Towards the expiry of the UCITS exemption from PRIIPs, we decided to write an article pointing out practical changes and differences between the UCITS SRRI (the Synthetic Risk and Reward Indicator used in the directive on undertakings for collective investment in transferable securities) and the PRIIPs SRI (the Summary Risk Indicator as part of the packaged retail investment and insurance-based products regulation).
Both operate on a 1-7 scale but have a completely different methodology. This has been a source of confusion amongst investors. As UCITS funds will be required to reclassify risk using the PRIIPs methodology, it is likely that the risk classification number of existing funds will become lower than previous.
For example, as will be elaborated in this article:
- Many equity UCITS funds that are classified as SRRI 6 or 7 will be classified as SRI 5.
- Many high yield fixed income UCITS funds that are classified as SRRI 4 or 5 will be classified as SRI 3.
- Some investment grade fixed income UCITS funds that are classified as SRRI 3 will be classified as SRI 2.
Good industry practice is that the fund managers should make clear to investors and sales distribution channels that the lower risk number does not represent a real reduction in risk but is merely the effect of a different risk calculation method. This lower risk level may also impact the product governance and target market decisions. The PRIIPs RTS does allow manufacturers to voluntarily increase risk classifications, but it is felt that this should only be done under an industry level alignment in order to maintain comparability between similar funds.
UCITS SRRI Calculation
The synthetic risk and reward indicator is a requisite part of the Key Investor Information Document (KIID) for UCITS funds. The SRRI is used to indicate the level of risk of a UCITS fund by providing a number from 1 to 7, with 1 representing the lowest risk and 7 representing the highest.
The SRRI is based on historical data of the fund prices. By calculating a standard deviation of the historical returns of the fund (i.e. realised/historical volatility) and then mapping it into seven buckets. This calculation is seen as very simplistic.
PRIIPs SRI Calculation
The Summary Risk Indicator is composed of two measures; Market Risk Measure (MRM) and Credit Risk Measure (CRM). Most UCITS funds have the lowest CRM due to two reasons: (1) The fund assets are held in segregated accounts and in the case of the fund manager becoming insolvent, the fund assets are still held within those accounts on behalf of the investors. (2) The PRIIPs RTS requires to consider credit risk on a look-through basis only in case of an exposure of 10% of more of the fund’s value to a certain entity.
When the CRM is the lowest (i.e. CRM 1), the SRI is affected only by the MRM, as illustrated in the following table (taken from the RTS, ANNEX II, PART 3, point 52):
As shown in the table above, when the CRM is 1 (i.e. CR1, first row), the SRI (indicated in the table cells) equals the MRM. Therefore, for the sake of this article referring the most UCITs, we will focus on the MRM, assuming the CRM is 1.
For most UCITS funds (linear exposure, i.e. PRIIPs Category 2), the formula used for calculating the PRIIPs MRM is the Cornish Fisher expansion formula. This statistical technique was first described in 1937 and helps to approximate the value at risk of an investment. The formula considers the historical returns of a fund and approximates the loss (or profit) in a certain probability (percentile). According to the PRIIPs RTS, the percentile for the MRM calculation is 2.5%, i.e. the probability for this loss is 2.5%, a rather low figure representing a worst case scenario.
Based on the result of this calculation, a volatility that can lead to this loss (or profit) at a probability of 2.5% is calculated. This is called VEV, which stands for VaR Equivalent Volatility. The VEV is then mapped to a 1 to 7 scale MRM based on the buckets shown in the PRIIPs RTS, ANNEX II, PART 1, point 2:Regulatory Change
Upon the expiry of the UCITS exemption from PRIIPs, UCITS funds will stop producing UCITS KIIDs and will begin generating PRIIPs KIDs. The timeline for the expiry should be published soon by the European Commission and is expected to be during 2022.
To get ready for the upcoming change, we decided to perform a set of SRRI and SRI calculations. We started with equity funds. We took two large cap funds and two small cap funds and calculated their risk classifications. In all cases the PRIIPs SRI was lower than the UCITS SRRI:
We also repeated the test for fixed income funds of two types: high yield funds and sovereign debt. The table below shows that the high yield fixed income funds also have a lower risk classification under PRIIPs. The sovereign debt moved in one case (which can be a function of long or short term). Conclusions
Fund managers should be prepared to lower risk classes for their funds. It is not advisable to voluntarily increase the SRI without a proper industry alignment. Instead, fund managers should communicate to distributors and investors that the reason for the lower risk is the change in methodology and not a real decline in their funds’ risk.
Fund distributors should receive the new risk classes from fund managers in advance of the go live date. The Product Governance committees of the fund distributors should rethink the mapping of MiFID Target Market to their clients, assuming the new risk classes.