In this blog we will discuss the revision of the PRIIPs Regulation for the performance scenario methodology of Category 2 investment funds. This affects the key information millions of retail investors use to determine what investment funds to buy.
Significance of PRIIPs Regulation
In 2017 new financial regulation for Packaged Retail Insurance-based Investment Products (PRIIPs) came into effect in the European Union to essentially make it easier for retail investors to know what they’re buying. PRIIPs include insurance products, investment funds, structured products, securities and deposits, which combined make up a huge chunk of the market for retail insurance and investment products.
As with many changes in the financial world, the impetus behind this regulation was due in large part to the financial crisis of 2008. The regulation reads: “Improving the transparency of PRIIPs offered to retail investors is an important investor protection measure and a precondition for rebuilding the confidence of retail investors in the financial market, in particular in the aftermath of the financial crisis.”
Therefore the regulation requires that companies that create and sell investment products that are PRIIPs, prepare Key Information Documents (KIDs) for consumers. These KIDs must include the type of PRIIP being purchased, a summary risk indicator (SRI), future performance scenarios of the product and possible costs. To this end the regulation distinguishes four PRIIP categories and prescribes specific technical standards and methodology per category. On the road to financial transparency…
However in the course of 2018, representatives of not only PRIIP producers, but also of PRIIP sellers and retail investors, already filed complaints to the European Supervisory Authorities (ESAs) about the unrealistically positive return forecasts for a wide range of PRIIPs in the market. For details, please refer to RiskQuest's white paper on this topic.
Moreover there exists a temporary exemption for so-called Undertakings for Collective Investment in Transferable Securities (UCITS) and open-ended Alternative Investment Funds (AIFs). UCITS and AIFs are the main categories of collective investment funds within the European framework, and for example your typical ETF like the popular iShares Core MSCI Europe ETF is a type of UCITS. According to the European Commission UCITS even account for around 75% of all collective retail investments in Europe, which makes this PRIIP exemption very relevant. These UCITS and open-ended AIFs are classified as Category 2 under the PRIIPs Regulation.
In response to the industry concerns, the ESAs published a consultation paper on November 8th 2018, in which three possible solution directions were proposed: (1) introducing a trend correction in the performance scenarios (risk-neutral simulation); (2) replacing the performance scenarios with a confidence interval of the return; (3) extending the mandatory price history from 5 years to 10 years.
On February 8th 2019, the ESAs published a report with the preliminary amendments to the PRIIPs Regulation, based on the feedback on the consultation paper from the industry. This showed that the representatives of PRIIP products did not support all three solution directions and that the PRIIPs Regulation was therefore not being amended for the time being. RiskQuest supported this feedback, and published an alternative solution direction in the beforementioned white paper, namely including economic recession quarters in the PRIIPs simulation through resampling.
Disagreement between the ESAs followed, and finally in 2020 a draft Regulatory Technical Standard (RTS) was sent to the European Commission. However not all ESAs approved this new draft, and it took until February 3rd 2021 for all of them to agree. This RTS is now expected to be validated and implemented by the European Commission, Parliament and Council in July 2022 for all PRIIPs. This expected validation date is based on a legislative proposal from the Commission send to the European Parliament on extending the transitional agreement for UCITS and open-ended AIFs until July 2022, ´given the time needed to implement the PRIIP amendments’. It is safe to say PRIIPs regulation has been one of the most controversial regulations in E.U. legislative history.
Methodology for performance scenarios
The biggest change in the upcoming PRIIPs Regulation is the prescribed methodology for calculating performance scenarios of Category 2 PRIIPs. The current performance scenario methodology is replaced by a direct estimate approach and the data requirements for the calculations are extended. Affecting the key information that millions of retail investors use to determine what investment product to buy!
The old methodology was based on moments of the approximated historical return distribution using a Cornish-Fisher (CF) expansion, with a minimum of 5 years of data. Issues with this approach are considered by the ESAs to be procyclical effects and the risk of communicating misleading estimates to unsophisticated investors. As illustrated by Figure 1, the performance scenarios replicate the last 5 years of return history with an amplification factor, which makes them heavily reliant on the state of the market.
Figure 1: Risks arising from performance scenarios calculated with old methodology
Using the old performance scenario methodology can therefore lead to over-optimistic favourable and unfavourable scenario’s. The absolute level of favourable scenarios can be higher than the highest historical return (I), and the unfavourable scenarios frequently show potential returns above 100% during market downturn, which can be wrongly interpreted as a capital guarantee (II). Moreover in this market downturn the absolute unfavourable scenarios can be lower than the lowest historical return (III).
The new methodology will take the worst, median and best evolution of the PRIIP’s real performance in sub-intervals of time corresponding to the recommended holding period (RHP), and replaces the current 5-year performance data requirement with a maximum of 10 years or 5 years more than the RHP. According to the ESAs this addresses issues of pro-cyclical estimates, and clarifies the mathematical link between past returns and scenarios values for less sophisticated investors. Figure 2 below gives an example of the new performance scenario calculation, distinguishing between subintervals a with a length equal to the RHP and shorter incomplete subintervals b.
Figure 2: Example of performance scenario calculation for Category 2 PRIIPs showing the different type of subintervals, where RHP= 2 years
The subintervals roll monthly through the historical return data and are ranked according to return net of all applicable costs. However these subintervals a can only be taken up to the RHP before the end of the historical data. After that subintervals b are calculated using a linear transformation to render all subintervals of comparable length.
In the example above, the performance of the first complete subinterval a is calculated as . For subinterval b the linearly extrapolated end price at 30-11-2022 is , which results in a return of .
Then, for the favourable and moderate scenario the best and respectively the median evolution will be chosen from al subintervals a. The unfavourable scenario amounts to the worst evolution of both subintervals a and b. Note that for the computation of the stress scenario nothing changes in the new methodology.
Advice of RiskQuest
Generally speaking, RiskQuest supports the new direct estimate approach for calculating performance scenarios of Category 2 PRIIPs. Issues resulting from procyclicality like over-optimistic favourable scenarios during bull markets and over-pessimistic unfavourable scenarios during bear markets are by definition not possible with this methodology. Furthermore with a larger lookback period false suggestions of capital guarantees are less likely, and the simplicity of this new approach can provide clarity to less sophisticated retail investors.
However we also have our concerns. Despite a minimum of 10 years of data, this approach still does not guarantee a constant ratio between economically good and bad years. Therefore the resulting performance scenarios can still be too optimistic or pessimistic, depending on current market conditions. Furthermore by including a linear extrapolation of returns, this supposedly direct estimate approach still simulates unobserved returns over the RHP that can be unrealistic. These incomplete intervals are solely used for the unfavourable scenario and can make it more conservative. RiskQuest believes the return of these incomplete intervals should be floored to the lowest observed historical return, in order to arrive at a truly direct estimate approach.
We again point to including economic boom and busts quarters in the PRIIPs simulation through resampling, as a more elegant, yet possibly less comprehensible solution.
The PRIIPs Regulation, and the upcoming revision, are good steps on the road to transparency for retail investors. This is even more true for popular products like UCITS, that account for 75% of all collective retail investments in Europe. In this framework performance scenarios are essential to ensuring that investors are provided with appropriate expectations about the possible returns they may receive. However it turns out that creating methodology for this that is both sophisticated and understandable is quite a challenge. Let the quest continue…
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