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.
ESMA’s proposals on index disclosure drew strong support from Morningstar.
“We would emphasise the need for greater transparency around the methodologies, constituents, and embedded costs of strategy indices,” said the firm. “As it pertains to these considerations, the proposed guidelines are spot on.”
Amundi echoed this but introduced a note of caution in its submission to ESMA: “Greater transparency in index-tracking funds is very welcome, especially regarding indices’ methodology and composition; nevertheless the degree of transparency relies on the ability and willingness of index providers to disclose such information.”
Responses from index providers have unsurprisingly concentrated on ESMA’s demands for better disclosure. The provision of indices has become a big business and index providers are strongly motivated to defend their business models. At the same time, respondents from all sides of the industry have pointed out the intellectual property and competition issues that are raised by the proposals. Under ESMA’s draft guidelines, index providers will need to publish the full details of an index’s composition, a level of information that is often currently available only to the holders of index licences, purchased from providers.
In a joint submission, MSCI, S&P and FTSE, who recently combined to form an index industry trade body, argue that ETFs themselves provide sufficient disclosure of index composition in their daily portfolio composition files (or PCFs). While this initially seems like a reasonable observation, ETF managers often use sampling techniques to determine their fund holdings so a fund’s composition can be quite different to that of the index being tracked.
Many respondents to ESMA’s consultation paper question the need to change the current arrangements. For example, Ossiam argues that: “Currently, some index providers agree to give the composition of an index, but with a lag, in order to prevent front-running by arbitrageurs and to protect the intellectual property linked to the index. We think this is the appropriate setup and that we should not impose a real-time availability of the index components.” This view was supported by EFAMA and IMA (the UK asset management trade body).
The consultation paper also proposes mandatory disclosure of the index calculation methodology. This is the norm for benchmark indices—although, as Amundi points out, some benchmark providers, MSCI for example, withhold these even for "vanilla" indices. Many strategy indices involve proprietary investment rules that index providers have historically been unwilling to disclose.
But not everyone agrees that the full disclosure of index methodologies is necessary; Deutsche Bank argues that “proprietary methodologies are the basis on which investment managers compete and are therefore commercially sensitive. Therefore, they should not be required to be fully disclosed. As long as an investor understands how the index operates and in which assets it invests—via appropriate disclosures—the interests of the investor are sufficiently protected.”
RBS also points out that “several regulators accept the disclosure of a redacted version of the methodology or full publication via a secured website only accessible by existing investors. These indices may nonetheless comply with UCITS index regulations and be fully rules-based as required. We believe that a redacted version of the methodology is sufficient, provided that it provides the necessary information to fully understand the mechanisms, techniques, composition and rules of the index.”
The disclosure debate shows how commercially sensitive ESMA’s draft index guidelines are. Supporters of strategy indices point out that they fulfill an important role in allowing investors access to markets and systematic strategies that would otherwise be unavailable. Yet, say many industry firms, the desired disclosure levels threaten existing business models, as well as possibly also leading to the front-running of index changes, something that could damage investors.
Whatever ESMA decides when it issues its final guidelines later this year, it’s clear that not everyone is going to be happy with the outcome. If mandated, increased levels of disclosure of intellectual property represent a big challenge to the index industry. ESMA’s proposals also have the potential to inflict profound changes on the management of active, as well as passive funds.