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CIS 5A.13 Efficient portfolio management

Application

CIS 5A.13.1R

This section (CIS 5A.13) applies to authorised fund managers, other than managers of feeder funds, except:

  1. (1)

    CIS 5A.13.3 R which applies to ICVCs and to managers of AUTs other than feeder funds;

  2. (2)

    CIS 5A.13.3 R (2)(c) which does not apply to ICVCs that are fund of funds schemes or to managers of AUTs that are fund of funds schemes or feeder funds;

  3. (3)

    CIS 5A.13.4 R (2)(b), which does not apply to authorised fund managers of fund of funds schemes and managers of feeder funds; and

  4. (4)

    CIS 5A.13.12 R, which applies to ICVCs and to trustees of AUTs, other than feeder funds.

Explanation: requirements of efficient portfolio management

CIS 5A.13.2G
  1. (1)

    This section (CIS 5A.13) gives an ICVC or a manager of an AUT the ability to reduce the risks or costs associated with making investments. For that purpose, this section provides machinery to enable the property of an authorised fund to be used for efficient portfolio management.

  2. (2)

    There are three broadly based requirements:

    1. (a)

      the transactions must be economically appropriate;

    2. (b)

      the exposure must be fully covered; and

    3. (c)

      the transactions must be entered into for one or more of three specific aims.

  3. (3)

    On (2)(a), this section (CIS 5A.13) requires that the transaction must be economically appropriate for the purposes of efficient portfolio management.

  4. (4)

    On (2)(b), this section (CIS 5A.13) requires that the exposure must be fully covered by cash or other scheme property sufficient to meet any obligation to pay or deliver that could arise.

  5. (5)

    On (2)(c), this section (CIS 5A.13) sets out (in CIS 5A.13.3 R(2)) what these three aims are:

    1. (a)

      the reduction of risk;

    2. (b)

      the reduction of cost; and

    3. (c)

      the generation of additional capital or income for the authorised fund with an acceptably low level of risk.

  6. (6)

    The first two aims, together or separately, allow for tactical asset allocation. Tactical asset allocation is a switch in exposure through the use of derivatives rather than through the sale and purchase of underlying property. The limits on this are set out in CIS 5A.13.4 R(1) and (2)(a).

  7. (7)

    There is also a specific requirement for UCITS schemes which is derived from the UCITS directive. Authorised funds subject to that directive must be invested in transferable securities, and it therefore follows that an alternative exposure obtained through derivatives in the portfolio should not remain there indefinitely; the authorised fund must revert to transferable securities of some kind, within a reasonable time. Therefore, the rules in this section provide that any tactical asset allocation of a UCITS scheme must be temporary.

  8. (8)

    The first aim of reduction of risk allows for the use of derivatives with a view to switching the currency exposure of all or part of the scheme property away from a currency which is considered to be at risk.

  9. (9)

    The third aim, of taking a low-risk gain, is further defined in CIS 5A.13.5 R. The gains are to be derived from arbitrage and from writing covered options. Gains from stock lending are covered in CIS 5A.14.

Appropriate transactions

CIS 5A.13.3R
  1. (1)

    This section enables the ICVC, or manager for the account of the AUT, to enter into transactions of the kind specified in CIS 5A.13.6 R (Permitted transactions) for the purpose of efficient portfolio management, but only when each of the following two conditions is satisfied:

    1. (a)

      the transaction is economically appropriate to that purpose, as required by CIS 5A.13.4 R (Economic appropriateness); and

    2. (b)

      the transaction is fully covered, as required by CIS 5A.13.8 R (Cover for transactions in derivatives and forward transactions)).

  2. (2)

    A transaction under (1) must only be entered into if it is to achieve one or more of the following in respect of the authorised fund:

    1. (a)

      the reduction of risk;

    2. (b)

      the reduction of cost; and

    3. (c)

      the generation of additional capital or income for the authorised fund with an acceptably low level of risk.

  3. (3)

    The purpose in (2) must relate to:

    1. (a)

      the scheme property of the authorised fund;

    2. (b)

      property (whether precisely identified or not) which is to be or is proposed to be acquired for the authorised fund; and

    3. (c)

      anticipated cash receipts of the authorised fund, if due to be received at some time and likely to be received within one month.

Economic appropriateness

CIS 5A.13.4R
  1. (1)

    Any transaction under this section must be one which (alone or in combination with one or more others) is ascertained with reasonable care by the authorised fund manager to be economically appropriate to the efficient portfolio management of the authorised fund.

  2. (2)

    In consequence, the authorised fund manager must take reasonable care to determine that:

    1. (a)

      for transactions undertaken to reduce risk or cost (or both), the transaction (alone or in combination) will diminish a risk or cost of a kind or level which it is sensible to reduce; and

    2. (b)

      for transactions undertaken to generate additional capital or income, the authorised fund is certain (or certain barring events which are not reasonably foreseeable) to derive a benefit from the transaction.

  3. (3)

    A transaction may not be entered into under this section (CIS 5A.13) if its purpose could reasonably be regarded as speculative.

  4. (4)

    Where the transaction is for the account of a UCITS scheme and relates to the actual or potential acquisition of transferable securities, then the authorised fund manager must intend that the authorised fund should invest in transferable securities within a reasonable time; and it must thereafter ensure that, unless the position has itself been closed out, that intention is realised within that reasonable time.

Generation of additional capital or income

CIS 5A.13.5R
  1. (1)

    There is an acceptably low level of risk for the purposes of CIS 5A.13.3 R (2)(c), in any case where the authorised fund manager has taken reasonable care to determine that the authorised fund is certain (or certain barring events which are not reasonably foreseeable) to derive a benefit:

    1. (a)

      on a basis set out in (2) or (3); or

    2. (b)

      from stock lending under section CIS 5A.14.

  2. (2)

    The first basis is to take advantage of pricing imperfections in relation to the acquisition and disposal (or disposal and acquisition) of rights in relation to property the same as, or equivalent to, property which the authorised fund holds or may properly hold.

  3. (3)

    The second basis is to receive a premium for the writing of a covered call option or a covered put option, even if that benefit is obtained at the expense of surrendering the chance of yet greater benefit.

Permitted transactions

CIS 5A.13.6R
  1. (1)

    A transaction under this section must be:

    1. (a)

      a transaction in derivatives; or

    2. (b)

      a forward transaction in a currency (or where the scheme property may include gold, in gold).

  2. (2)

    A transaction in derivatives under (1)(a) must be:

    1. (a)

      in an approved derivative ; or

    2. (b)

      one which complies with CIS 5A.6.6 R (OTC transactions in derivatives); or

    3. (c)

      a synthetic future.

  3. (3)

    Any transaction in an approved derivative must be effected on or under the rules of an eligiblederivatives market.

  4. (4)

    Any forward transaction must be with an approved counterparty within the meaning of CIS 5A.6.6 R (2)(OTC transactions in derivatives).

  5. (5)

    Not more than 5% of the value of the scheme property is to be directed to initial outlay in respect of over the counter transactions with any one counterparty.

  6. (6)

    A transaction in derivatives or forward transaction which would or could lead to delivery of property to the depositary (or to the ICVC) may be entered into only if:

    1. (a)

      the property can be held by the authorised fund; and

    2. (b)

      the authorised fund manager has taken reasonable care to determine that delivery of the property by the transaction will not lead to a breach of the rules in this chapter.

Cover for transactions in derivatives and forward transactions

CIS 5A.13.7G
  1. (1)

    Like futures and options schemes, transactions in derivatives and forward transactions entered into for the purpose of efficient portfolio management should be fully covered.

  2. (2)

    Cover is fully explained in CIS 5A.13.8 R. There is a general requirement for individual cover of the right kind (stock for stock, or cash sum for cash sum) and CIS 5A.13.9 G provides examples of how the cover is to be found. There is also a global cover requirement, to prevent or limit gearing.

  3. (3)

    In accordance with CIS 5A.2.7 R(2)(b) (Chapter to be construed as a whole) cover used in respect of one transaction in derivatives or forward transaction may not be used for cover in respect of another transaction in derivatives or forwards.

  4. (4)

    There must be sufficient available cover for all transactions concerned.

Cover for transactions in derivatives and forward transactions

CIS 5A.13.8R
  1. (1)

    No transaction may be entered into under this section (CIS 5A.13) unless the maximum potential exposure created by the transaction, in terms of the principal or notional principal of the derivative or forward contract, is:

    1. (a)

      covered individually under (2) or (3); and

    2. (b)

      covered globally under (4).

  2. (2)

    Exposure is covered individually if there is, in the scheme property:

    1. (a)

      (in the case of an exposure in terms of property) a transferable security or other property which is of the right kind, and sufficient in amount, to match the exposure; and

    2. (b)

      (in the case of an exposure in terms of money), cash or near cash (or borrowing under CIS 5A.13.12 R (Borrowing in the context of efficient portfolio management)) or transferable securities which is or are, or, on being turned into money in the right currency, will be, sufficient in amount to match the exposure.

  3. (3)

    However, exposure to an index or basket of securities or other assets is covered individually for the purposes of (2) if the authorised fund holds securities or other property which (taking into account the closeness of the relationship between fluctuations in the price of the two) can reasonably be regarded as appropriate to provide cover for the exposure; they may be so regarded even if there is not complete congruence between the cover and the exposure.

  4. (4)

    Exposure is covered globally for the purposes of this section if, after taking account of all the cover required under (2) or (3) for other positions already in existence, adequate cover from within the scheme property is available to enable the fresh transaction to be entered into.

  5. (5)

    A transaction in derivatives or forward transaction is not available to provide cover for another derivative or forward transaction under this section, but:

    1. (a)

      the two transactions involved in a synthetic future are to be treated as if they were a single derivative, and the net exposure from the combination is to be covered on the basis of the higher of the cover requirements of the options which make up the synthetic future;

    2. (b)

      synthetic cash is available to provide cover for a transaction as if it were cash; and

    3. (c)

      a covered currency forward or a covered currency derivative may provide cover for a derivative.

  6. (6)

    Cash not yet received into the scheme property but due to be received within one month is available as cover for the purposes of (2)(b) and (3).

  7. (7)

    Property anticipated under a derivative transaction does not count as property under (2)(a).

  8. (8)

    Property is not available for cover if it is the subject of a transaction under CIS 5A.14 (Stock lending), unless the authorised fund manager has taken reasonable care to determine that it is obtainable (by return or re-acquisition) in time to meet the obligation for which cover is required.

Examples of cover requirements

CIS 5A.13.9G

Examples of the cover requirements:

  1. (1)

    A bought put option (or a written call option) on 1000 ordinary £1 shares (fully paid) of ABC plc is covered by an existing holding in the authorised fund of 1000 ordinary A1 shares (fully paid) of ABC plc (CIS 5A.13.8 R(2)(a)).

  2. (2)

    A bought call option (or written put option) on 1000 ordinary £1 shares (fully paid) of ABC plc is covered by cover (in the form of cash or an allowable substitute for cash or transferable securities) which is sufficient in amount to meet the purchaseprice of the shares on exercise of the option (CIS 5A.13.8 R(2)(b)).

  3. (3)

    A sold contract for differences on short-dated sterling is covered by cash or near cash or transferable securities, the values of which together at least match the notional principal of the contract (for example, a LIFFE short sterling contract, or a succession of such contracts, is covered by £500,000) (CIS 5A.13.8 R(2)(b) and CIS 5A.2.7 R(2)(b)).

  4. (4)

    A sold future on the FT-SE 100 Index is covered by holdings of equities, which satisfy the test of appropriateness for cover in CIS 5A.13.8 R(3) in relation to that future, and the values of which together at least match the current mark to market valuation of the future (for example, if the multiplier per full index point is £10, and if the eventual obligation under the future is currently at 2800, the valuation of the futures position is 2800 x £10 = £28,000) (CIS 5A.13.8 R(3)).

  5. (5)

    Where an authorised fund has holdings in blue chip UKshares and the authorised fund manager wishes to provide more exposure to the US market and decides to sell a FT-SE index future to the value of those shares (this transaction satisfying the test of appropriateness for cover in CIS 5A.13.8 R(3)), then the sterling synthetic cash position created is used as cover for a Standard and Poors 500 index future provided that the authorised fund ensures that the cover remains sufficient (for example, by reference to the sterling/US dollar exchange rate) (CIS 5A.13.8 R(3) and CIS 5A.13.8 R(5)(b)).

The use of index derivatives: congruence

CIS 5A.13.10G
  1. (1)

    CIS 5A.13.6 R (Permitted transactions) permits the use of index derivatives for efficient portfolio management ("EPM"). CIS 5A.13.8 R sets out the cover requirements for derivatives (including for index derivatives). Where index derivatives are used, cover may be provided by securities even if there is not complete congruence between the components of the index and the securities, provided that it is reasonable to use one as appropriate to cover for the other, taking into account the closeness of the relationship between fluctuations in their prices (see CIS 5A.13.8 R(3)). In considering the appropriateness of the instrument, authorised fund managers will need to take reasonable care that it is economic, suitable and reasonably congruent. This guidance deals with the matter of congruence.

  2. (2)

    It is not possible for the FSA to reach a view, in the abstract, on any particular level of congruence. The level of congruence necessary to satisfy the requirement that it is reasonable to regard the index derivative as appropriate, should be determined only in light of the individual circumstances of the case concerning a particular authorised fund.

  3. (3)

    Clearly, the higher the level of congruence, the less likely the authorised fund manager would be open to any challenge that the index derivative chosen is not appropriate. Whilst it does not necessary follow that a low level of congruence means that the index derivative chosen will be inappropriate, the derivative used in those circumstances is likely to require much further justification. In certain types of authorised fund it may be that no index derivative is appropriate.

  4. (4)

    It should be noted that it is not the intention of CIS 5A.13.8 R to preclude the use of an appropriate index derivative that has a relationship with part of the scheme property. That is particularly so where the EPM technique is to be adopted in respect of part only of the scheme property, as will normally be the case.

  5. (5)

    The following steps can be taken by an authorised fund manager when using index derivatives and when determining whether or not an index derivative is "reasonably congruent" to an underlying portfolio of investments. Consideration of these steps needs to reflect the respective responsibilities of the authorised fund managers and depositaries under CIS 7 (Powers and duties).

    1. (a)

      In determining the extent and manner in which index derivatives are used for EPM, the authorised fund manager should set out why it considers the transaction to be appropriate. In-house rules should be prepared which identify, on a scheme by scheme basis, the instruments the authorised fund manager is likely to use and the extent of this use.

    2. (b)

      Authorised fund managers should show these in-house rules to, and discuss them with, the depositary. Depositaries need not endorse the rules, although they may wish to give a view on whether they consider them as being reasonable in principle.

    3. (c)

      If the matter is not covered by the in-house rules and the authorised fund manager is in doubt whether a particular transaction is appropriate, it should discuss this with the depositary before taking any action.

    4. (d)

      Any remaining doubt should be discussed with the FSA.

    5. (e)

      Procedures should be established between the authorised fund manager and depositary that enable the depositary to monitor the investment in derivatives in accordance with its duty under CIS 7. These procedures will cover the details of any transactions in index derivatives entered into and the authorised fund manager's justification that the transaction complies with the rules in this chapter.

  6. (6)

    Other approaches to those outlined in (5) may be appropriate in the light of the authorised fund manager's own circumstances. Whatever approach is taken, authorised fund managers will need to review, as and when circumstances dictate, and in the light of developments on indices, the instruments they regard as appropriate for use in their authorised funds.

Borrowing in the context of efficient portfolio management

CIS 5A.13.11G
  1. (1)

    CIS 5A.13.12 R sets out requirements for borrowing in the context of efficient portfolio management. That rule deals with two aspects of such borrowing.

  2. (2)

    First, borrowed cash and cash committed for borrowing goes to swell the scheme property for the purpose of providing cover in the form of cash. Effectively, an additional 10% of cover can be found in this way.

  3. (3)

    Second, a back to back currency loan can be regarded as switching the borrowed currency into the scheme property, and switching the deposited currency out. The lending transaction does not require cover, as it is a loan rather than a forward or future. But it enables the authorised fund by borrowing to have cash in another currency to use as cover.

  4. (4)

    Although CIS 5A.13.8 R(2)(b) does not require cash cover to be in a currency matching the exposure, the authorised fund manager needs to monitor currency rates in order to ensure that cover remains sufficient. Borrowing in the right currency may thus make the cover simpler to operate.

Borrowing in the context of efficient portfolio management

CIS 5A.13.12R
  1. (1)

    Cash obtained by borrowing, and borrowings which the authorised fund manager reasonably regards an eligible institution or an approved bank to be committed to provide, are available for cover under CIS 5A.13.8 R as long as the normal limits on borrowing (as to which see CIS 5A.15.3 R (General power to borrow) and CIS 5A.15.4 R (Borrowing limits)) are observed.1

  2. (2)

    Where, for the purposes of this section (CIS 5A.13), the ICVC or the trustee for the account of the AUT with the instructions of the manager:

    1. (a)

      borrows an amount of currency from an eligible institution or an approved bank; and1

    2. (b)

      keeps an amount in another currency, at least equal to the borrowing for the time being in (a), on deposit with the lender (or his agent or nominee);

    then this section (CIS 5A.13) applies as if the borrowed currency, and not the deposited currency, were part of the scheme property, and the normal limits on borrowing under CIS 5A.15.3 R and CIS 5A.15.4 R do not apply to that borrowing.

The continuing nature of requirements and limits

CIS 5A.13.13R
  1. (1)

    The authorised fund manager must, at each valuation point (and more frequently if necessary), re-calculate the amount of cover required in respect of positions already in existence under this section (CIS 5A.13). Derivatives and rights under forward transactions under this section (CIS 5A.13) may be retained in the scheme property only so long as they remain covered both individually and globally under CIS 5A.13.8 R.

  2. (2)

    If at any time:

    1. (a)

      any fact or matter relating to the authorised fund or its economic environment; or

    2. (b)

      the aggregate of all outstanding positions under this section (CIS 5A.13);

    is such that at least one of the relevant transactions (assuming it did not exist) could not properly be effected, either in that size or at all, the authorised fund manager must immediately on becoming aware of that fact take the necessary steps to rectify the situation, whether by closing out or by providing additional cover or otherwise.