The world of exchange traded products constitutes a menagerie. In the U.S., at least, providers of plain-vanilla exchange traded funds are worried that the proliferation of exchange traded products will end up with an unnecessary black eye.
What’s at stake is how ETPs gain exposure to securities: physical replication, where they buy most or all the stocks that underlie an index; or synthetic replication, where exposure is gained through derivatives, whether they are futures or over-the-counter swaps. There are other concerns, too, about how leveraged or short ETFs track their indexes and whether investors comprehend this.
Hence a demand for “truth in advertising,” so that investors know what it is they are buying, and how it will perform under a variety of market conditions, and perhaps a sharper distinction between what may be called “traditional” ETFs and newcomers – not only leveraged ETFs but also ETFs and exchange-traded notes that track commodity indexes
The same demands are being voiced in Europe, albeit, less loudly, in part because the “retailisation” of ETPs is far less advanced than in North America. Still, there are calls for more disclosure and the European Securities and Markets Authority has heeded it, with the release last month of a consultation paper on ETF regulation. Retail investors, however, represent only 10% to 20% of the European ETF market.
Beyond that ETFs, with $275 billion in European assets, command a tiny share of entire “packaged retail investment market” — mutual funds, insurance contracts and other advisor-sold investments — estimated at $8 trillion. Thus, concerns about ETFs may be incommensurate with their market impact, at least for retail investors.
At the root of the issue is what qualifies as a UCITS – and undertaking for collective investment transferable securities – the European term for an investment fund that allows for regular purchases and redemptions.
A UCITS fund enjoys the possibility of pan-European marketing. Once approved in one member country, is available for sale in all. UCITS so far has concentrated on such things as consumer disclosure (Key Investor Information Document), diversification rules and derivatives exposure, so that investors can know what the fund is aiming at, how conflicts of interest are handled and how non-market risk (i.e., fund manager and counterparty) risk mitigated.
So far, so good, if a bit anodyne.
But ETFs, which generally qualify as UCITS products, have been, as they have been in the United States, a lightening rod. Indeed, it has been in Europe, rather than the U.S. that debates have most fiercely focused on potential counterparty risk and market disruptions. Many of those products -exchange-traded notes and exchange-traded commodities – don’t however qualify under UCITS rules, although they are available to retail investors, classed as “complex” products.
To clear up some of the confusion, the ESMA paper proposes more standardized disclosure about UCITS ETFs – including identifying themselves as exactly that: UCITS ETFs. For all UCITS index-tracking funds (not all of which are ETFs), it recommends laying out which index is tracked, how it is tracked, what instruments are used to track it, how it is calculated (this concerns “strategy indexes”) and so forth.
EDHEC Risk Institute, which released a position paper critical of European ETF regulation just before the ESMA paper came out, generally welcomes the ESMA paper. It notes that the “key areas highlighted for attention have been counterparty risk, liquidity risk, systemic risk and possible detrimental impacts of ETFs on their underlying markets, potential risks of innovations such as leveraged and inverse ETFs, and the possibility of confusion between ETFs and other ETPs.”
The ESMA paper meets EDHEC most of the way. Investor protection, EDHEC thinks, would be better served by regulatory harmonization, instead of focusing on products listed on exchanges. Thus, it would include “the promotion of a horizontal approach to regulation calling for a coherent treatment of economically equivalent products irrespective of their legal form or channel of distribution. The current ‘patchwork of regulation’ in the European retail investment market already offers rich pickings for regulatory arbitrage; using a silo approach to tighten product rules in the most regulated segment of the industry is likely to add further incentives to this practice.”
An example of a horizontal approach lies in bringing securities lending by ETFs and other UCITS under the same umbrella as over-the-counter swaps. In an over-the-counter swap, generally used by ETFs that synthetically replicate the index that they track, the collateral for the swap yields interest that can reduce the costs of the swap. Similarly, ETFs that physically replicate stock indexes can earn fees from lending out their holdings.
Notes EDHEC. “The recent debate on counterparty risk within the investment industry has initially focused on the over-the-counter (OTC) derivatives operations of synthetic replication ETFs, but the securities lending transactions that are an essential source of revenues for physical replication ETFs are now being scrutinised; this is fair since these are economically equivalent operations.”
ESMA agrees with this observation and goes one step further and recommends that all fees from security lending go to the fund, rather than being split with the fund manager. This is part of the “efficient portfolio management” operations that should be disclosed to investors.
In addition, ESMA decided not to apply the ETF moniker solely to those ETFs that use physical purchase of the underlying stocks, with or without sampling, thus excluding funds that use OTC derivatives or futures.
As EDHEC pointed out: “In fact all UCITS can engage in OTC derivatives and securities lending transactions within the same limits. More importantly, non-UCITS funds and other products available to retail investors may engage in the same transactions without affording the same high levels of counterparty risk mitigation and disclosure as UCITS. From an investor-protection or a regulatory arbitrage mitigation standpoint, the wisdom of frightening investors away from the most regulated segment of the investment industry is not immediately apparent. “
This then is another example of the need for horizontal regulation, EDHEC argues. “When it comes to categorising funds, the focus needs to be on the economic exposure achieved or the payoff generated and not on the methods or instruments used to engineer this exposure or payoff.”
Related to this is whether some UCITS funds get a free pass, while others are branded as ‘complex.”
“Should European authorities decide to name some UCITS complex …we strongly feel that this should be on the basis of the complexity of the payoff rather than that of the portfolio management techniques (e.g. scientific diversification) or investment tools (e.g. derivatives) employed. …
…
“We consider it key to recognise the difference between passive UCITS which track a financial index and other funds. With the former, investors choose a linear and constant exposure to an index, which is managed in a transparent and systematic manner and boasts a published track record. With the latter, the payoff depends on risk-taking and portfolio management models that may neither be systematic nor transparent.”
Despite this, one gets the feeling that the whole discussion is way over the heads of investors. Nevertheless, asset managers beware. It may not be over the head of regulators.