In commenting on the ESMA Consultation Paper entitled “ESMA’s guidelines on ETFs and other UCITS issues” (ESMA/2012/44, January 2012), EDHEC-Risk Institute has welcomed the broadened focus of this new consultation, which goes a long way towards approaching important issues in a horizontal way across all UCITS, rather than in a vertical way limited to UCITS ETFs, but regrets that the consultation paper has not gone further in several key areas.
While underlining the differences between passively and actively managed funds and proposing more disclosures on tracking error, the consultation paper falls short of giving a definition of passive management that would be framed in terms of a limit on the maximum level of tracking error acceptable.
EDHEC-Risk strongly believes that for an index-tracking vehicle to be considered a passive investment vehicle, it is also necessary that the underlying index be a financial index whose composition is dictated by a set of pre-determined rules and objective criteria allowing for strict systematic implementation. For an index to be considered representative of passive management, its ground rules should leave no room for implicit, let alone explicit, discretionary choices.
While the guidelines recommend that information on the performance of indices should be freely available to investors, EDHEC-Risk regrets that the proposed guidelines stop short of requiring that all information concerning indices–notably, their historical composition–be made freely available to the public. This information is difficult to obtain for traditional indices, even though the rules of the latter are typically simple, and in the case of strategy indices, it is almost impossible to procure at reasonable cost.
Free public disclosure of this information, for all types of indices, would not only allow UCITS and end-investors to perform their due diligence at minimal cost, but also foster the development of independent research on indices that would contribute to market efficiency.
More attention should be given to the quality of index governance and the auditability of decisions made by index committees.
Ground rules may be ambiguous enough to implicitly allow for discretionary decisions and they may also explicitly provide for the possibility of discretionary choices. Such decisions can have a very significant impact on the composition of an index and there are many more dimensions to conflicts of interest in this regard than recognised in the consultation.
The exercise of discretion in the implementation of ground rules blurs the distinction between passive and active management. EDHEC-Risk’s recommendation is for ESMA to start working on these issues and launch a consultation on indices that will pave the way for major progress in the information of UCITS and end-investors with respect to the quality, governance, and auditability of indices.