Elmer Fudd’s difficulty was never that he couldn’t track the rabbit; it was that he couldn’t bring the hunt to a satisfactory conclusion once he had done so.
Much current controversy over Europe’s ETFs, though, arises from the sense that the ability to track the underlyings is in question. In January of this year, an EDHEC-Risk Institute Report, “What are the Risks of European ETFs,” said that “a definition of what constitutes an index-tracking-instrument, higher levels of disclosure on the indices tracked, [and] a standardized measure of tracking error” are all long overdue.
Also in January, the European Securities and Markets Authority set out in a consultation paper its guidelines on exchange traded funds and other issues relating to the Undertaking for Collective Investment in Transferable Securities, and it asked for comments by March 30. Much of the ESMA paper involves issues of tracking and disclosure.
ESMA’s consultation paper proposes mandatory disclosures for the prospectus of an index-tracing UCITS (a broad category of instrument in which ESMA includes ETFs). The prospectus should include for example: a clear description of the index with details of its underlying components; information on how the index will be tracked; a statement of policy concerning ex-ante tracking error; a description of factors likely to affect the accuracy of the tracking; details on whether the tracking is to be accomplished by full replication model or by sampling.
ESMA asked commenters for their views specifically on whether the disclosures on tracking error “should be complemented by information on the actual evolution of the fund compared to its benchmark index over a given period.”
To this, EDHEC in a March 25 comment says that the proposed disclosures could well go further, that they might include information about how sampling “which is not always robust” can risk considerable tracking error. But EDHEC was not enthusiastic on adding “actual evolution” data to the prospectus’ disclosures, since it expects “that annual and semi-annual reports of an index-tracking fund could include such information.”
Other Issues: Leverage and Identifiers
ESMA also considered the issue of leverage. Index-tracking UCITS are permitted to leverage, and the most common ways of doing so are the double return or the double-inverse return multiples, i.e. leverage sufficient to achieve for investors either twice the positive or twice the negative return of the benchmark. Its guidelines provide that the prospectus must include a disclosure on the leverage policy, how it is achieved, the role of short exposure, and how the “frequency of calculation of leverage impacts on investors’ returns over the medium to long term.”
Further, this information should be included not only in the prospectus but in the Key Investor Information Document.
EDHEC welcomes the proposals concerning leverage, and especially welcomes the “horizontal manner” in which they are to be applied, i.e. that they will be applied through the UCITS world generally, not specifically to UCITS ETFs.
ESMA defines a UCITS ETF by the fact that it is listed on “at least one regulated market” and by the presence of at least one market maker who works to keep the stock exchange value in line with the net asset value. These features distinguish it from other index-tracking UCITS. Investors should be able to recognize immediately which instruments have this feature and which don’t. Thus, an ETF so defined should use the letters ETF as an identifier in the prospectus, KIID, marketing communications and even in its name, while non-ETFs should not use that identifier in any of those contexts.
EDHEC concurs with this proposal, too.
Another issue facing the ETF market in Europe today involves the role of securities lending – and this brings us back to that of tracking. As ESMA notes, both physical and synthetic ETFs may engage in securities lending, although it is more likely to be a significant part of the activity of physical ETFs, “given the size of their available portfolio of securities and the ability to generate significant returns.”
ESMA notes that this activity raises at least two issues from the investor-protection point of view, and a third issue from a broader systemic perspective. The systemic concern is that securities lending could contribute to a future crisis. If several ETF providers should have to meet redemption demands, they might do so by recalling their on loan securities on a large scale, and that in turn could generate a nasty market squeeze. One of the investor protection concerns is simply that securities lending raises the risk of counter-party default. Another, though, is that this activity becomes a source of tracking error.
ESMA proposes a number of guidelines that would address such issues. Many of these concern the disclosures that would have to be made in a prospectus.
ESMA also asked commenters for their views on a number of other options that may have an impact on securities lending. “[D]o you see merit in prescribing an exhaustive list of assets eligible for use as collateral?’ for example, and “Do you believe that the proportion of the UCITS’ portfolio that can be subject to securities lending activity should be limited? If so, what would be an appropriate percentage threshold?”
In its responsive comment, EDHEC-Risk says that its position has long been that the existing guidelines of the Committee of European Securities Regulators concerning the collateralization of over-the-counter derivatives by UCITS should be employed to improve the collateralization of all transactions that expose either UCITS or non-UCITS vehicles to counterparty risk, “notably securities lending, repurchased agreements, and other economically comparable operations.”
EDHEC also suggests the development of a new metric, which it calls the Total Return Ratio, a statement of the share of a fund’s returns from any source that is passed through to investors. This would be an improvement on the total expense ratio precisely because TRR would assess “the true cost of asset management,” TRR would capture the returns that arise from securities lending operations, though the TER does not.