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).
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.
example, as will be elaborated in this article:
equity UCITS funds that are classified as SRRI 6 or 7 will be classified as SRI
high yield fixed income UCITS funds that are classified as SRRI 4 or 5 will be classified
as SRI 3.
investment grade fixed income UCITS funds that are classified as SRRI 3 will be
classified as SRI 2.
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
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
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
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.
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
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.
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.
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:
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
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:
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
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.
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.