Following the publication on January 30, 2012, of the European Securities and Markets Authority’s (ESMA) consultation paper on ETFs and other UCITS issues (ESMA/2012/44), EDHEC-Risk welcomes the broadened focus of the new ESMA consultation, which approaches important issues in a horizontal way across all UCITS rather than in a vertical way limited to UCITS ETFs; as underlined in its recent contribution*, EDHEC-Risk believes that continued adherence to a silo approach would have increased the risks of adverse selection by investors and regulatory arbitrage by issuers.
Among the points addressed by the consultation paper which EDHEC-Risk feels are particularly important:
Tracking error
- EDHEC-Risk welcomes the amended definition of tracking error for index-tracking UCITS compared to the previous discussion paper of July 2011. The definition of tracking error as the volatility of the difference between the return of the index-tracking UCITS’ portfolio and the return of the benchmark or index corresponds more closely to academic standards and will better enable investors to compare different funds.
- EDHEC-Risk has also welcomed the inclusion of additional information in the prospectus of an index-tracking UCITS: the fund’s policy regarding the ex-ante tracking error, including its target level, together with the size of the tracking error ex-post and an explanation of any divergence between the target and actual tracking error for the relevant period; and details of whether the index-tracking UCITS will follow a full replication model or use, for example, sampling or synthetic replication.
- EDHEC-Risk’s recommendation for the definitive ESMA guidelines is that the risks of sampling replication, which is not always robust, notably in diversified geographical universes, be fully documented.
Identification
- With regard to labelling, the regulator has avoided the error of recommending the application of identifiers that would have created artificial and misleading distinctions between funds on the basis of the tools or techniques they use, including to replicate indices.
- Moreover, EDHEC-Risk agrees with ESMA’s decision to specify when the “ETF” label can be used for UCITS.
- It was important to highlight, as ESMA has, the differences between passively managed and actively managed UCITS ETFs. One might regret, however, that ESMA did not set maximum levels of tracking error which would enable investors to differentiate between passively and actively managed funds.
Counterparty risk and securities lending
- Concerning counterparty risk, the ESMA guidelines are in line with the results of the EDHEC-Risk study, which found that both physical and synthetic replication ETFs can be subject to counterparty risk. Communication leading investors to believe that synthetic replication was subject to counterparty risk while physical replication was not (despite securities lending activities) was misleading. ESMA recognises that securities lending allows a fund to take more unmitigated counterparty risk exposure than OTC derivatives and that it is subject to fewer constraints in the area of risk management; it notably does not benefit from European guidelines on collateralisation of the type mandated for the management of counterparty risk arising from the use of OTC derivatives. From that viewpoint, EDHEC-Risk is in total agreement with ESMA’s conclusion that it important to impose additional requirements for the management of securities lending activities undertaken by UCITS.
- In the light of the guidelines and conclusions drawn from the comprehensive and rigorous analyses performed by both ESMA and EDHEC-Risk, industry actors should refrain from communicating on the relative levels of risk of physical and synthetic replication, which is misleading to investors.
- EDHEC-Risk agrees with ESMA that investors should be informed of the revenues from securities lending and the rules on the distribution of fee income should be clarified.
Indices
- As EDHEC-Risk stressed in its study, the consultation on ETFs also concerns passive investment in general, and highlights the risk of index tracking, so ESMA’s references to the necessary due diligence are positive. EDHEC-Risk regrets nonetheless that ESMA stopped short of requiring that all information concerning indices be made freely available, notably to allow investors to recalculate their track records. This information is already difficult to obtain for cap-weighted indices, even though the rules of the latter are simple, but in the case of strategy indices it is almost impossible to procure, at reasonable cost, the historical composition of the indices and to check both the accuracy of the implementation of the ground rules and the performance of the indices. This is despite the fact that these elements enable industry actors to perform requisite due diligence. ESMA has addressed this problem but progress remains to be made.
* A copy of the EDHEC-Risk study can be found here:
EDHEC Position Paper What are the Risks of European ETFs?
An ETFs roundtable entitled “Perceived Risks and Benefits of ETF Investments and Regulators’ Considerations: Towards More Regulation for ETFs?” will be held as part of the EDHEC-Risk Days Europe 2012 conference at The Brewery conference centre in London on March 27, 2012, enabling this subject to be discussed with numerous industry representatives and regulators.
