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Edhec-Risk Institute welcomes ESMA’s ETF guidelines

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Edhec-Risk Institute has welcomed the exchange-traded fund guidelines released by the European Securities and Markets Authority on 25 July.

The guidelines are consistent with the conclusions of Edhec-Risk Institute’s research on ETF risks and ESMA’s consultation paper, which were both published earlier this year.

These guidelines go further than the consultation document in two notable areas.

The first is securities lending, where ESMA indicates clearly that all profits from securities lending should be returned to the fund. Edhec-Risk had brought up the problem of transparency in its research, but nobody thought that ESMA would go as far as it did on the subject. The new rule changes the situation and the business model of ETF providers who have chosen physical replication because securities lending represented considerable sources of revenue for the asset management firms.

These revenues did not correspond to disproportionate profits but allowed ETFs to show lower management fees. As a result of receiving all of the lending profits, the ETF can now expect its management fees to increase; the arrangement will nonetheless have the merit of clarifying the real costs of replication and the profits associated with the risk taken in the area of securities lending.

It also seems that the new rules on securities lending by Ucits will have a strong impact on the volumes handled on the securities lending market. This market is an important factor in ensuring a good level of liquidity and improving the efficiency of equity markets. It would therefore be important for an impact study to be produced in order to reinforce ESMA’s decision.

The second area is the new requirements in the domain of financial indices. Edhec-Risk Institute says is very satisfied that the European regulator has taken a major step towards transparency in an industry which up until now, with some exceptions, was characterised, under the pretext of protecting intellectual property, by the low level of information given to investors on index methodologies and compositions.

ESMA, through these recommendations, is putting an end to these practices, and is allowing all stakeholders to access details on the methodology, which should allow the investor to replicate the index and the composition of the indices without any additional cost.

Edhec-Risk Institute says ESMA’s position is quite logical given the importance of indexed investment and the fact that it seems difficult for a provider to claim that their indices are a reference without giving exhaustive information on that reference. From that perspective, Edhec-Risk Institute feels that it is important that any financial index that is marketed on the basis of its track record, which itself is produced on the basis not only of live performance but also of historical simulation, be able to justify that track record both through systematic ground rules that leave no room for ambiguity or discretionary decisions and through compositions that correspond to those ground rules.

The key provisions of ESMA’s guidelines are:

• Ucits that fall under the definition of Ucits ETFs will have to carry the identifier “Ucits ETF” in their name;
• Ucits ETFs will have to ensure appropriate redemption conditions for secondary market investors by opening the fund for direct redemptions when the liquidity in the secondary market is not satisfactory;
• Ucits entering into efficient portfolio management techniques (EPM) like securities lending activities will have to inform investors clearly about these activities and the related risks.  All revenues net of operating costs generated by these activities should be returned to the Ucits.  When a Ucits enters into securities lending arrangements, it should be able at any time to recall any securities lent or terminate any agreement into which it has entered;
• Ucits receiving collateral to mitigate counterparty risk from OTC financial derivative transactions or EPM techniques should ensure that the collateral complies with very strict qualitative criteria and specific limits in relation to the diversification; and
• Ucits investing in financial indices will have to ensure that investors are provided with the full calculation methodology of financial indices.  Also, Ucits should only invest in financial indices which respect strict criteria regarding, inter alia, the rebalancing frequency and their diversification.

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