ESMA consultation paper on UCITS ETFs

ESMA’s proposals concern both synthetic and physical UCITS ETFs, and include suggested rules for index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices. The scope of the proposed guidelines covers UCITS ETFs as well as all UCITS that engage in securities lending or whose investment policy tracks an index.

The consultation paper sets out the following proposals:

Index-tracking UCITS

Proposals

The prospectus of an index-tracking UCITS should include:

- a clear description of the index, including its underlying components. This can be provided by a link to a website publishing the exact composition of the index;

- information on how the index will be tracked (full replication or whether a sample or other method will be used), and how this affects the exposure of the investor to underlying index and counterparty risk;

- factors likely to affect the ability of the UCITS to track performance (such as transaction costs, small illiquid components, divided reinvestments etc) and the policy regarding the ex-ante tracking error. The ex-ante tracking error is the discrepancy between the value of the UCITS portfolio and the actual return of the index.

Annual and half-yearly reports should state the size of the tracking error for that period. The annual report should explain any divergence between the target and actual tracking error.

Index-tracking leveraged UCITS

Proposals

The prospectus of an index-tracking leveraged UCITS should include:

- disclosure of the leverage policy and how it is achieved, the cost of leverage and any associated risk;

- disclosure of the impact of any reverse leverage (this should also be included in the KIID);

- a description of how the frequency of calculating the leverage impacts on investors’ returns in the medium to long term.

Index-tracked leveraged UCITS should not be used to circumvent, and must comply with, limits on global exposure.

Definition of UCITS ETFs and identifier

Proposals

ESMA proposes that a UCITS exchange-traded fund be defined as a UCITS at least one unit or share class of which is continuously tradable on at least one regulated market or multilateral trading facility (MTF) with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value. This is broadly similar to the MiFID definition and ESMA may consider further alignment between the two.

UCITS that fall under the above definition should use the identifier ‘ETF’ in their name, fund rules or instrument of incorporation, prospectus, KIID and marketing communication. UCITS not falling under the above definition should not use ‘ETF’ in the aforementioned publications.

Actively managed UCITS ETFs

Proposals

There must be clear information in the prospectus, KIID and marketing communications that the UCITS ETF is actively managed and not an index tracker. This must include how it will meet its investment policy, its policy regarding portfolio transparency and information on where its iNAV (indicative net asset value), if applicable, is published.

The prospectus must disclose how the iNAV is calculated and the frequency of this calculation.

Secondary market investors

Market makers buy and sell shares (“creation units”) directly from the UCITS which they then split and sell on a secondary market. Only the market makers can redeem from the UCITS ETF.

Proposal Option One

UCITS ETF or its management company should ensure the market maker continues to offer redemption to secondary market investors whilst the market remains open. If the market maker is no longer able or willing to act, appropriate action must be taken to replace the market maker whilst ensuring investors are protected, which may include arrangements allowing investors to sell directly back to the UCITS ETF.

The prospectus should explain ETF units are generally not redeemable from the fund.

The prospectus and marketing communications should include the following statement:

“UCITS ETF units/shares cannot usually be sold directly back to the fund. Investors must buy and sell units/shares on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. Investors may pay more than the current net asset value when buying units/shares and may receive less than the current net asset value when selling them.”

Proposal Option Two

Investors shall be able to redeem their shares directly from the UCITS ETF at any time, and the UCITS prospectus and KIID should state the redemption fee that will apply.

Efficient portfolio management techniques

The main efficient portfolio management (EPM) techniques addressed are securities lending and repo (sale and purchase agreements) and reverse repo (purchase and resale agreements). The proposals seek to make these techniques more transparent to the investors and impose requirements on any collateral received.

Proposals

The prospectus should contain information on:

- techniques and instruments relating to transferable securities and money market instruments;

- the UCITS collateral policy;

- fees arising from EPM techniques, disclosing any related fee-sharing arrangements;

- a disclosure if the third party is an investment manager or a connected party.

A UCITS ETF must be able to recall any security lent or terminate any securities lending agreement at any time.

Collateral received should comply with the relevant CESR Guidelines, and any collateral posted by a third party should be sufficiently diversified. UCITS diversification rules should be generally complied with.

Entities receiving collateral should have their registered office in an EU Member State or be subject to the prudential rules of the competent authority in the EU Member State the UCITS is registered in.

There must be a documented haircut policy for each class of asset received.

The annual report should contain details of the underlying exposure from EPM techniques, the identity of the counterparties to these EPM techniques and the type and amount of collateral received by UCITS to reduce counterparty exposure.

Total return swaps

Some UCITS are using total return swaps (TRS) to provide investors with a predefined payout. The underlying assets can be a variety of assets, strategies and indices, and are normally passively managed by the counterparty.

Proposals

UCITS diversification rules must be complied with in regard to:

- for unfunded swaps, the UCITS investment portfolio, the return of which is swapped, the underlying to the swap and any collateral posted to the swap counterparty. If the counterparty risk will be mitigated by posting collateral rather than resetting the swaps on a regular basis the collateral should be sufficiently diversified;

- for funded swaps, the collateral posted by the swap counterparty. Entities receiving collateral should have their registered office in an EU Member State or be subject to the prudential rules of the competent authority in the EU Member State the UCITS is registered in.

The prospectus should provide investors with information on:

- the underlying strategy and composition of the investment portfolio or index, counterparty(ies), and, where relevant, the type and level of collateral required and reinvestment policy (including the risks arising from it);

- the risk of counterparty default and the effect on investor returns;

- if the swap counterparty has discretion over the investment policy or their approval is required for any portfolio transaction, the extent of their control;

- if the swap counterparty has discretion over the composition or management of the portfolio, the agreement between them and the UCITS is treated as an investment management delegation arrangement and should comply with UCITS requirements and the counterparty disclosed as an investment manager.

Comment

While the UCITS diversification rules should be expected to apply to a UCITS itself, the suggestion that they should apply to the underlying of a swap entered into by the UCITS appears arbitrary. Further, whilst disclosure on the quality of collateral is to be welcomed, it would be burdensome to disclose the exact instruments comprising the collateral in the prospectus as these are likely to differ depending on market variables.

ESMA’s paper does not draw a distinction between the investment strategy and the instruments used to gain exposure to this strategy, and this could be clarified. There is also widespread disagreement in the industry with ESMA’s statement that TRS are normally passively managed, as it is the investment manager of the UCITS who decides whether to buy the TRS and on what terms it will pay out. The requirement for swap counterparties to be disclosed as investment managers is also seen by some as unnecessary, and may not even be possible to implement (or may only be possible to implement at significant additional cost to investors) if the counterparty does not have the appropriate regulatory permissions to act as investment manager.

Strategy indices

A strategy index is an index seeking to replicate a quantitative strategy or trading strategy, and is normally operated by the index provider rather than the UCITS.

Proposals

Where relevant, the prospectus must inform investors of the intention to make use of increased diversification limits and why this is justified. A single component of an index, including different commodities with a commodity index, should not exceed the relevant diversification requirements.

Strategy indexes must satisfy the index criteria by having a clear single objective (to represent an adequate benchmark for the market), and the universe and basis of selection of components must be clear to investors and competent authorities.

The prospectus should disclose the rebalancing frequency and its cost within the strategy. Indices which rebalance on an intra-day or daily basis will not be sufficient as they do not satisfy the requirement that the frequency should not prevent investors replicating the financial index.

Information on index constituents, index calculation, re-balancing methodologies, index changes and information on operational difficulties in providing information should be easily accessible (e.g. via the internet) to enable investors to replicate the strategy.

The constituents of the index and their weightings must be published after each rebalancing, their selection must be pre-determined by objective criteria, there must be no backfilling of values, there must be documented due diligence on the quality of the index and there must be an independent valuation of the index (including when valuing any swap).

Comment

Industry participants have indicated that disclosures should aim at allowing investors to replicate the calculation of the performance of the index rather than physically replicate the index. It has also been pointed out that in-depth disclosures are likely to be of limited use to the vast majority of investors, who will not have sufficient expertise and knowledge to understand the detailed methodology. Further, the requirement that strategy indices should be able to represent a benchmark is debatable as the index needs to be flexible. With regard to the statement that a daily rebalancing frequency will not satisfy the UCITS requirements for replication and transparency, some in the industry argue that daily and intra-daily frequency should be permitted as limitations on the application of such frequencies could lead to decreased performance in the index and increased cost for investors.

Conclusion

While improvements in transparency for investors in UCITS are generally to be welcomed, ESMA will need to tread carefully to ensure that any guidelines it adopts are proportionate and consistent with other regulatory reform initiatives.

Various market participants have pointed out that it is inappropriate to view UCITS ETFs and structured UCITS in isolation from other instruments that are subject to MiFID, and that rules governing their marketing and product disclosure should be considered in connection with the current MiFID review. Given that UCITS are already subject to comprehensive regulation in respect of their product structure and disclosure to investors, there is a strong argument that no UCITS should be classified as complex under MiFID. Industry views are currently divided on this point, with some firms describing the splitting of UCITS into “complex” and “non-complex” categories as confusing to investors and potentially damaging to the UCITS brand, and other firms supporting this distinction and favouring the inclusion of complex UCITS within the scope of the Alternative Investment Fund Managers Directive. As the development of new rules for complex products under MiFID is still ongoing, it is perhaps unsurprising that ESMA did not address the distinction between complex and non-complex UCITS in its consultation paper.

The deadline for responses to ESMA’s consultation is 30 March 2012. ESMA’s final guidelines are expected to be adopted in Q2 2012. UCITS managers will need to ensure relevant fund documentation (e.g. the rules or instrument of incorporation of the UCITS, its prospectus, its KIID, and any marketing communication) complies with the guidelines within one year of the adoption of the guidelines, or at such earlier date following adoption of the guidelines on which the documentation in question is issued or renewed.