Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 9 March 2012

Transcription

1 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues I. Index-tracking UCITS Q1: Do you agree with the proposed guidelines? Ben Johnson Director of European ETF Research ben.johnson@morningstar.com Hortense Bioy, CFA Senior ETF Analyst hortense.bioy@morningstar.com Gordon Rose, CIIA ETF Analyst gordon.rose@morningstar.com We agree wholeheartedly with the proposed guidelines. A clear and comprehensive description of index-tracking UCITS benchmark indices is essential and ultimately facilitates informed comparisons amongst multiple funds tracking identical or similar indices. We would add that it is important to highlight the treatment of income embedded in the index s calculation (gross return, net return, price return, etc.) and how the tax treatment of income within the UCITS may differ from the tax assumptions embedded in the benchmark s calculation. Differences in tax treatment of income between the benchmark and the UCITS itself can have important implications for tracking. Q2: Do you see merit in ESMA developing further guidelines on the way that tracking error should be calculated? If yes, please provide your views on the criteria which should be used, indicating whether different criteria should apply to physical and synthetic UCITS ETFs. Yes, we see merit in the development of a standard industry measure of tracking error. We believe that such a measure would be a large step forward towards facilitating comparisons of products tracking identical or similar indices. We do not believe that different criteria should apply to physical and synthetic UCITS ETFs as these funds objective is identical regardless of the replication method in question to deliver high fidelity tracking of the fund s prospectus benchmark. Q3: Do you consider that the disclosures on tracking error should be complemented by information on the actual evolution of the fund compared to its benchmark index over a given time period? In addition to a standardised quantitative measure of tracking error, we would welcome accompanying qualitative information describing the chief sources of tracking error for indextracking UCITS (fees, securities lending revenue, swap costs, sampling, etc.). II. Index-tracking leveraged UCITS Q4: Do you agree with the proposed guidelines for index-tracking leveraged UCITS? We believe that item (c) is especially important. Q5: Do you believe that additional guidelines should be introduced requiring index tracking leveraged UCITS to disclose the way the fund achieves leverage?

2 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 2 Most leveraged ETFs in Europe use synthetic replication. As such, the leverage is embedded in their benchmark indices calculation. Therefore, the fund does not engage in borrowing or lending to achieve the leveraged (or inverse) return. However, physically replicated ETFs offering leveraged and/or inverse exposure will actually have to borrow to achieve their relevant exposure- -which introduces a new layer of risk. Hence, we believe that the manner in which the fund achieves leverage should be made clear as this might differ depending on the fund s replication method. Also, we believe that it would be in investors best interests to harmonise the naming convention for index-tracking leveraged UCITS. Specifically, we believe that these funds names should contain the name of the relevant index (i.e. DAX, CAC 40, FTSE 100, etc.), the frequency with which the leverage factor is reset (typically daily or monthly) and a reference to the leverage factor (+1X, -1X or short or inverse, for example). In addition, we believe that it is investors best interests to include hypothetical illustrations of the funds performance in the context of a variety of market environments to illustrate the path-dependent nature of their returns over longer holding periods. III. UCITS Exchange Traded Funds Definition of UCITS ETFs and Title Q6: Do you agree with the proposed definition of UCITS ETFs? In particular, do you consider that the proposed definition allows the proper distinction between Exchange-Traded UCITS versus other listed UCITS that exist in some EU jurisdictions and that may be subject to additional requirements (e.g. restrictions on the role of the market maker)? Yes, we agree with the proposed definition of UCITS ETFs. Q7: Do you agree with the proposed guidelines in relation to the identifier? Yes, we believe that the ETF identifier should appear in the fund s name so as to further codify the distinction between UCITS ETFs and other non-ucits exchange-traded products (ETPs). Q8: Do you think that the identifier should further distinguish between synthetic and physical ETFs? While we do not necessarily believe that the identifier should distinguish between synthetic and physical ETFs, we do believe that there is a need to harmonise the labeling and disclosure of UCITS ETFs replication methods. Specifically, we believe that--at a minimum--providers should clearly label their funds with a Replication Method attribute tag that contains one of three values: Synthetic, Physical Full, or Physical Sampled. The current naming conventions (where they exist) for synthetic replication in particular vary quite widely across providers. Harmonising the labeling convention and making the replication method in question more

3 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 3 apparent is in investors best interests, as many have a clearly stated preference for one type over another. Q9: Do you think that the use of the words Exchange-Traded Fund should be allowed as an alternative identifier for UCITS ETFs? Yes, we believe that the use of the words Exchange-Traded Fund should be allowed as an alternative identifier for UCITS ETFs. Q10: Do you think that there should be stricter requirements on the minimum number of market makers, particularly when one of them is an affiliated entity of the ETF promoter? We have seen evidence that having a single market maker for a UCITS ETF that is an affiliate of the ETF promoter can have negative implications for investors. As such, we believe that there should be stricter requirements on the minimum number of market makers for UCITS ETFs. Alternatively, we would also argue that putting stricter penalties in place in the event that a market maker(s), be it the sole market maker for a given fund and an affiliate of the fund promoter or a group of market makers, fail to make an orderly market (provide timely and accurate pricing) in an ETF s shares could also serve to prevent breakdowns in ETF liquidity. Actively-managed UCITS ETFs Q11: Do you agree with the proposed guidelines in relation to actively-managed UCITS ETFs? Are there any other matters that should be disclosed in the prospectus, the KIID or any marketing communications of the UCITS ETF? We agree with the proposed guidelines in relation to actively-managed UCITS ETFs. We believe that providing transparency around the calculation and publication of the inav is particularly important as it is a vital touch point for investors to ensure that they are receiving quality trade execution. Additionally, we think that there is a need for a formal definition of actively-managed as it pertains to UCITS ETFs. We think that this is especially important in light of the ongoing proliferation of more complex exposures made available to investors via the ETF vessel. Specifically, we believe that any ETF that either uses full on active management or follows an index which includes a substantial element of human discretion (we d exclude committee decisions such as those relevant to such indices as the S&P 500 Index from this category) should be clearly labeled as active. Examples of existing UCITS ETFs using full on active management would include, but not be limited to the PIMCO Source Euro Short Maturity ETF, the db X-trackers SCM Multi Asset ETF, and the Alpcot Active Greater Russia ETF. Examples of ETFs tracking indices which include a substantial element of human discretion include but are not limited to the Source Man GLG Europe Plus ETF, the db x-trackers db Hedge Fund Index ETF, and the RBS Market Access CTA ETF. We propose that both types be clearly classified as active. Secondary market investors

4 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 4 Q12: Which is your preferred option for the proposed guidelines for secondary market investors? Do you have any alternative proposals? We prefer Option 1. Q13: With respect to paragraph 2 of option 1 in Box 5, do you think there should be further specific investor protection measures to ensure the possibility of direct redemption during the period of disruption? If yes, please elaborate. No. We believe that in certain circumstances such an arrangement could be detrimental to the fund s performance, adversely affecting the remaining shareholders. Conducting numerous, ad hoc, sub-scale redemptions likely in the midst of a market dislocation could be costly and would certainly be inefficient from a portfolio management perspective. These costs would likely be borne by remaining shareholders in the form of deteriorating tracking performance. Q14: Do you believe that additional guidelines should be provided as regards the situation existing in certain jurisdictions where certificates representing the UCITS ETF units are traded in the secondary markets? If yes, please provide details on the main issues related to such certificates. Q15: Can you provide further details on the relationship between the ETF s register of unit-holders, the sub-register held by the central securities depositaries and any other sub-registers held, for example by a broker or an intermediary? IV. Efficient portfolio management techniques Q16: Do you agree with the proposed guidelines in Box 6? In particular, are you in favour of requiring collateral received in the context of EPM techniques to comply with CESR s guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS? Yes, we agree with the proposed guidelines in Box 6. And yes, we are in favour of requiring collateral received in the context of EPM techniques to comply with CESR s guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS, particularly as it pertains to considerations of the collateral s liquidity, valuation, and diversification. Q17: Do you think that the proposed guidelines set standards that will ensure that the collateral received in the context of EPM techniques is of good quality? If no, please justify.

5 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 5 Q18: Do you see merit in the development of further guidelines in respect of the reinvestment of cash collateral received in the context of EPM techniques (the same question is relevant to Box 7 below)? No. We also believe that Non-cash collateral should not be sold, re-invested or pledged, and that cash collateral should only be invested in risk-free assets. Q19: Would you be in favour of requiring a high correlation between the collateral provided and the composition of the UCITS underlying portfolio? Please explain your view. We are torn on this topic. On the one hand, maintaining a high degree of correlation between the collateral provided and the composition of the UCITS underlying portfolio has certain benefits. Specifically, this high degree of correlation would increase the likelihood that the value of the collateral or substitute basket (in the case of ETFs using synthetic replication) would move in tandem with the underlying benchmark. This could result in operating efficiencies which would serve to keep ongoing operating costs low. On the other hand, holding collateral with a low level of correlation to the composition of the UCITS underlying portfolio may also have certain benefits. In the event of a counterparty default, having uncorrelated collateral could serve to ensure maximum liquidation value for ETF shareholders, in the event the fund was ultimately dissolved. However, this type of collateral is typically more expensive, and these expenses would ultimately be borne by investors. All told, we would prioritise appropriate haircuts, liquidity, valuation, and diversification of collateral above the collateral s level of correlation with the composition of the UCITS underlying portfolio. Q20: Do you agree that the combination of the collateral received by the UCITS and the assets of the UCITS not on loan should comply with the UCITS diversification rules? Q21: With regards to eligibility of assets to be used as collateral, do you have a preference for a list of qualitative criteria (as set out in CESR s guidelines on risk measurement) only or should this be complemented by an indicative list of eligible assets? We believe that this should be complemented by an indicative list of eligible assets in order to provide investors with concrete examples of securities possessing the relevant qualitative attributes. Q22: Do you believe that the counterparty risk created by EPM techniques should be added to the counterparty risk linked to OTC derivative transaction when calculating he maximum exposure under Article 52.1 of the UCITS Directive? Q23: Alternatively, do you see merit in prescribing an exhaustive list of assets eligible for use as

6 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 6 collateral? If so, please provide comments on whether the list of assets in paragraph 52 is appropriate. We believe that the list of assets in paragraph 52 would be appropriate. Q24: Do you agree that entities to which cash collateral is deposited should comply with Article 50(f) of the UCITS Directive? Q25: Do you believe that the proportion of the UCITS portfolio that can be subject to securities lending activity should be limited? If so, what would be an appropriate percentage threshold? Q26: What is the current market practice regarding the proportion of assets that are typically lent? As we outlined in a recent study of the current securities lending practices of sponsors of UCITs ETFs, current practices vary quite widely. At any given point in time there have been UCITS ETFs with anywhere from 0% to 100% of their assets out on loan. A version of the study can be viewed here: Transparency.aspx Q27: For the purposes of Q25 above, should specific elements be taken into account in determining the proportion of assets (e.g. the use made by the counterparty of the lent securities)? Q28: Do you consider that the information to be disclosed in the prospectus in line with paragraphs 1 and 2 of Box 6 should be included in the fund rules? Q29: Do you see the merit in prescribing the identification of EPM counterparties more frequently than on a yearly basis? If yes, what would be the appropriate frequency and medium? Yes, we believe that quarterly disclosure via the sponsors public Web sites would be a low cost way to increase transparency around the identities of EPM counterparties for investors. Q30: In relation to the valuation of the collateral by the depositary of the UCITS, are there situations (such as when the depositary is an affiliated entity of the bank that provides the collateral to the UCITS) which may raise risks of conflict of interests? If yes, please explain how these risks could be mitigated? The question is also valid for collateral received by the UCITS in the context of total return swaps

7 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 7 Yes, there are situations (such as the one outlined in the question) that may raise risks of conflicts of interest. However, the proposed guidelines pertaining to the composition of collateral received by UCITS in the context of total return swaps should serve (assuming they are implemented) to mitigate any such conflicts. Q31: Do you think that the automation of portfolio management can conflict with the duties of the UCITS management company to provide effective safeguards against potential conflicts of interest and ensure the existence of collateral of appropriate quality and quantity? This question is also relevant to Box 7 below. V. Total return swaps Q32: Do you agree with the proposed guidelines? Though we would add that in the spirit of maintaining consistency with the treatment of collateral in the context of EPM techniques in physical replication funds (the subject of question 18) should also apply to the collateral or assets of synthetic replication funds. Specifically, we believe that non-cash collateral/assets should not be sold, loaned to third parties, re-invested or pledged, and that cash collateral/assets should only be invested in risk-free assets. Q33: Do you think that the proposed guidelines set standards that ensure that the collateral received in the context of total return is of good quality? If not, please justify. In particular, making it clear that UCITS diversification requirements should apply to both collateral in the case of a funded swap and fund assets in the case of an un-funded swap is an important development. Q34: Do you consider that the information to be disclosed in the prospectus in line with paragraph 5 of Box 7 should be included in the fund rules? Q35: With regards to eligibility of assets to be used as collateral, do you have a preference for a list of qualitative criteria (as set out in CESR s guidelines on risk measurement) only or should this be complemented by an indicative list of eligible assets? We believe that this should be complemented by an indicative list of eligible assets in order to provide investors with concrete examples of securities possessing the relevant qualitative attributes.

8 Morningstar s Response to ESMA s Consultation Paper on ETFs and Other UCITS Issues 8 Q36: Alternatively, do you see merit in prescribing an exhaustive list of assets eligible for use as collateral? If so, please provide comments on whether the list of assets in paragraph 73 is appropriate. We believe that the list of assets in paragraph 73 would be appropriate. Q37: Do you agree that the combination of the collateral received by the UCITS and the assets of the UCITS not on loan should comply with the UCITS diversification rules? Q38: Do you consider that the guidelines in Box 7 and in particular provisions on the diversification of the collateral and the haircut policies should apply to all OTC derivative transactions and not be limited to TRS? VI. Strategy indices Q39: Do you consider the proposed guidelines on strategy indices appropriate? Please explain your view. Yes, we believe the proposed guidelines are appropriate. In particular, we would emphasise the need for greater transparency around the methodologies, constituents, and embedded costs of strategy indices. As it pertains to these considerations, the proposed guidelines are spot on. Q40: Do you think that further consideration should be given to potential risks of conflict of interests when the index provider is an affiliated firm of the management company? In order to minimise the potential for conflicts of interest, we believe that (in the case that they are affiliated entities) the index provider and fund sponsor should be separated by a Chinese wall. VII. Transitional provisions Q41: Do you consider the proposed transitional provisions appropriate? Please explain your view.