The European Securities and Markets Authority has issued a consultation paper on exchange-traded funds and related issues within the UCITS system. EDHEC-Risk Institute has replied, both with a press release and with a 70- page white paper of its own. The EDHEC press release observes that ESMA has in the past too often discussed and regulated different instruments as if they inhabit different “silos,” and that this “silo approach [had it continued] would have increased the risks of adverse selection by investors and regulatory arbitrage by issuers.”
Thus, EDHEC-Risk happily notes, in its newest consultation paper ESMA “approaches important issues in a horizontal way across all UCITS.”
Tracking and Tracking Error
The ESMA paper, dated January 30, 2012, includes recommendations on what the prospectus of an index-tracking UCITS must include. At present, the prospectuses “may not always specify the replication mechanism, physical or synthetic, used to track the index or, in the case of physical replication, whether full replication or sampling is used.” So it proposes, and asks stakeholders for comments on, a draft of new disclosure guidelines that would remedy this.
Another of the points raised in the consultation paper involves tracking error. Since transaction costs and the illiquidity of certain portions of the index make ideal tracking impossible, there will be a difference between the return of the UCITS’ portfolio and the return of the underlying index. Investors should be informed of the factors that are likely to affect the size and the volatility of this difference. Further, the “annual and half-yearly reports of an index-tracking UCITS should state the size of the tracking error at the end of the period under review.”
The responsive EDHEC-Risk Institute paper, “What are the Risks of European ETFs?” both notes positive aspects of the ESMA approach and keeps somewhat aloof. It agrees that indexers must be required to disclose tracking error targets and results, and it approves of the definition of tracking error ESMA uses in its consultation paper. It says that this definition, which focuses on the volatility of the variance, corresponds more closely to academic standards than does a definition ESMA offered in an earlier consultation paper, released in July 2011. The earlier definition had relied simply on the “ex post distance” between the two returns.
Also on this point, EDHEC considers it “startling” that there is as yet “no standardized measure or mandated disclosure of the quality of index replication at the European level.”
Nonetheless, EDHEC said, it is unfortunate that ESMA is incurious about certain important “first-order issues” such as the degree to which ETF performance claims are comparable, that ESMA has left unexamined. It further says that regulators have thus far failed to give “a legal definition of what constitutes an index.”
ETFs didn’t start trading in Europe until 2000, eleven years after they were first available in the U.S. But they have had quite a take-off in Europe. By the end of November 2011, there were 1,226 such funds constituting the European ETF industry (out of 2,982 worldwide) and they managed $273.5 billion in assets.
Most of the industry in Europe does consist of what both ESMA and EDHEC call “plain-vanilla index trackers.” Of these funds, 36 percent track the indexes physically, the other 64 percent synthetically (a very small sliver, 0.1 percent, are “hybrid” replicators). The deal structure in which the synthetic replication takes place may look something like the figure above.
The whole of the European ETF industry, except for those funds based in Switzerland, are structured as UCITS.
Synthetic ETFs come in two varieties, funded and unfunded. The difference is that in a funded synthetic ETF the UCITS transfers the cash of its investors to the swap counterparty as collateral, as in the figure below.
Collateral allows the ETF provider, as EDHEC explains, to “transfer the tracking risk to the swap counterparty,” but it does so only at the expense of assuming a counterparty risk, that is the “risk that the counterparty fails to deliver the promised return differential.”
EDHEC will host a roundtable discussion on “Perceived Risks and Benefits of ETF Investments and Regulators’ Considerations” as part of the EDHEC-Risk Days Europe 2012 conference at The Brewery conference center, in London, on March 27, 2012.