PRIIPs RTS v2: Concerns About Misleading Performance Scenarios
PRIIPs suffers lots of
criticism around its methodology for Performance Scenarios. Both manufacturers
and consumers claim the results are often too optimistic, since they are based
on the last 5-year performances and these were positive.
In an effort to solve
these issues, the ESAs introduce in PRIIPs RTS v2 a new methodology for the
calculation of the Favourable, Moderate and Unfavourable scenarios for most
funds. Or more precisely, it applies to linear products, called Category 2 in
PRIIPs terminology. The new methodology follows a back-testing approach over at
least 10 years and the unfavourable scenario is based on the worst scenario
Why should the new
methodology lead to more balanced results?
The longer period (10
years vs. RTS v1’s 5 years) is expected to “catch” additional samples, with a
higher probability of some negative scenarios. In addition, while the
unfavourable scenario in RTS v1 is based on the 10th percentile, in
RTS v2 it is based on the worst scenario. Again, a higher probability for a
negative result. Moreover, the methodology for the unfavourable scenario embeds
a mechanism to catch further negative performances: the back-testing should take
into consideration not only full holding periods, but also shorter periods
during recent years (and extend them using “linear transformation” to the
required holding period, that’s another topic for a different article). This
technique further increases the chances to find negative unfavourable
Does the new
In many cases, it
does. Unfavourable scenario will show negative results, illustrating the
possibility of loss to the investors. However, still, under current market
development over the last 10 years, there are many cases the new methodology
will not help. And now, there is another concern: in many cases the new
technique for the unfavourable scenario shows unrealistically over-pessimistic
Let’s see some
unfavourable scenario for “mainstream” equity funds
For a recommended
holding period of 5 years (market practice for equities), many equity funds
will show a positive return in the unfavourable scenario. Why? Since those
funds (1) did not experience a loss in case of 5-year holding over the past 10
years, and (2) they did have negative returns for a minimum holding period of
one year over the past 5 years to date. Note that one year is the minimum
period in the technique of applying “linear transformation” on shorter periods,
again, due to reading constraints that’s a topic for another article.
For example, we
calculated the unfavourable scenario for Invesco S&P 500 UCITS ETF (calculation date: 27.01.2022). For an
investment of USD 10,000 it shows a value of USD 13,343 after 5 years. This translates to a
positive annualized return of 5.94% in the unfavourable scenario (!), and we
are talking of a fund tracking a popular, mainstream equity index.
By the way, you might
say no worries, RTS v2 allows us to choose lower percentiles from the
calculated scenarios, if we believe the results are too optimistic. Well, you
are wrong. This possibility exists only for the non-linear products (Category 1
& 3 in PRIIPs terminology) with the unfavourable scenario based on the 10th
percentile. In the case of the back-testing methodology, the unfavourable
scenario is based on the worst outcome. Sorry, there is no lower scenario.
negative unfavourable scenarios
On the other hand, for
funds that experienced a negative performance over the last year, the
methodology assumes this negative performance will repeat, again and again.
This is not happening in equity markets. Usually, after a period of one to two
years, there is a recovery (and in many cases even before).
As an example, we
chose fund Xtrackers MSCI
China UCITS ETF (calculation date: 27.01.2022) and calculated its unfavourable
scenario. Since this fund experienced a loss of -33% over the last year, this translates into a
compounding loss of -86.42% over 5 years. This never happened! Actually, the
results lead to a lower return than the stress scenario that still follows the
Cornish Fisher expansion-based methodology. In this case, according to RTS v2,
the stress scenario needs to be adjusted: it should be capped at the
unfavourable scenario level.
happens with any fund experiencing a significant loss over the last year.
We know, finding a
methodology that always works is difficult if not impossible. The new
methodology for performance scenarios of funds has higher chances to eliminate
overly optimistic results. However, as illustrated above, too-good results will
still occur, while exaggerated pessimism in the unfavourable scenarios will become
a common phenomenon.