EDHEC-Risk Institute has ‘strongly welcomed’ the UCITS ETF guidelines released last week by the European Securities and Markets Authority (ESMA). [See European regulator ESMA publishes UCITS ETF guidelines].
EDHEC’s Paris campus.
According to EDHEC-Risk Institute, the guidelines are consistent with both the conclusions of the institute’s own research on ETF risks and ESMA’s consultation paper.
However, EDHEC-Risk Institute notes that the guidelines go further than the consultation document in two notable areas: securities lending and financial indices.
On securities lending, ESMA indicates that all profits from securities lending should be returned to the fund. “It is clear that this subject comes as a surprise to industry participants,” says EDHEC-Risk Institute, “nobody thought that ESMA would go as far as it did on the subject.”
“This new rule potentially 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 currently allow ETF providers to lower the management fees they charge. Now, as a result of receiving all of the lending profits, ETF management fee may increase. Nonetheless, this arrangement will have the merit of clarifying the real costs of replication and the profits associated with the risk taken in the area of securities lending.
On financial indices, EDHEC-Risk Institute is “very satisfied” that the European regulator has taken a major step towards transparency in an industry which up until now, with some exceptions, has arguably been 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 a logical 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,” says EDHEC-Risk Institute.
The institute believes ESMA’s position is logical given the increasing 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.
“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.
“It is clear that ESMA’s desire to make the compositions of indices freely available, if it materialises through the availability of all of the historical compositions of the indices, will have significant consequences for the business model of index providers, some of whom draw a considerable share of their revenues from the sale of data.”
ESMA’s report and consultation paper is available here: ESMA – Guidelines on ETFs and other UCITS issues