Andrew O'Callaghan is a partner within the audit and business advisory services of PricewaterhouseCoopers, based in Ireland. Andrew has more than 14 years' experience in the investment management industry in both the USA and Dublin, and includes among his clients major US, UK and Japanese asset managers and their fund vehicles. He has been actively involved in the Dublin funds industry since 1995 and has helped many of the leading global players to structure products in Dublin. Andrew has written and spoken widely on the challenges and opportunities facing the industry, and currently specialises in providing performance improvement solutions to fund managers and service organisations.

Deirdre McManus is a manager within regulatory compliance services at PricewaterhouseCoopers, which she joined in July 2007. Deirdre has over 16 years' experience in financial services, in particular in the areas of fund administration, compliance and operational risk. She has extensive knowledge in the area of fund regulation, both in Ireland and at a European level. Deirdre's work within PwC to date has seen her take investment firms through the authorisation process, providing technical advice in relation to the authorisation process and ongoing supervision requirements for investment funds. She has contributed widely towards a number of industry papers in relation to the regulatory environment in Ireland and in writing materials for industry seminars in Dublin. Deirdre has also played a key role in developing industry guidance and standards at both national and global levels.

ABSTRACT
This paper focuses on the building of an effective risk management process (RMP) for undertakings for collective investment in transferable securities (UCITS) funds across Europe. In particular, the paper provides details of the current challenges faced by UCITS III funds in terms of the increased scope for complex investment strategies within the UCITS regime and the demands from investors and regulators to ensure that an effective RMP is in place.

The approach of the paper is to look at the specific RMP regulatory requirements detailed in the UCITS Directive and the key challenges faced by risk managers in building a cost-efficient, but effective and valuable, RMP. It provides practical advice and a recommended approach in developing the RMP, and provides a comparative analysis of the RMP requirements imposed by the regulatory authorities in both Ireland and the UK.

Having considered the key components to an effective RMP, the paper then looks to review the findings of the European Commission's research report on the investment policies of UCITS and its associated risk management. The report focuses on the investment policies of UCITS, their use of derivatives, and analyses how the introduction of the UCITS III Directives has impacted the UCITS product and its associated risk management in relation to the RMP.

Keywords: risk management process (RMP); requirements; challenges; effective; recommended approach; value at risk (VaR); regulators; European Commission; risk sensitivities; stress test; lookback; lookforward; confidence level; max absolute VaR; max relative VaR; Financial Reporting Standard 29 (FRS29)

INTRODUCTION
The introduction of funds under the Undertakings for Collective Investment in Transferable Securities (UCITS) III Directives - that is, Directives 2001/107/EC (relating to management companies)¹ and 2001/108/EC (relating to products)² of 21^st January, 2002, of the European Parliament and the Council - has brought new opportunities for fund managers and investors alike. The regulations do, however, also carry risk management challenges that need to be addressed.

RISK MANAGEMENT CHALLENGES IN UCITS III FUNDS
UCITS III presents opportunities to use complex financial derivative products and investment strategies in regulated funds. The scope for increased complex investment strategies within a UCITS fund was further enhanced with the transposition of the Eligible Assets Directive³ on 19^th December, 2007. These complex investment strategies give rise to greater risk exposure for UCITS funds.

UCITS III forces fund managers to implement a more disciplined approach to risk management and financial disclosure. The present global credit crunch and its related issues bring the risk management challenges of UCITS funds into even sharper focus. There is also an increasing emphasis on risk management procedures from both investors and regulators.

In February of this year, CESR published their Level 3 advice on Risk Management Principles for UCITS⁴. The advice reflects CESR's view that sound risk management systems are necessary for UCITS and should be set out through common principles, so that the principles can help foster convergence among competent authorities and provide guidance for market participants. The principles set out apply to both management companies and self-managed UCITS, and reflect the need to ensure that investors are adequately protected and that the risk management process is appropriate for, and in proportion with, the nature, scale, and complexity of the activities of the management company and of the UCITS it manages. The detailed principles are arranged around the following areas:

• Supervision by competent authorities;
• Governance of the risk management process;
• Identification & measurement of risks relevant to UCITS;
• Management of risks relevant to UCITS; and
• Reporting & monitoring.

CESR's Risk Management Principles for UCITS⁵ are due to be complemented by a further paper on the technical and quantitative issues regarding UCITS portfolio parameters to measure global exposure, leverage and counterparty risk concerning financial derivative instruments to be issued in due course.

UCITS FUNDS SEEK TO CAPTURE CORE HEDGE FUND PRINCIPLES, BUT CONTINUE TO OPERATE WITHIN A HIGHLY REPUTABLE REGULATORY REGIME
The growing demands of the industry and from investors alike has meant that the UCITS framework has moved towards adopting key hedge fund principles - in particular, the move from long-only-type funds to a more enhanced multi-strategy approach within a UCITS portfolio. These enhancements to the UCITS regime allow for additional portfolio scope, including diversified asset types, complex derivative strategies and asset classes. Retail investors are now afforded the opportunity to avail themselves of these strategies within a UCITS fund, while also still having comfort that their investment continues to operate within a highly regulated structure. But traditional long-only fund managers cannot simply switch over to managing and dealing in complex derivative investment strategies. Investment firms must be in a position to demonstrate a high level of experience in effective derivative trading strategies, have a proven record in risk control techniques and sophisticated systems in place to operate these trading strategies effectively.

UCITS III RISK MANAGEMENT REQUIREMENTS
A UCITS must demonstrate to potential investors and the home state regulatory authority that it has appropriate risk management controls and valuation procedures in place. The risk management processes to be applied are not specifically laid down in the UCITS Directive and are, therefore, determined by member States on an individual basis.

KEY CHALLENGES TO DATE
The key challenges to date have been the successful and cost-efficient implementation of a formal risk management process (RMP) that meets with all of the regulatory requirements. PricewaterhouseCoopers business advisory services has assisted a number of firms in implementing effective RMPs and in terms of compliance assessment of value at risk (VaR) models for regulatory oversight. The key requirements for an effective and compliant risk measurement system can be summarised as follows:

i) Report tracking errors, volatility and VAR.
ii) Calculate global, leverage and counterparty exposures using different time periods.
iii) Produce historical simulation and Monte Carlo VaR.
iv) Attribute risk by country and sector.
v) Undertake user-defined investment style analysis.
vi) Conduct ‘what if ' tests for prospective trades.
vii) Ensure ability to capture up-to-date market prices.
viii) Stress test potential situations in which the use of financial derivative instruments would bring about a loss to the UCITS.

To respond to these challenges and to remain competitive, institutions need to establish best practices in their risk and control operations. Risk managers need to evaluate effectively the quality of their organisation's risk management, quantitative analysis and modelling infrastructure.

THE RISK MANAGEMENT PROCESS (RMP)
The key to building an effective RMP is the design of methodologies that will help management to understand better the sources of value and risk, as well as the key financial drivers affecting them.

The recommended approach to an efficient and valuable RMP should include the following:

i) Identify and define short-term vs long-term risk management goals.
ii) Review risk management methodologies (ie consistent and documented approaches).
iii) Review the organisation (in terms of substance, risk reporting design, definition of escalation procedures, etc).
iv) Undertake system testing and enhancement where necessary.
v) Determine stress test parameters, undertake analysis, and develop and implement stress testing procedures.
vi) Determine and implement back-testing procedures.
vii) Formulate data management procedures and undertake analysis of data flows (ie data management).
viii) Ensure that the risk model captures the full range of financial risks and reliably produces the metrics to be reported to management and regulators.
ix) Ensure that the risk model is rigorously tested, validated and documented.
x) Ensure that consistent methodologies for the analysis, valuation and reporting of risks across instruments and portfolios are applied.

Specific areas that often require improvement include:

• the development of VaR and other risk analytics methodologies;
• the measurement and reporting of risk sensitivities;
• the validation of modelling assumptions, inputs, and implementation for stress testing and scenario analysis;
• the valuation of complex derivatives portfolios.

Should a firm manage a ‘sophisticated fund' - that is, one using derivatives extensively for investment - the regulations require that its RMP must, in particular, incorporate a daily calculation of the VaR of the fund. VaR, however, does not allow for exceptional events that might occur outside the confidence limits.

To implement a fully effective RMP, the European Commission recommends⁶ that sophisticated UCITS include a rigorous programme of stress-testing simulations that seek to analyse the reactions of the UCITS investment portfolio to the occurrence of a number of extreme events, or abnormal market movements. The stress-testing programme should include all of the risk factors having a significant influence on the portfolio's value, and should take account of any reduced diversification and correlation changes between these risk factors. These stress-testing scenarios must be adapted to the specific nature of the UCITS portfolio and risks, with the resulting calculations analysed and, where required, the overall UCITS risk profile adjusted accordingly.

The Commission made certain stipulations about the specific method used to calculate VaR, but left a significant degree of freedom to individual jurisdictions, in the hope that an agreed best practice would emerge. Regulators across all member States have issued guidance and circulars on the use of appropriate methods for the management of financial risks and the use of financial derivative instruments within a UCITS portfolio. Table 1 highlights the VaR requirements applicable in Ireland⁷ and the UK.

---

Table 1     VaR required in Ireland and UK
Parameter	Ireland (Guidance Note 3/03)	UK (EU Directives)
Lookback	The historical observation period should not be less than one year - but a shorter observation period may be used if it can be justified	‘Recent' volatilities - ie no more than one year from the calculation date (without prejudice to further testing by the competent authorities)
Lookforward	The holding period should not be greater than one month with ‘holding period of 20 days'	A holding period of one month
Confidence level	99%	99%
Max absolute VaR	20%	Not explicit
Max relative VaR	Two times	Not explicit
Stress tests	Stress tests should measure any potential major depreciation of the UCITS value as a result of unexpected changes in the relative value parameters and their correlation. Stress tests must be carried out at least once a quarter	Requires investment companies to apply stress tests in order to help manage risks related to a possible abnormal market

---

Note:

• UCITS may also use different quantitative limits and parameters under the condition that these are scaled and equated to the quantitative standards of a 99% confidence level and a 20-day holding period.
• In the case where a 1-day holding period is used with a 99% confidence level, the absolute VaR limit remains 5% of net asset value.

Some market experts have interpreted the combination of a 99 per cent confidence level and a one-year lookback as endorsing and requiring a Monte Carlo method for calculating VaR, because a simple historical simulation method may not have sufficient data available to make the calculation robust. On consultation with industry experts, the Irish Financial Regulator recognised this difficulty and hence encouraged a longer lookback, which is compatible with other VaR estimation methods⁸.

ORGANISATION, PROCEDURES AND REPORTING
The effectiveness of the controls and procedures of a UCITS is key to risk minimisation and prevention, and is an important part of the ‘substance' requirements. The key aspects to the effectiveness of these controls can be summarised as follows:

• the segregation of business areas and duties;
• a clearly defined relationship chart of different business units;
• the implementation of operational procedures and controls, and effective escalation procedures;
• the identification and understanding of information and communication flows;
• data flows, and the assurance of the integrity and reliability of data;
• experienced personnel with the necessary qualifications and adequate resources to provide the products and services offered;
• management autonomy and independence of shareholders, service providers and third parties involved;
• the scope of liability and accountability of the management company clearly defined;
• transparency and availability of information to investors.

THE EUROPEAN COMMISSION REPORT
In February 2008, the European Commission published a research report on the investment policies of UCITS and its associated risk management⁹. The report focuses on the investment policies of UCITS, their use of derivatives, and analyses how the introduction of the UCITS III Directives has impacted the UCITS product and its associated risk management.

Some of the key findings of the report can be summarised under the following key headings:

• the impact of the use of derivatives;
• leverage risk;
• valuation risk;
• liquidity risk;
• counterparty risk;
• other risk management issues.

The impact of the use of derivatives
The analysis shows an effective use of the wider investment powers introduced by the UCITS III Directives:

• the proportion of target funds in the population has increased significantly;
• the use of derivatives seems to be more intensive, both in terms of type and quantity;
• there is growing evidence of convergences between traditional funds and alternative funds.

One of the main results of the study is that the increased use of derivatives has been matched by neither greater volatility, nor better performance, nor higher level of leverage in comparison with other analysed funds.

The study also examined the risks associated with the use of enlarged investment powers, such as leverage risk, valuation risk, liquidity risk and counterparty risk. The survey found that fund managers develop strong risk management procedures before launching new, more complex products. Asset managers consider the suitability of their funds for retail investors, as well as the RMP that they need before launching such funds. Some operational risks specific to over-the-counter (OTC) derivatives did, however, appear to have grown.

The Commission's analysis confirms the increasing presence of derivatives in a larger proportion of funds - especially futures, options and swaps. Repurchase/reverse repurchase agreements have not increased dramatically, but futures remain the most observed derivative type and swap contracts had the highest growth over the period.

Ninety-two per cent of respondents to the study stated that derivatives exposure is generally motivated by hedging purposes. Almost half of the respondents used derivatives for trading or arbitrage purposes. The use of derivatives for leverage, however, is very limited. In practice, the extensive use of derivatives allowed by UCITS III gives the possibility for sophisticated funds to net positions that will be captured by the VaR.

Leverage risk
The Commission's report indicated that 80 per cent of the asset managers surveyed consider leverage to be inappropriate for retail investors and that it can be sold among those institutional investors that understand it well. In practice, leverage is very limited even if leverage opportunities resulting from UCITS III are well understood in France, Luxembourg and, to a lesser extent, Germany and the UK. A distinction is made between leverage on the market (the ‘β') and leverage of some arbitrage opportunities (the 'α').

The leverage of the β is never considered appropriate, except for some institutional investors. The leverage of the α may be appropriate, but with strong risk models and with appropriate disclosure to investors. Sixty per cent of interviewees noted no demand for leverage by investors.

Valuation risk
The valuation risk has not been reported as significant for complex instruments in sophisticated UCITS. Valuation issues are often considered carefully before new investments are accepted. As shown by the sub-prime crisis, however, valuation risk may be more significant in relation to investments that are deemed to be standard. In addition, it appears that the ability to price an instrument independently before trading it is hugely important for UCITS funds.

Liquidity risk
Liquidity analysis is developed and applied, but not to a large extent. It can also be observed that VaR calculation does not always include the impact of liquidity. This is even more the case for nonharmonised funds.

Financial Reporting Standard (FRS) 29¹⁰ may, however, change this: it defines liquidity risk as ‘the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities' and requires that an entity discloses specific information in relation to the liquidity risk arising from financial instruments.

The entity must make both qualitative and quantitive disclosures in relation to liquidity risk, as follows.

i) Qualitative disclosures:
   (a) the exposures to liquidity risk and how they arise;
   (b) its objectives, policies and processes for managing the risk, and the methods used to measure the risk; and
   (c) any changes in (a) or (b) in comparison with the previous period.

ii) Quantitative disclosures:
   (a) summary quantitative data about its exposure to liquidity risk at the reporting date, to be based on the information provided internally to key management personnel of the entity - for example, its board of directors and chief executive officer;
   (b) when an entity uses several methods to manage a risk exposure, it should disclose information using the method(s) that provide the most relevant and reliable information;
   (c) a maturity analysis for financial liabilities that shows the remaining contractual maturities and a description of how it manages the liquidity risk inherent therein - to the extent that it is not provided in (a) above, unless the risk is not material; and
   (d) concentrations of risk if not apparent from (a) and (b).

Counterparty risk
Counterparty risk is logically measured by most asset managers. This is imposed by UCITS III for OTC derivatives. Counterparty risk measurement tends to be harmonised among asset managers even if it is not harmonised by regulators.

Asset managers tend to adopt the most conservative approach when performing measurements.

Other risk management issues
A majority of the respondents to the survey (68 per cent) have a formal risk management committee in place. Of these, all asset managers promoting sophisticated UCITS have a risk management committee. The Committee is actively involved in approving new product strategies (81 per cent) and in every decision related to the risk measurement methodology.

The majority of respondents have also established a new products committee (69 per cent). The main reason for rejecting new products refers to the impossibility of evaluating the new product (19 per cent).

The analysis of this schedule confirms the increasing presence of derivatives in a larger proportion of funds, especially futures, options and swaps. Following the introduction of UCITS III, an increased demand for Statement on Auditing Standards (SAS) 70¹¹ controls reports among investment management firms has also been noted.

In practice, the extensive use of derivatives allowed by UCITS III gives the possibility for sophisticated funds to net positions that will be captured by the VaR. It should be noted that where financial derivatives do not form the main part of a fund's investments but are, rather, employed for the purposes of efficient portfolio management, these risk management procedures still apply and override any previous rules for derivatives used for efficient portfolio management.

130/30 FUNDS
By adopting the UCITS III sophisticated strategy, fund managers can avail themselves of many of the core principles for hedge fund investments. Fund managers must, however, remain focused as to the extent to which these principles may be applied. A key aspect to this is the use of the 130/30 fund strategy for UCITS.

The European Commission has since provided some clarification around the interpretation of the Directive, concluding that covered short selling is not UCITS-compatible for the following reasons:

• Stock borrowing to cover short sales does not protect the fund from potentially unlimited market risk.
• Covered short selling entails some risks additional to, or more acute than, synthetic exposure.
• Article 36 of the Directive prohibits borrowing by a UCITS, except on a temporary basis and limited to 10 per cent of cash and assets.
• UCITS does not contain provisions governing the management of risk generated by covered short selling.

It is further acknowledged by the Commission that synthetic short selling gives rise to some similar risks, but that use of these derivatives are explicitly permitted within the limits and are subject to common provisions on risk control. It was accepted by the Commission that approaches to risk management on physical short selling were absent from the Directive and CESR guidance¹². As such, the Commission has since instructed CESR to amend its Level III guidance to remove any ambiguity around such principles.

The 130/30 strategy is still available to UCITS funds - but it must be undertaken through the process of synthetic short selling.

SUMMARY AND KEY CONSIDERATIONS
When implementing the programme described in this paper, risk managers need to be confident that:

• risks taken are fully understood and within tolerable levels;
• the effects of alternative business strategies can be quantified;
• models capture the full range of financial risks, and reliably produce the metrics that are to be reported to management and regulators;
• models are rigorously tested, validated and documented;
• consistent methodologies for the analysis, valuation and reporting of risks across instruments and portfolios are in place;
• the risks inherent in financial instruments are understood, monitored and controlled.

CONCLUSION
UCITS III had a very significant impact in terms of product development across Europe. It is also clear that the Directive has affected fund risks, that the UCITS framework allows for portfolio scope and that it provides a flexible environment for fund mangers to apply a multi-strategy approach. Retail investors may take comfort that their investment continues to operate in this highly reputable and regulated structure, but that they are offered more choice in terms of the risk-and-reward profile that UCITS now brings.

The Commission's study and regulatory analysis has, however, highlighted some concerns in relation to some recognised differences at country level: for example, the definition of sophisticated funds, VaR implementation, counterparty risk, calculation of commitment and potential leverage are not fully harmonised across Europe. How UCITS IV will seek to enhance the popularity of the UCITS Brand remains to be seen; however, it is recognised that further work is required to ensure a consistent approach to the RMP for UCITS is applied in all member states.

REFERENCES
(1) Directive 2001/107/EC of the European Parliament and of the Council of 21^st January 2002 amending Council Directive 85/611/EEC of 20^th December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management company and simplified prospectuses, OJ L/41, 13^th February, 2002, p. 20.
(2) Directive 2001/108/EC of the European Parliament and of the Council of 21^st January 2002 amending Council Directive 85/611/EEC of 20^th December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with regard to investment of UCITS, OJ L/41, 13^th February, 2002.
(3) Directive 2007/16/EC of the European Parliament and of the Council of 19^th March 2007 implementing Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards the clarification of certain definitions, OJ L/79, 20^th March, 2007.
(4) CESR (2009) CESR's Advice on Risk Management Principles for UCITS, February, CESR/09-178.
(5) Ibid.
(6) European Commission Recommendation 2004/383/EC of 27^th April 2004 on the use of financial derivative instruments for undertakings for collective investment in transferable securities (UCITS), OJ l/144, 30^th April, 2004.
(7) Irish Financial Regulator Guidance Note 3/03, Undertakings for Collective Investment in Transferable Securities (UCITS): Financial Derivative Instruments, October, 2008, available online at http://www.financialregulator.ie/frame_main.asp?pg=/industry/in_fds_pol.asp&nv=/industry/in_nav.asp.
(8) Irish Financial Regulator Guidance Note 1/00, Valuations of the Assets of Collective Investment Schemes, 15^th August, 2008, available online at http://www.financialregulator.ie/frame_ main.asp?pg=/industry/in_fds_pol.asp& nv=/industry/in_nav.asp.
(9) European Commission (2008) Study on Investment Funds in the European Union: Comparative Analysis of the Use of Investment Powers, Investment Outcomes and Related Risk Features in both UCITS and Non-Harmonised Markets, February, available online at http://ec.europa.eu/internal_market/investment/other_docs/index_en.htm#studies.
(10) Accounting Standards Board (2005) Financial Instruments: Disclosures, FRS 29 (IFRS 7), 9^th December.
(11) American Institute of Certified Public Accountants (AICPA) (1993) Service Organizations, SAS 70, 31^st March.
(12) CESR (2007) CESR's Guidelines Concerning Eligible Assets for Investment by UCITS, March, CESR/07-044.

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