Tim Mortimer, managing director at Future Value Consultants, explains how the requirement for asset managers to display future performance simulations on their fund literature under PRIIPs regulations has created problems.
Therefore, having concluded - with some justification - that reporting simple past performance would not be adequate, the EC set about defining a complicated simulation basis involving the "resampling" of historical data to create a simulation framework. This was originally formulated to be used for the risk calculation.
The major problems occurred when this approach was extended to generate performance scenarios, intended to show a favourable, moderate, and unfavourable scenario (defined as the 90th, 50th and 10th percentiles respectively).
This idea was only made public in the intended final draft RTS made public in April 2016, less than nine months before implementation date.
In my view, it is very difficult to really get across to investors the status of these figures. Everyone with any exposure to investments is used to seeing past performance figures with the standard caveat that the "past is no guide to the future".
Concerns about past performance omission need to be addressed
However, the type of projection that had been proposed in the PRIIPs KIDS will inevitably be seen as some kind of forecast, or in the case of the favourable and unfavourable scenarios, virtual best and worst cases.
I do not think that this point was appreciated enough by the EC. Both the proposals for MiFiD II and previous FCA guidance have striven for a balance between past performance and simulation and a clear distinction between the two.
Analysis and conclusions based on forward looking simulations definitely have a key role in risk management and assessment of investments. However, the first question that gets asked when results from a simulation are put forward is "what are the assumptions behind it?".
Simulations
There are many ways to set up simulations, but care must be taken to ensure that the results will be reasonable for the purpose that they are intended, and that consistency is achieved over the range of investments that are being considered, and over time, as market conditions change.
In the PRIIPS context, the resampling technique was supposed to be an ideal solution comprising both historical data and a simulation framework.
It also does not rely on estimating parameters or requiring data that is hard to source, and contained little need for subjectivity or interpretation, meaning that any two parties should assess the same investment in the same way.
However, the reason that the mutual fund industry objected to these calculations was that, because of the technical nature of the simulation, the result depends purely on the historical volatility of the fund and the current risk-free interest rate.
Thus, all funds in a given volatility range will look the same at a given point in time irrespective of previous performance. This represents a flattening of the merits of individual funds that the mutual fund industry was not prepared to accept.
