The European Securities and Markets Authority (ESMA) has published guidelines on index-tracking UCITS and UCITS ETFs.
UCITS, which stands for Undertakings for Collective Investment in Transferable Securities, are authorised funds which can be sold to retail investors across the European Union.
The guidelines set out the information that should be given to investors about index-tracking UCITS and UCITS ETFs, together with specific rules for UCITS when entering into over-the-counter (OTC) financial derivative transactions, such as swaps, and securities lending. The guidelines also set out the criteria for indices.
The guidelines include a number of key provisions. These include:
- ETFs that fall under the definition of UCITS ETFs will have to carry the identifier “UCITS ETF” in their name and will have to ensure appropriate redemption conditions for secondary market investors by opening the fund for direct redemptions when the liquidity in the secondary market is not satisfactory;
- UCITS ETFs entering into securities lending activities will have to inform investors clearly about these activities and the related risks. All revenues net of operating costs generated by these activities should be returned to the ETF. Additionally, when a UCITS ETF enters into securities lending arrangements, it should be able at any time to recall any securities lent or terminate any agreement into which it has entered;
- UCITS ETFs receiving collateral to mitigate counterparty risk from OTC financial derivative transactions (such as swaps) or securities lending should ensure that the collateral complies with very strict qualitative criteria and specific limits in relation to the diversification;
- UCITS ETFs will have to ensure that investors are provided with the full calculation methodology of underlying benchmark indices and should only track indices which respect strict criteria regarding, among other things, rebalancing frequency and diversification.
Steven Maijoor, ESMA Chair, said: “These comprehensive guidelines are aimed at strengthening investor protection and harmonising regulatory practices across this important EU fund sector. They increase the level and the quality of information provided by UCITS to their investors, clarify the criteria for the management of collateralised transactions such as securities lending, repo and reverse repos and OTC derivatives, and set out the types of financial index in which UCITS may invest.”
Commenting on the guidelines, Joe Linhares, head of iShares EMEA, said: “[The] guidelines represent a positive step towards ensuring investors better understand the risks and attributes associated with exchange-traded products (ETPs). BlackRock and iShares have long campaigned for greater disclosure and transparency within the ETP industry.
“We have always believed that clearer labelling of ETPs helps investors and that product labelling should not simply be confined to ETFs per se, but to other ETPs such as exchange-traded notes and exchange-traded commodities. We also believe investors benefit from knowing whether their ETP is physically replicating or derivatives replicating, which can be achieved with clear labelling.
“Investor protection has been at the heart of ESMA’s guidelines and whilst we concur that investors should have a clear understanding of the risks associated with ETPs, including counterparty and market risk, we also believe that investors should be made aware of the potential benefits that activities such as securities lending can bring to them.”
Meanwhile, Moody’s, a credit rating agency, noted that the guidelines could hurt the profitability of some ETF providers as a result of higher compliance costs and curtailment of profitable securities lending activities. Vanessa Robert, Vice President and Senior Credit Officer at Moody’s, said: “Under the new guidelines, which we do not expect to go into effect until early next year, all securities lending revenues, net of operating costs, must be returned to the ETF to compensate investors for assuming the associated counterparty risk.
“While some ETF sponsors, such as Comstage and Credit Suisse, already return 100% of securities lending fee income to fund investors, others retain a percentage of the fee income for themselves. Some sponsors, such as EasyETF and SPDR ETF, keep up to 50% of the revenue.”
However, Alastair Kellett, an ETF analyst at Morningstar, suggested that the guidelines relating to securities lending revenues wouldn’t necessarily result in investors receiving a greater share of the proceeds, or indeed ETF providers losing out: “From a transparency standpoint, the new policies are great for investors, who have thus far been mostly in the dark about exactly how securities lending proceeds get divvied up. But the letter of the guidelines does not necessarily ensure that the end investor will get any more of the revenue, or that securities lending will be any less profitable for the fund providers or lending agents. Nor does it force providers to change their philosophies towards who deserves how much of the pie. Mandating the return of 100% of revenues from securities lending sounds great, but when it’s 100% net of direct and indirect fees and expenses, and providers can allocate those fees and expenses as they see fit, the stipulation loses some of its teeth.”