UCITS Structured Products and Complex Trading Strategies- Prospectus Disclosure

Background and Overview

1. This guidance applies, inter alia, to the use by a responsible person for a relevant UCITS of the following investments / investment techniques:

• financial indices;
• structured notes (e.g. collateralised debt obligations);
• FDI;
• systematic trading models (e.g. algorithmic trading strategies);
• capital protection strategies.

2. The purpose of the guidance is to provide clarification with regard to the disclosure of such trading strategies in the prospectus of a UCITS in order to ensure that the important principle of investor-protection continues to be given primacy. It should be stressed that UCITS are retail products and so should ensure that their investment strategies are suitably disclosed to enable retail investors to make an informed decision. Unsophisticated investors may not fully understand the different risk and return characteristics of these products, notwithstanding that some complex strategies may in fact be less risky than some traditional long only structures.

Disclosure Requirements

3. Part 4 of the Central Bank UCITS Regulations sets out the information that the prospectus of a UCITS must contain with regard to its investment objective and policy. Regulation 89(1)(a) of the UCITS Regulations specifically requires that the descriptions “shall include the information necessary for investors to be able to make an informed judgement of the investment proposed to them, and, in particular, of the risks attached thereto”. In drafting suitable disclosure for retail investors, significant challenges may arise when formulating appropriate wording for innovative and complex products and strategies. In this regard the minimum information that should be included should clearly explain:

• what the underlying exposure obtained through the strategy is; and
• how the strategy will be executed (e.g. via FDI, indices, model etc.)

4. The description should be carefully drafted and written in a logical and non-confusing manner. The responsible person should make a judgement as to the amount of information that is relevant. In some cases it may be helpful to discuss the proposed strategy with the Central Bank prior to submission of an application for authorisation in order to identify drafting issues at an early stage and to ensure that the proposed strategy is fully understood. The Central Bank will require that poorly drafted prospectuses are re-submitted, potentially delaying authorisation.

5. The order of information in the prospectus may be adapted to reflect the UCITS specific investment objectives and policy. It is critical that these sections are written in plain English and in a clear and concise manner, avoiding common mistakes such as the use of unnecessary jargon, poor sequencing of information, the provision of too much or too little information, referencing defined terms to other defined terms and generally using opaque language and format.

6. The underlying exposure is often unclear due to the complexity of the structure proposed. This is generally due to the number of sophisticated financial instruments and methodologies used in the structure. An example is a UCITS offering a capital protected product with an underlying credit exposure, structured via a total return swap based on the return of a number of credit default swap indices, and where the allocation of exposure to those indices is dictated by a systematic trading model with capital protection provided by notional exposure to a zero-coupon bond. The very important message regarding underlying exposure can get lost amid the technical description of the structure used.

Additional Risk Disclosure

7. It is important that an investor understands, in broad terms, the risks they face in relation to their investment. In particular, an indication of the degree of leverage expected to be generated through the use of FDI should, in all cases, be disclosed, notwithstanding that such use will be within permitted levels. The use of complex trading strategies may also require additional risk disclosures, for example in relation to high levels of expected volatility or the use of sophisticated risk measurement models such as value at risk. Disclosure is only required when relevant and material, based on risk impact and probability.

Description of Payout Profile

8. Investors are also interested in the question “given the risks, what might I get back?” It is therefore desirable to describe the level of risk exposure and payout profile of the strategy in terms of, say, comparison to a benchmark index, or describing potential levels of volatility, or otherwise informing investors through the use of simple tables, schematics or graphs. If used, these should illustrate situations that result in both profit and loss to an investor.

Use of Appendices

9. It is also possible, through the use of appropriate appendices, to provide more detail in the prospectus. Such appendices should also, however, be capable of being readily understood by a retail investor. They should therefore not contain too much technical data that may not be easily understood by the average retail investor such as the inclusion of detailed swap agreement terms.

Issued: 5 October 2015
Latest revision: 5 October 2015