German Investment Funds Association BVI calls for Priips correction and postponement of the start date

The German Investment Funds Association BVI is seeking urgent corrections to important key elements of the Packaged Retail and Insurance-based Investment Products - Key Investor Information Document (Priips Kid) Regulation before it becomes applicable to all retail funds in Germany. The Priips regime will apply to funds including structured funds from 2020 and up until then private investors will only receive a Priips Kid when purchasing unit-linked policies.

"The Priips information sheets need to be revised, especially the information on costs and performance," said Thomas Richter, chief executive officer of BVI. "The EU Commission should use the review of the Priips rules scheduled for the end of 2018 for this purpose."

The use of the fund wrapper in the structured products market is a common occurrence in some European jurisdictions including The Netherlands, France, Belgium, Spain, and Poland. Structured products sold in Europe using the fund wrapper amount to over 9,000 of which 1,765 are still live. Belgium (432 funds), France (382), Spain (198), Germany (159) and Czech Republic (149) are the countries with the highest number of live structured funds. In 2017, issuance of pure structured funds in Europe amounted to 130 with a sales volume of €4.2bn whereas sales of funds wrapped as life insurance products sold over €3.6bn.

The trade body sees a serious risk of reputational damage to the fund industry, according to Magdalena Kuper (pictured), vice president legal at the BVI. "The misleading information - e.g. on performance scenarios - entails the risk that retail investors will lose confidence in the fund providers regardless of the fact that the industry just implements misleading regulatory requirements," said Kuper, adding that in any case, it is quite visible that distributors are not actively using Priips Kids for explaining product features to investors. "This means that Priips Kids will most likely become another piece of legal documentation without added value for investor information."

Kuper points that this situation is not only creating issues when comparing different wrappers but is also putting funds in an unfavourable position. "In fact, direct transaction costs occur mostly in investment funds which is why the impact of the arrival price methodology on other products is quite limited," said Kuper. "As regards performance scenarios, similar or even worse problems with the unrealistic scenario outcomes can be observed in Priips Kids for structured products. However, one must be aware that the calculation methodologies for performance scenarios are different for funds (which are mostly so-called category II products) and structured securities (as category III products). Therefore, comparability of results is fairly limited anyway."

Serious flaws

In view of the serious and complex flaws, BVI is calling for an extended revision phase and has proposed the postponement of the start date for the new Priips Kid by 24 months to January 2022.

The BVI has repeatedly raised issues regarding the calculation of performance scenarios and transaction costs, as well as the lack of consistent information, and has also pointed to the regulator that the first months of experience with the Priips Kid have revealed shortcomings in the underlying methodologies which lead to obviously wrong and misleading figures being disclosed to investors, according to Kuper.

Kuper notes that performance scenarios are biased by the historic performance of the product/market. In the Ucits Kiid, performance information is provided by disclosing figures on past performance which must be accompanied by the warning about the limited value of past performance as a guide for future performance prospects, according to Kuper.

"Despite the long-lasting awareness of such limitation, the Priips standards require calculation of future performance scenarios on the basis of past performance figures for the last five years which are then projected into the future (based on the recommended holding period of a fund)," said Kuper. "For most funds this means that the excellent market performance of the last five years is indiscriminately projected into the future, regardless whether the recommended holding period is one year, five years or, in the context of unit-linked insurance contracts, 30 or even 40 years. Especially for those long recommended holding periods, the prospective returns calculated in accordance with the Priips methodology amount to several hundred percent even in the moderate scenario."

The BVI expects the Priips approach to performance scenarios to become more problematic if the currently bullish markets start to fall. In this case, Priips manufacturers will not be able to reflect the changed return prospects in the performance scenarios and thus will be effectively forced to mislead and misinform investors by complying with the Priips requirements, according to Kuper.

Market conditions

"Assuming that the market conditions of the last five years will last for so long is obviously unrealistic," said Kuper. "Nonetheless, the Priips framework does neither provide for any flexibility for the Priips manufacturer to lower the performance estimates in case he deems them overly optimistic, nor does it allow for additional explanations of their limited relevance."

In relation to transaction costs which are highly impacted by price movements, the ESAs have invented an entirely new calculation methodology in order to capture implicit costs, according to Kuper. "In short, this methodology requires to determine transaction costs as the difference between the execution price and the mid-market price of an asset (so-called "arrival price")," she said, adding that it assumes that in every market and for every asset, there is a valid and determinable 'arrival price' as a reference value for the calculations.

"This is absolutely not the case. The 'arrival price' approach does not work in bond and currency markets due to the current lack of price transparency and in general with regard to less liquid assets. In these cases, calculations are severely flawed by outdated data used as 'arrival prices' which means that movements in the market price of assets are systematically treated as costs. Overall, the methodology results in consistently under- or overestimating costs and in many cases produces negative cost figures."

Disclosure of negative transaction costs is highly problematic as it suggests that investors make profits by the sole transaction activities in a fund which is never the case, according to Kuper.

"Moreover, negative figures for transaction costs must be accounted for in the summary cost indicator and lead to a general understatement of costs," said Kuper. "Negative transaction costs are, in our view, not a teething problem of the 'arrival price' methodology, but must be even expected to propagate once markets start to fall. While there is clearly a need to measure and disclose implicit costs, the 'arrival price' methodology systematically generates false and misleading figures."

The BVI is discussing different options for improving the calculation of transaction costs and solving the issue of unrealistic performance scenarios, according to Kuper. "However, further analyses and interactions with different industry groups are needed before we can formulate suggestions for specific amendments of the Priips rules," said Kuper, pointing that it is expected that the European Parliament elections in May 2019 will probably delay the process.

Additional reporting by Suzanna Moni.

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