40 rule which refers to maximum permitted exposures per issuer. This is principally relevant to portfolios of transferable securities and money market instruments but does have relevance to UCITS which use commodity indices for risk diversification as opposed to trackers.
The UCITS III Product Directive did not explain how the general diversification rules would apply to indices based on non-eligible financial instruments such as commodity futures but this issue was addressed in the CESR advices of January 2006 where CESR noted that in the case of FDI on financial indices based on noneligible assets that the rules be "adapted to the specific risk of such financial indices". CESR suggested the following approach:
- where FDI on an index composed of non-eligible assets are used to track or gain strong exposure to the index, the index should be at least as diversified as set out under the diversification ratios of Article 22 (a) (the 20% weighting and 35% weighting);
- where FDI on an index composed of non-eligible assets are used for risk diversification purposes, provided the exposure on the individual commodity indices complies with the 5/10/40 ratios, there is no need to look at the individual components of these indices to ensure that they are sufficiently diversified.
That 20%/35% rule allows for a maximum exposure of 20% per issuer with capacity for the Central Bank to permit one holding to go above 20%, as high as 35% "where that proves to be justified by exceptional market conditions". In other words, these higher limits will be available per commodity exposure for UCITS seeking to track or take a high exposure to a commodities futures index. In its January 2006 advices, CESR stated that when assessing these diversification ratios, components which are highly correlated (i.e. futures on oil traded on different regulated markets) should be treated as giving exposure to the same commodity. This was not, however, repeated in the implementing UCITS III Directive or Level 3 advices.
(iii) Adequate Benchmark
The relevant index must measure the performance of the group of assets it is purporting to represent and therefore, in the submission to the Central Bank on the relevant indices, there should be an explanation as to how each index meets that requirement.
Information to be included should include data on constituent selection criteria, constituent price collection procedures, asset allocation rules and guidelines etc. There is also an expectation that the index will be revised and rebalanced periodically to ensure that regulatory requirements with regard to allowed concentration limits are satisfied. Information must also be provided as to how the index calculation methodology is verified and on any fees embedded in the index.
(iv) Publication in an appropriate manner
The index must be published in an appropriate manner. This means that that an investor should be able to access relevant material information on the index with ease, for example, via the internet. Index performance must be freely and continually available so that, to the extent permitted by the index provider, information on matters such as index constituents, calculation, rebalancing methodologies, etc. should be available. Information that an index provider considers to be of a proprietary and commercially sensitive nature is not expected to be published in a detailed manner.
(v) Independent Management
The index must be independently managed from the management of the UCITS and its performance must be calculated in an independent environment free from any external influences.
(vi) Hedge Fund Indices
Hedge fund indices may qualify as "financial indices" to which exposure can be taken through financial derivative instruments provided that they meet the index criteria indicated above and where:
- the index methodology has a set of predetermined rules and objective criteria for the selection and rebalancing of index components;
- the index provider does not accept payments from potential index components for the purpose of being included in the index; and
- back-filling (i.e. retrospective changes to previously published index values) is not permitted.
There are additional due diligence requirements imposed upon a UCITS which wishes to gain exposure to a hedge fund index which requires that a UCITS considers the quality of the relevant hedge fund index taking into account (at least) both the comprehensiveness of the index methodology and availability of information regarding the index and a UCITS must keep a record of these assessments.
In determining the comprehensiveness of the index methodology, the UCITS should consider whether the methodology contains an adequate explanation of matters such as the weighting and classification of components and the treatment of defunct components and whether the index represents an adequate benchmark for the kind of hedge funds to which it refers. In relation to the availability of information regarding the index, matters to be taken into account include whether there is a clear narrative description of what the index is seeking to represent, whether the index is subject to an independent audit and the scope of the audit as well as how frequently the index is published and whether that would affect the ability of the UCITS to accurately calculate its own NAV.
Consideration should also be given to the treatment of index components including the procedures by which the index provider carries out due diligence on the NAV calculation procedures of the underlying index components, the level of detail available regarding index components and their NAVs (including whether they are investable or non-investable and whether the number of components in the index achieves sufficient diversification).
Normal rules regarding OTC derivatives, in the case of exposure to an index by means of OTC derivatives, apply.
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