ESMA issued its new ETF guidelines at the end of July, just before many Europeans took off for a month on the beach. As the guidelines are unlikely to come into force until early 2013, the indexing and ETF industry has plenty of time to analyse and interpret the rules. But, make no mistake, some significant changes to business models are in store.
Many commentators on the guidelines have focused on ESMA’s new requirements for securities lending in ETFs and other UCITS funds, a relatively opaque area of fund management, but one that’s been attracting increased interest from regulators. But, perhaps more importantly, ESMA’s document also represents a fundamental reassessment of the ground rules for index-based investing.
ESMA’s stated objective is to strengthen the protections for those investing under the UCITS framework, which governs funds approved for distribution to retail investors in Europe. The section of the guidelines dealing with indices has a particular focus on improving the transparency of information provided to investors, as well as the effective imposition of new limits on the complexity of so-called “financial indices” (as defined below).
Industry insiders will admit off-the-record that the third version of UCITS (“UCITS III”), which came out in 2001, as well as some of the guidelines issued by CESR (the predecessor of ESMA), have been abused by some market participants. UCITS III allowed retail investment funds to invest in a variety of financial indices via derivatives contracts. One commonly cited example of such abuse is a “black-box”, discretionary strategy buying derivatives on an index specially created for the purpose and thereby being disguised as an index-tracking fund. As such, the new guidelines are a much needed purgative for the market.
Scope Of The New Rules
In a change to the earlier consultation papers, ESMA has decided to adopt a horizontal treatment to the use of financial indices. This is a significant change to regulators’ previous practice of layering rules upon rules. It also signals ESMA’s realisation that a clean start is needed. ESMA has made it clear that the new guidelines will apply to all UCITS investing in financial indices, meaning that they affect active, as well as passive funds.
UCITS rules specify three key requirements for a financial index (an index in which a fund may invest, often via the use of over-the-counter—i.e., bilaterally negotiated—derivatives contracts): it must be transparent, i.e., have clear rules and be published in an appropriate manner; its composition must be sufficiently diversified; and the index must represent an adequate benchmark for the market to which it refers.
Despite strong pushback during the consultation process, particularly from index providers concerned about the protection of their intellectual property, ESMA has decided that investor protection is best served by insisting on the full disclosure of index calculation methodologies, as well as the provision of a detailed breakdown of index constituents.
The final guidelines state that UCITS funds and ETFs should not invest in financial indices for which the index provider does not disclose the full calculation methodology. An investor should be able to find this information free of charge, ESMA says, for example via the internet. The investor should be able to obtain information on the performance of the index and the information provided should also be sufficient to enable a third party to replicate the index, the regulator stipulates.
ESMA’s request for index transparency chimes with recent comments by the Dutch financial regulator, the AFM. In a recent report, the AFM made critical comments about the adequacy of index-related information on ETF issuers’ websites.
“The methodology of the index was often not explained [on ETF firms’ websites],” said the AFM, adding that “there was frequently no mention of the exact place where information could be found regarding the applicable benchmark.”
In its new guidelines, ESMA has, however, stepped back from requiring the real-time disclosure of index constituents. Instead, index constituents, together with their weightings, may be published retrospectively and covering the period prior to the most recent rebalancing of the index. All index levels must also be published for the previous period, ESMA says.
As with earlier versions of the rules, UCITS may only invest in indices that respect certain diversification requirements. In particular, no more than 20% of an index-tracking fund can be invested in securities of a single issuer. ESMA has now decided that the diversification requirements should explicitly cover leveraged indices, to protect investors from excessive concentration. Commodity indices have also seen some changes: UCITS can no longer invest in non-diversified commodity indices and ESMA has set out formal criteria for the treatment of related groups of commodities with respect to diversification limits.