The International Organization of Securities Commissions (IOSCO) has finally released its comments and proposals around how ETFs should be regulated in the future. No big surprises here – but the IOSCO proposals do go straight to the heart of the matter by getting serious about tracking error, something too few investors understand.
The main benefit of ETFs is that they provide a low-cost way to match the index – a set it and forget it way to closely track the market. It’s an essential belief among investors and it’s led them to put their money and their faith in the ETF promise of index replication.
Tracking error turns the ETF promise on its head – in such cases the ETF’s performance moves away from the index it’s supposed to track. This is usually caused by factors such as fees, liquidity and diversification constraints. Some ETFs get around this by replicating the index synthetically but this comes with its own set of transparency challenges.
So what is IOSCO proposing to do? The regulator is considering disclosure requirements around how an ETF replicates the index it tracks. Does it physically hold a sample of full basket of the securities in the index? Or does it do so synthetically? ISOCO is also proposing ETF providers provide investors with information on index composition, on the index replication methodology (physical or synthetic), the methodology used to measure tracking error, the ETF provider’s policy for minimizing tracking error, and a list of what issues could hinder the ETF from being able to fully replicate the index (ie, transaction costs of illiquid components).
You can review the full set of proposals here. I think the proposals are a good idea – but I do think they’ll put the onus on investors to understand the mechanics of ETFs and how they actually do what they promise to do.
Originally published on Benefitscanada.com