CIS 5A.13 Efficient portfolio management

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.

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.

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)).

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.

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.