A key, but perhaps less well-publicised section of the European securities regulator’s recent consultation paper on exchange-traded funds and UCITS funds was devoted to strategy indices. Strategy indices are defined by ESMA as “indices which aim to replicate a quantitative or trading strategy” and were the subject of a recent IndexUniverse.eu article.
ESMA’s draft guidelines include several requirements to make strategy indices more transparent. Under the guidelines, the index provider will have to disclose the full calculation methodology, allowing investors to replicate the index. This means the disclosure of index constituents, of the calculation and rebalancing methodology, and of changes to the index methodology. Index providers will also need to publish index allocations and must put index levels into the public domain.
ESMA published the responses to its consultation early last month, with the bulk of the replies coming from ETF and index industry participants, banks and trade groups. Although the majority of the respondents expressed broad agreement for the aims of the proposed strategy index guidelines, there was less common ground when it came to the details of future index regulation.
To place the index debate in its proper context, it’s useful to revisit how Europe’s UCITS regulations work and, specifically, how the regulations have been adapted over the years to cater for index-based funds. The four UCITS (Undertakings for Collective Investment in Transferable Securities) directives, enacted between 1985 and 2011, created a harmonised framework for investment funds within the European Union. UCITS defines several core features of a fund, such as risk diversification, as well as specifying the assets eligible for investment.
The original rules for asset diversification caused a problem for UCITS wishing to track indices with weightings of individual constituent securities of more than 5 percent or aggregate weightings of issuers of more than 10 percent. Since the 2001 revision of UCITS (“UCITS III”), however, the diversification rules for funds tracking indices have been relaxed, as long as the underlying benchmark is deemed as “sufficiently diversified”, an adequate benchmark for the market to which it refers, and if it is published in an “appropriate” manner. Up to 20 percent of an index eligible for use by an index-tracking UCITS may now be invested in securities issued by a single body. In exceptional circumstances, this limit can be raised to 35 percent.
UCITS III also expanded the universe of eligible assets beyond transferable securities to include money market instruments, units of other funds as well as banking deposits. UCITS III also allowed fund managers to make greater use of certain derivatives contracts (interest rate, FX and certain credit derivatives, but not commodity derivatives). Derivatives based on “financial indices” were also permitted, subject to the indices meeting the usual criteria (diversification, benchmark, publication). This change paved the way for the development of synthetic index-tracking funds, as well as allowing funds to invest in commodities and property through index derivatives. UCITS III also provides for non index-tracking funds to invest in index-based derivatives and, provided this is done for risk diversification purposes, such funds can do so without having to look through to an index’s underlying assets to ensure they are sufficiently diversified.
What The Index Proposals Cover
Some respondents to ESMA’s consultation paper requested a more precise definition of “strategy indices”, as well as expressing uncertainty as to how the new proposals for strategy indices will comply with the existing UCITS framework.
Many respondents questioned whether the guidelines will be applicable to all indices, or only to strategy indices. BVI, the German investment management industry body, believes that: “the guidelines should be relevant [only] for ’strategy indices’ as the suggested disclosure standards (in terms of calculation methodology and index performance) might be difficult to fulfill by a number or broadly recognised market indices”. AFG and EFAMA (the French and European investment management industry bodies) take the opposite view, however, arguing that, at least for UCITS wishing to benefit from the derivatives exemption given to financial indices, the guidelines should be applicable to all indices. Lyxor also argues for broader, more generic regulation, rather than the creation of specific rules for subsets of indices.
Several respondents ask whether ESMA is seeking to regulate the use of indices by index-tracking funds only, or index use by any UCITS fund. Some, like Lyxor, argue that the regulations should apply equally to all UCITS that wish to take advantage of the special exemptions given to financial indices, but that regulation is unnecessary when managers choose to “look through” to an index’s underlying assets.
Others point out potential inconsistencies with current rules. According to ETF Securities: “Additional clarification would help to make sure that the recommendations around diversification of a strategy index conform to current CESR guidelines. For example, for traditional financial indices, CESR has allowed UCITS to gain exposure to (but not replicate) sub-indices that are not diversified as long as the exposure to the sub-index is sufficiently diversified at the portfolio level.”
Threadneedle, an active fund manager, makes a similar point with respect to the use of single commodity indices, proposing that ESMA should only apply its new rules to index-tracking funds.