ETFs Are Regulated Just Like Active Funds

[This article is from the Learn section of our website, a comprehensive database of educational articles]

The guiding regulation for most European ETFs is the region’s “UCITS” fund framework. UCITS (“Undertakings for Collective Investment in Transferable Securities”) refers to a series of European Union directives in place since 1985.

A few European ETFs are not UCITS—notably, certain funds issued (domiciled) in Switzerland, Sweden and Eastern Europe.

It’s easy to tell if an ETF is a UCITS: From 2014, all compliant funds will have to include the words “UCITS ETF” in their names.

UCITS sets a variety of minimum standards for funds authorised for sale to Europe’s retail investors.

These include:

-Liquidity – a UCITS is redeemable on demand, although in practice, regulators may permit deferred redemptions in times of market stress

-Risk management – a UCITS manager must employ a detailed risk management policy

-Transparency – a UCITS must produce annual and semiannual financial reports, and calculate a net asset value at least fortnightly

-Restrictions – a UCITS may invest only in eligible assets and is subject to diversification limits

-Leverage limits – a UCITS may not have total market exposure exceeding 200% of its net asset value

-Service providers – a UCITS must have a custodian and an independent auditor, both of which have duties of care to the fund’s investors

Since 2011, each UCITS must also produce a key investor information document (KIID), which offers summary information in a standardised format.

The diversification requirements for UCITS are worth remembering. The key requirement is called the “5/10/40” rule: a UCITS may not invest more than 5% of its assets in securities of a single issuer, although this limit can be increased to 10% per single body so long as the total value of all holdings exceeding 5% does not exceed 40%.

For index-tracking UCITS, the diversification limits can be relaxed, subject to agreement from the local regulator: The limit for exposure to an individual issuer can be increased to 20%, and in exceptional circumstances to 35%.

It’s also worth noting that although UCITS can invest directly only in eligible assets (transferable securities), it’s possible for a UCITS to gain exposure to ineligible assets via a derivatives contract on a financial index. This exemption paves the way for UCITS to track indices of otherwise-ineligible assets like commodities.

In 2012, the European Securities and Market Authority published a number of additional guidelines for ETFs and other UCITS. These included more prescriptive rules for the collateral received when UCITS use derivatives or lend securities; greater transparency requirements for the indices used by UCITS; and a requirement for a UCITS ETF manager to offer a direct redemption facility for investors if a fund becomes illiquid.

UCITS authorised in the UK are also subject to more detailed regulatory requirements, as set out in the Financial Conduct Authority’s Collective Investment Schemes Sourcebook (COLL). COLL covers funds’ operating duties and responsibilities, investing and borrowing powers, and investor relations.

Regulatory documents for UCITS ETFs can run to hundreds of pages. Investors considering an investment in a particular fund should consult the KIID and fund fact sheet as a starting point, then key sections of the prospectus (investment policy and objective, risks, fees, conflicts of interest) to get a fuller picture.