IRELAND: UCITS and complex trading strategies – Consultation Paper on Prospectus Disclosures Requirements

Thursday December 21 2006

The Financial Regulator has published a Consultation Paper on a proposed Guidance Note to clarify prospectus disclosure requirements where a UCITS invests in structured products and complex trading strategies. The Consultation Paper can be found at the above link.

This Guidance Note applies, inter alia, to the use by UCITS of the following investment techniques:

*Financial Indices;

*Structured Notes (e.g. collateralised debt obligations);

*Financial Derivative Instruments;

*Systematic Trading Models (e.g. algorithmic trading strategies);

*Capital Protection Strategies.

The proposed Guidance Note sets out that it `s purpose is to ensure that the important principle of investor-protection continues to be given primacy. “It must be stressed that UCITS are retail products and so must 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.”

The Guidance commences by stating that with regard to complex products and trading structures the minimum information that should be included should clearly explain:

1.What the underlying exposure obtained through the strategy is; and

2. How the strategy will be executed (e.g. via FDI, indices, model etc.).

In addition to setting-out the obvious requirements that the disclosures be in plain English, clear and concise etc, the proposed Guidance Note does include some matters of substance (including suggestions for schematics, tables and graphs) as set-out in the extracts below:

Commercial Rationale behind the strategy

Investors in UCITS which adopt more complex strategies, and use some or all of the investment techniques mentioned on page 1, may also need to be provided with information on the commercial rationale behind the strategy. It is often unclear, due to the complexity of the structure proposed, what the underlying strategy is in commercial terms. This may be due to the number of sophisticated financial instruments being used to gain exposure to the underlying assets. An example could be a UCITS offering a capital protected product with an underlying credit exposure. This could be structured via a total return swap on the return of a number of credit default swap indices where the allocation of exposure to those indices is directed by the use of a systematic trading model, and capital protection is provided by notional exposure to a zero-coupon bond. In such a case it would be helpful to provide a short description as to why an investor would consider investing in such a product as this message can get lost in the technical description of the structure used.

Additional Risk Disclosures

It is important that an investor understands, in broad terms, the risks they have to face in relation to their investment. The specific degree of leverage that is expected to be generated through the use of FDI should, in all cases, be clearly 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 should only be made where such risks are relevant and material, based on risk impact and probability.

Description of Payout Profile

Investors are also interested in the question “Given the risks, what might I get back?” It is desirable to therefore 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.