Guidelines on ETFs and other UCITS issues

Transcription

1 Guidelines on ETFs and other UCITS issues Foreword Having reviewed the current regulatory regime applicable to certain types of UCITS and particular activities such as efficient portfolio management techniques, the European Securities and Markets Authority (ESMA) has issued Guidelines on ETFs and other UCITS issues (ESMA/2012/474 of 25 July 2012). According to ESMA, the purpose of these guidelines is to protect investors by providing guidance on the information that should be communicated with respect to index-tracking UCITS and UCITS ETFs together with specific rules to be applied by UCITS when entering into overthe-counter financial derivative transactions and efficient portfolio management techniques. Finally, the guidelines set out criteria that should be respected by financial indices in which UCITS invest (ESMA/2012/474). Overview Introductory comment EDHEC welcomes the horizontal approach taken by ESMA to considering issues across all UCITS and for economically equivalent transactions. Index-tracking UCITS The new disclosures imposed on index-tracking UCITS are in line with EDHEC s (2012a) proposals and will provide investors with useful additional information on indices and tracking error risk. However, EDHEC regrets that the new guidelines fall short of giving a definition of passive management that would be framed in terms of a limit on the maximum level of tracking error acceptable. UCITS ETFs Identifier and specific disclosure EDHEC welcomes ESMA s decision to use an identifier to signal that an ETF is UCITScompliant and is pleased to see that its suggestion (2012a, 2012b) to use the acronym UCITS in the identifier (UCITS ETF) has been adopted. With regard to labelling, EDHEC notes that ESMA has avoided the error of imposing the use of identifiers that would have created artificial and misleading distinctions between funds on the basis of the tools or techniques they use. However, EDHEC regrets that this decision was motivated by practical considerations rather than principles. Actively-managed UCITS ETFs EDHEC considers it key to recognise the difference between passive UCITS that track a financial index and other funds. With the former, investors choose a linear and constant exposure to an index, which should be managed in a transparent and systematic manner and boast a published track record. With the latter, the payoff depends on risk-taking and portfolio management models that may not be systematic and are rarely transparent. Differences in transparency and management of risk exposure may result in risks to the investor providing basis for specific identification. Against this backdrop, we welcome ESMA s decision to improve investor information about actively-managed UCITS ETFs; we are aware that this is a minority view, but would not have been shocked by the imposition of a specific market for actively-managed ETFs, given the difference in risk characteristics between these instruments and index-tracking UCITS.

2 Management of collateral for OTC financial derivative transactions and efficient portfolio management techniques With respect to the limitation of counterparty risk, EDHEC welcomes the inclusion of exposure from efficient portfolio management techniques in UCITS counterparty risk limits. Up to now and as we had underlined (2012a), UCITS could take on more unmitigated counterparty risk through efficient portfolio management techniques, such as securities lending, than via OTC derivatives. Likewise, we fully support the new ESMA rules on collateral, which largely answer our call (2012a) for consistent regulation of counterparty risk mitigation, by creating uniform rules for both OTC derivatives and efficient portfolio management techniques. These decisions result in better and more consistent protection of UCITS investors against counterparty risk. They should also put an end to the debate between providers on both sides of the replication divide (i.e. physical vs. synthetic) about the risks of each other s products. Efficient portfolio management techniques EDHEC has previously (2012a, 2012b) emphasised the need for investors to be informed of the revenues from securities lending and other efficient portfolio management techniques and thus welcomes the disclosure requirements created by the new ESMA guidelines. EDHEC is surprised by the boldness of ESMA s proposal to require that all the revenues arising from efficient portfolio management techniques, net of operational costs, be returned to the UCITS. While it is only fair that investors receive the full benefits of the risks taken on their behalf, EDHEC had advocated a more modest approach that relied on disclosure and competition to improve terms for investors. The ESMA decision is a landmark decision that will force a dramatic reshaping of the European securities lending industry in a very short time span. Financial indices Last but not least, EDHEC is extremely pleased with the radical transparency requirements that ESMA is imposing on all financial indices. The decision by ESMA to follow most of the recommendations made by EDHEC (2012b) is a momentous one. By requiring that index calculation methodologies as well as index constituents and weightings be easily and freely available to investors and prospective investors, ESMA is mandating a complete reshaping of the index provision industry, for the benefit of UCITS and end-investors. This information is required to check how index ground rules are implemented. ESMA also requires UCITS to carry out due diligence on the quality of the financial indices they use and prohibits investment in indices whose methodologies are not based on a set of predetermined rules and objective criteria. Ground rules may be ambiguous enough to implicitly allow for discretionary decisions. Against this backdrop, we recommend that ESMA clarifies that free access to historical data on index composition and on the basis for index changes is required for UCITS eligibility. This would allow investors to independently calculate the track records of indices in terms of risk and performance, and allow UCITS to discharge their new obligations at minimal cost. Detailed comments Index-tracking UCITS EDHEC-Risk Institute welcomes the new disclosures put forward in the proposed guidelines, in particular the description of the index and its components (V.9.a), the fund s policy regarding the ex-ante tracking error (V.9.c), 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 (V.11).

3 EDHEC-Risk Institute also welcomes the proposed disclosures on how the index will be tracked and the implications this will have in terms of exposure to the underlying index and counterparty risk (V.9.b) and the description of factors affecting the tracking ability (V.9.d). These new disclosures are in line with EDHEC s (2012a) proposals. However, we regret that, while underlining the differences between actively managed funds and index tracking vehicles and imposing more disclosures on tracking error, the new guidelines fall short of giving a definition of passive management that would be framed in terms of a limit on the maximum level of tracking error acceptable. 1 Index-tracking leveraged UCITS We have previously voiced strong support for ESMA s policy orientations in this area (2012a, 2012b) and the new guidelines are consistent with these policy orientations. We welcome the horizontal manner in which ESMA has decided to apply these higher levels of disclosure about leverage. UCITS ETFs Identifier and specific disclosure On the need for an identifier flagging UCITS compliance We welcome ESMA s decision to use an identifier in an ETF name, fund rules or instrument of incorporation, prospectus, key investor information document and marketing communications to signal that it is UCITS compliant (VII.15). We are pleased to see that our suggestion (2012a, 2012b) to use the acronym UCITS in the identifier (UCITS ETF) has been adopted. On identifiers flagging the use of specific investment tools or portfolio management techniques With regard to labelling, ESMA has avoided the error of imposing the use of identifiers that would have created artificial and misleading distinctions between funds on the basis of the tools or techniques they use, notably to replicate indices (i.e. physical vs. synthetic replication vehicles). However, we regret that this decision is motivated by practical considerations (i.e. implementation difficulties and failure to address hybrid cases) rather than principles. We strongly believe that the regulator should avoid promoting communication about alleged differences between instruments that is not based on relevant risk characteristics. As we have previously explained (2012a), we consider that the index replication method(s) used and the specific risks each method gives rise to, should be suitably disclosed (as the new guidelines so require), but we do not regard methods or tools as viable criteria for product classification. When it comes to categorising funds, we believe that the focus needs to be on the economic exposure achieved or the payoff generated and not on the methods or instruments used to engineer this exposure or payoff. Differences in naming conventions or markers, if any, should result from differences in economic exposures and payoff structures at the overall fund level. 1 Instead, an actively-managed UCITS ETF is defined as a UCITS ETF, the manager of which has discretion over the composition of its portfolio, subject to the stated investment objectives and policies. And index-tracking UCITS is defined as a UCITS the strategy of which is to replicate or track the performances of an index or indices.

4 Actively-managed UCITS ETFs As mentioned in our earlier contribution and Position Paper on the risks of European ETFs (2012a), we consider it key to recognise the difference between passive UCITS that track a financial index and other funds. With the former, investors choose a linear and constant exposure to an index, which should be managed in a transparent and systematic manner and boast a published track record. With the latter, the payoff depends on risktaking and portfolio management models that may not be systematic and are rarely transparent. Differences in transparency and management of risk exposure may result in risks to the investor providing basis for specific identification. We thus welcome ESMA s decision to improve investor information about activelymanaged UCITS ETFs in the context of the prospectus, key investor information document and marketing communications of that fact. We would not have been shocked by the imposition of a specific market for actively-managed ETFs, given the difference in risk characteristics between these instruments and index-tracking UCITS. Treatment of secondary market investors of UCITS ETFs We are in agreement with the new guidelines, their extra disclosures, and the protections afforded to investors in situation of market disruption. Efficient portfolio management techniques We previously (2012b) voiced agreement with ESMA regarding the need for investors to be informed of the revenues from securities lending and other efficient portfolio management techniques and welcome the disclosure requirements created by the new guidelines (X.25 and X.32). We also underlined the need for clarification of the rules on the distribution of fee income (2012a, 2012b) and thus fully support the new disclosures regarding the operational costs/fees arising from efficient portfolio management techniques that may be deducted from the revenue delivered to the UCITS (X.28 and X.32). We are surprised by the boldness of ESMA s proposal to require that all the revenues arising from efficient portfolio management techniques, net of operational costs, be returned to the UCITS (X.29).While it is only fair that investors receive the full benefits for the risks taken on their behalf, we had advocated a more modest approach that relied on disclosure and competition to improve terms for investors. The ESMA decision will force a dramatic reshaping of the European securities lending industry in a very short time span; the impact of the decision on the structuring of the securities lending industry and on the supply and demand for securities lending should be studied urgently. The requirement that UCITS ensure that they can recall at any time any security lent out (X.30) also has disruptive potential. Financial derivative instruments We welcome the decision by ESMA to require that the portfolio playing the economic role of collateral comply with the investment limits set out in Articles 52, 53, 54, 55 and 56 of the UCITS Directive (XI.33). This creates a level playing field between funded and unfunded swaps 2. We also welcome the statement that the underlying exposures of the financial derivative instruments should be taken into account to calculate the investment limits laid down in Article 52 of the UCITS Directive (XI.34). We support the other disclosures (XI.35 and XI.37) and clarifications (XI.36). 2 Likewise, all assets received by UCITS in the context of efficient portfolio management techniques should be considered as collateral for the purpose of these guidelines (XII.39).

5 Management of collateral for OTC financial derivative transactions and efficient portfolio management techniques We welcome ESMA s clarification (XII.38) that the risk exposures to a counterparty arising from OTC financial derivative transactions and efficient portfolio management techniques should be combined when calculating the UCITS counterparty risk limits 3. We fully support the new ESMA rules on collateral for OTC derivative transactions and efficient portfolio management techniques (XII.40) as they are in line with our proposals (2012a), which called for EU-wide consistent regulation of counterparty risk mitigation and recommended that limits on counterparty risk should apply to all transactions giving rise to such risk and not simply to OTC derivatives. The new guidelines update the CESR guidelines (CESR/10-788) related to the collateralisation of OTC derivatives by UCITS, which we had recommended (2012a) as a reference to improve collateralisation of all transactions, exposing UCITS and non- UCITS investment vehicles to counterparty risk, notably securities lending, repurchase agreements and other economically comparable operations. We welcome this horizontal approach. Financial indices We are delighted that ESMA followed our advice (2012b) and imposed new transparency requirements on all financial indices rather than strategy indices only. These new transparency requirements concern the calculation methodology as well as index constituents and weightings (XIII.52; 53). Likewise, we welcome ESMA s decision (XIII.53) to follow our recommendation (2012b) and require this information to be easily accessible, free of charge, by investors and prospective investors. This is a landmark decision that will reshape the index provision industry, which heretofore had been providing only limited information to investors under the pretext of protecting intellectual property. We had previously underlined (2012b) that this information was difficult to obtain for traditional indices, even though the rules of the latter are typically simple, and in the case of strategy indices, that it was almost impossible to procure at reasonable cost. We had stressed that such information was required to check how ground rules were implemented and to independently calculate the track records of indices in terms of risk and performance. Free public disclosure of this information not only allows UCITS and end-investors to perform their due diligence at minimal cost, but also fosters the development of independent research on indices that would contribute to market efficiency. We also welcome the proposed requirement for UCITS to carry out due diligence on the quality of the financial indices they use (XIII.57). In the context of the acceleration of the growth of passive investment, EDHEC-Risk Institute feels that more attention should be given to the quality of index governance and the auditability of decisions made by index committees. These ESMA guidelines thus correctly underline that ground rules must be pre-determined and objective (XIII.54) and require UCITS to determine whether there is an independent audit of index quality (XIII.57). Ground rules may be ambiguous enough to implicitly allow for discretionary decisions. The exercise of discretion in the implementation of ground rules blurs the distinction between passive and active management. Ground rule changes bear comparable risks and deserve comparable attention. We thus seek clarification from ESMA on the amount of transparency and free public disclosure it is requiring (under XIII.53). ESMA indeed requires constituents and weightings to be published, e.g. after each re-balancing on a 3 See article 52.

6 retrospective basis. For ESMA, this information should (at minimum) cover the period since the last rebalancing and include all levels of the index. It is unclear whether this obligation is intended going forward or whether it should be provided since index inception. Our recommendation is for full transparency and free public disclosure of all historical information on the composition of indices as well as the basis for index changes and supporting documentation. This would allow investors to independently calculate the track records of indices in terms of risk and performance, and would allow UCITS to discharge their new obligations (e.g. under XIII.54 and XIII.57) at minimal cost to the end-investors. We take note of the important scope limitations imposed by ESMA: for an index to be eligible for UCITS investment, it must satisfy the index criteria in Article 53 of the UCITS Directive and Article 9 of the Eligible Assets Directive, including that of being a benchmark for the market to which it refers (XIII.48). Customised indices are banned (XIII.49). Indices that are rebalanced daily or more frequently (technical adjustments excepted) are disqualified (XIII.51). Bibliography Cited work CESR (2010). CESR s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS. Committee of European Securities Regulators, CESR/10-788, 2010 (July). EDHEC (2012a). Amenc, N., Ducoulombier, F., Goltz, F., and Tang, L. What Are the Risks of European ETFs? Position Paper, EDHEC-Risk Institute, 2012 (January). EDHEC (2012b). Amenc, N., Ducoulombier, F. EDHEC-Risk Institute comments on ESMA Consultation Paper, ESMA/2012/44. Comment Letter, EDHEC-Risk Institute, 2012 (March). ESMA (2012). Guidelines on ETFs and other UCITS issues Consultation on recallability of repo and reverse repo arrangements.» Report and Consultation paper, European Securities and Markets Authority, ESMA/2012/474, 2012 (July). Related work EDHEC (2012c). Amenc, N., Ducoulombier, F. Public Comment on Principles for the Regulation of Exchange Traded Funds, EDHEC-Risk Institute contribution to IOSCO Consultation Report CR05/12. Comment Letter, EDHEC-Risk Institute, 2012 (June).