PRIIPs: Recommended Holding Period
Recommended Holding Period in the PRIIPs context
PRIIPs manufacturers ought to define a Recommended Holding Period, or RHP, to display in the Key Information Document and use in various calculations.
Regulatory prescription & identified challenges in defining Recommended Holding Period
European Commission Delegated Regulation concerning Packaged Retail and Insurance-based Investment Products (or PRIIPs) is live since January 1st, 2018. It encompasses all products, regardless of their structure, where the amount payable to a retail investor can fluctuate due to the performance of assets not directly purchased by said retail investor.
One of the concepts introduced by the PRIIPs regulation is the “Recommended Holding Period”, or RHP. Within the Key Information Document (or PRIIPs KID), a whole section entitled “How long should I hold it and can I take my money out early?” is dedicated to disclose this RHP, a number expressed in years. The manufacturer of the product describes in this section the reasons for selecting the particular RHP and impacts of cashing-in early, in terms of risk, early exit penalties or applicability of capital guarantees.
By contrast, the UCITS regulation does not require any explicit specification of the investment horizon, except for a simple mention in the “Investment policy” section of the KÌID. Similarly, MiFID II regulation allows for less granular definition of investment horizon using descriptive phrases. On that matter, PRIIPs shows more prescriptive and detailed than other regulations. In turn, the RHP plays an important role in the calculation of multiple metrics displayed in the KID.
The choice of RHP by the PRIIP’s manufacturer is thus crucial. It results from a difficult trade-off between various factors, e.g. the nature of the product, the specific profile of the investor it is intended for, and the market practices for similar products.
Recommended Holding Period – observed market practices
Market view on the Recommended Holding Period
Deloitte’s analysis based on a representative sample of more than 31.500 share classes, covering all investment strategies, shows that more than 60% of the share classes are using the 5-year horizon as the RHP.
In the Regulatory Technical Standards supplementing PRIIPs regulation, the 5 years recommended holding period is used as an illustrative example, which may explain why some PRIIPs manufacturers are using 5 years as a ‘default’ value.
Furthermore, some PRIIP manufacturers might be relying on the descriptive investment horizon (e.g. from the MiFID Target Market). This figure can then be translated into a unique figure for the PRIIPs purpose using the EWG’s EMT guidelines, where medium to long-term investment horizon corresponds to 5 years.
Recommended Holding Period – impact and potential for manipulation
Various PRIIPs metrics impacted by the choice of the RHP
Recommended Holding Period impact on Market Risk Measure (MRM)
In theory, RHP is one of the variables entering into the market risk calculations, in particular the VaR-equivalent volatility (“VEV”) compilation. However, our analysis shows that once the RHP is greater than one year, the effect on VEV (and henceforth on MRM), becomes negligible.
In the example of the illustrative fund in the graph below, even increasing the RHP to 100 years did not move VEV sufficiently to fall into another MRM bucket. In particular, the VEV fluctuates between 6.16% and 6.02%, while the MRM 3 covers VEV between 5% and 12%.
However, we recommend paying special attention to the cases where the VEV is very close to the bucket limit, as the small changes can affect the final SRI.
As can be seen on the graph above, the biggest impact is observed for the RHP below 1 year – in that case, the risk increases substantially. This is in line with what we intuitively expect, i.e. the short horizon implying greater level of risk.
Recommended Holding Period impact on Credit Risk Measure (CRM)
According to the PRIIPs methodology, the computation of the CRM takes also the RHP into account. In practice, this adjustment increases the credit quality if the RHP is less than one year, and decreases the credit quality when RHP exceeds twelve years. Since the vast majority of PRIIPs have an investment horizon comprised between one and twelve years, the CRM adjustment is again non-material. Below is the table showing how PRIIPs RTS recommends adjusting the credit quality step (finally mapped onto CRM) to reflect the recommended holding period of the investment (from RTS, Annex II, point 42.)
Recommended Holding Period impact on performance scenarios
One of the most visible impact of Recommended Holding Period on performance scenarios is that it defines at which periods the performances are displayed in the PRIIPs KID.
Performance scenarios are compiled using the historical returns of the PRIIP during the past five years. Recent history shows essentially bull markets in most asset classes. If such positive past returns are projected over the future, the PRIIPs methodology assumes that this will continue in perpetuity. In short, recent trends tend to be exaggerated in case they are projected over long investment horizons.
Another impact of RHP in the compilation of performance scenarios occurs when RHP is less than one year. In such case, the displayed returns should not be annualized but cover only the recommended investment horizon. Below is the comparison of the two ways to display returns for an illustrative fund with RHP of 3 months.
Recommended Holding Period impact on Reduction in Yield (RIY) and total costs
Alongside with performance scenarios, PRIIPs KIDs display the RIY at various points in time, based on the RHP. In particular, RIY tends to decrease over time. This is no surprise, since the effect of one-off costs tend to be diluted on a longer period of time. On the long run, RIY tends to converge to the sum of recurring and incidental costs.
The effect is even more observable in the table ‘Composition of costs’, showing the impact each year of different types of costs on the investment return an investor might get at the end of the RHP. In particular, due to amortization effect it may be difficult for the retail investor to assess the actual costs they will be exposed to.
Below is a comparison of disclosed costs for an illustrative sub-fund with entry costs of 5%, meaning that the investor should pay €1000 for each €10 000 they invest in both cases:
The tables displayed are only to illustrate the impact of RHP on PRIIPs figures and should not be relied on or used for any other purpose.
In April 2019, the European Supervisory Authorities (ESAs) published additional Q&A on the Key Information Document for PRIIPs, including a new question under point 4. in “General Topics” about various aspects to be be considered when determining the RHP of a PRIIP. ESAs highlight that while PRIIPs manufacturers should take into consideration the minimum required holding period and/or a maturity date, it may or may not coincide with the recommended holding period. They further underline that the manufacturers should focus on advising a time horizon for the targeted retail investor by considering the fundamental structure of the product, such as risk and reward profile, capital guarantee mechanism, cost structure and even tax implications. In case of multiple viable holding periods, ESAs recommend this be reflected in the section “How long should I hold it and can I take my money out early?”.