EUROPE: CESR publish consultation on hedge fund indices for UCITS

Tuesday February 6 2007

In January 2006, CESR published its Recommendation on Eligible Assets of UCITS. The European Commission has published a Draft Directive based on this work and which should come into force in March 2007. A question that was left open in this previous CESR consultation was the question of whether hedge fund indices (HFIs) can be classed as financial indices for the purpose of UCITS; the issue being whether HFI are then acceptable financial indices as regards the underlying of financial derivative instruments (FDI).

In October 2006, CESR published an issuers paper seeking the views of market participants in respect of hedge fund indices, in order that CESR could reach an informed view on such indices. Having reached this informed view, CESR has now published a Consultation Paper in which it sets out some draft measures for consultation. The consultation period runs until 16 April 2007and CESR intends to publish final Level 3 measures in May 2007.

The consultation paper can be found at the above link.

OVERVIEW

In its previous work on eligible assets of UCITS, CESR set down a number of conditions (each with a number of criteria to be fulfilled) which financial indices had to meet in order to be acceptable. These were, in summary, that:

*They were sufficiently diversified

*They represent an adequate benchmark for the market to which they refer

*They are published in an appropriate manner.

In this current Consultation Paper, CESR consult on whether further Level 3 Guidelines are needed in respect of the above conditions as regards HFI. The Level 3 Guidelines which CESR are proposing to lay down are as follows:

In respect of a hedge fund index, the criterion of `representing an adequate benchmark` will not be met unless the UCITS:

* verifies that the index provider clearly defines, and makes publicly available, an explanation of what the index is trying to represent. This definition should include a narrative description of what the index is trying to track and not merely list underlyings;

* assesses whether the methodology of the index construction means the representativeness for the market to which it refers is likely to be achieved.

In respect of a hedge fund index, the criterion of `representing an adequate benchmark` will not be met unless the UCITS verifies that the methodology of the index requires the selection of index components to be made using pre-determined rules, on the basis of objective criteria.

In respect of a hedge fund index, the criterion of `publication in an appropriate manner` will not be met unless the UCITS:

* confirms that the index provider makes publicly available the full methodology of the index, including weighting, the treatment of defunct components, and where applicable, the classification of components;

* verifies that the methodology of the index does not allow retrospective changes to previously published index values (`backfilling`).

In respect of a hedge fund index, the criterion of `publication in an appropriate manner` will not be met unless the UCITS verifies that the index will be subject to an independent audit at least annually. The audit can be conducted by either a third party, or an internal unit within the index provider (e.g. an `audit committee`) which is independent of the department in charge of managing the index. The summary audit opinion must be available to the UCITS on request. As a minimum, the audit should:

*consider whether the index’s published methodology has been respected during the period in question (including, where applicable, for the treatment of defunct components and classification of components);

*validate that, for a sample of index calculation points, the index value was calculated consistently with the disclosed methodology.

Box 5.

In respect of a hedge fund index, the criterion of `representing an adequate benchmark` will not be met unless the UCITS:

*verifies that the index provider makes available to the UCITS details of whether each index component is investable or non-investable;

* verifies that the index provider makes available to the UCITS details of the index components (including a list of components and their prices and weight in the index) for each index calculation point.

Box 6.

In respect of a hedge fund index, the criterion `publication in an appropriate manner` will not be met unless the UCITS confirms that the index provider carries out due diligence on the net asset value calculation procedures used by each index component. The audit referred to in Box 4 above should confirm the adequacy of this due diligence and that it is being appropriately carried out.

Funds-Axis will respond to the Consultation in due course.