More Transparency and Protection for Investors: EU Issues Guidelines on ETFs, Other UCITS Issues

On 25 July the European Securities and Markets Authority (ESMA) published Guidelines on ETFs and other UCITS issues, following two consultations on ETF-related issues (to which CFA Institute responded) and considerable work on the subject. ESMA also launched a short consultation on the treatment of repurchase and reverse repurchase agreements (included in Annex IV of the Guidelines document).

The most important changes in ESMA’s proposals pertain to collateral characteristics and disclosure, to securities lending and repos (enhanced disclosure), and to restrictions in the use of indices. New ETF-specific rules are introduced as well.

It is important to note that all Guidelines apply to all UCITS funds, but only to UCITS (which stands for Undertakings for Collective Investment in Transferable Securities). While the vast majority of ETFs in Europe are UCITS, some are not (for example, Swiss ETFs and some U.S. ETFs that are traded on Euronext), and will therefore be unaffected by these rules. These Guidelines also do not cover other Exchange-Traded Products (notes, certificates, etc.).

Some of the rules only affect ETFs, while others apply to all UCITS funds, as they are not ETF-specific. With the guidelines applying to all UCITS, ESMA covers the following:

1)      Index-tracking UCITS: ESMA makes recommendations for enhanced disclosure in the prospectus, Key Investor Information Document (KIID), and in the half-yearly and annual reports.

2)      Index-Tracking Leveraged UCITS: Enhanced disclosure and global exposure compliance

3)      Efficient portfolio management techniques: Improved investor disclosure rules relating to the use of securities lending and repos, their risks, and their costs. Obligation for the UCITS to ensure that it is able to recall at any time any security which has been lent out.

4)      Derivatives: Assets held by a UCITS that enters into a total return swap or enters into other derivatives must comply with investment limits in the UCITS Directive, including the investment portfolio in an unfunded swap. The underlying exposures of derivatives must be taken into account to calculate the investment limits set by the UCITS Directive. Enhanced disclosure in the prospectus and in the annual report on total return swaps and other derivatives (strategy and composition of the investment portfolio or index, information on counterparties, risk of counterparty default, counterparty discretion).

5)      Collateral for OTC derivatives, securities lending, and repos: ESMA is revisiting collateral rules for OTC derivatives and at the same time extending the rules to collateral from securities lending and repos (for which so far there was no regulation at EU level).

6)      Financial indices: ESMA is tightening the rules on eligible financial indices, including those on commodities. Indices will be eligible only if the full calculation methodology, performance, constituents, and weightings are available to the public free of charge.

7)      Transitional provisions: All new UCITS should comply immediately with the Guidelines. For existing UCITS, transitional periods vary: they have either 12 months to comply, or up to the first occasion after the application of the Guidelines when a certain event takes place (either cash collateral is reinvested, or the prospectus and other information documents are modified for other reasons). Existing structured UCITS do not have to comply as long as they no longer accept subscriptions.

For UCITS ETFs, ESMA’s Guidelines cover the following topics:

• UCITS ETFs – identifier and specific disclosure: UCITS ETFs are required to use the identifier “UCITS ETF” in their name, fund rules, prospectus, KIID, and marketing documents. Other UCITS may not use such identifier.
• Actively-managed UCITS ETFs: UCITS ETFs must clearly disclose that they are actively managed.
• Treatment of secondary market investors of UCITS ETFs: As redemptions from the fund (at NAV) are generally not possible for investors in ETFs, a specific warning must be included in the fund documentation and marketing material. Furthermore, if the value of units deviates significantly from its NAV, investors who bought on the secondary market should be allowed to sell their shares back directly to the UCITS ETF. The prospectus should indicate the procedure and the potential costs.

Among the above topics, of particular interest are the extension of collateral rules from OTC derivatives to securities lending and repos, and the rules on revenue from securities lending and repos — both close important regulatory gaps in UCITS regulation.

Regarding collateral, it must all comply with various criteria: liquidity, valuation, issuer credit quality, diversification, risk management. Furthermore, there are rules regarding the entity which can hold the collateral; the collateral received should be fully enforced by the UCITS at any time without approval by the counterparty; and non-cash collateral should not be sold, reinvested, or pledged, and cash collateral can only be invested in specific instruments or placed with certain credit institutions. If the collateral is at least 30 percent of UCITS assets, it must be subject to stress testing. ESMA also enhances disclosure to investors regarding the collateral policy.

Regarding securities lending and repos, disclosure is improved on the use of such techniques and their risks, but above all ESMA sets requirements for disclosure in the prospectus and the annual report of the costs/fees that may be deducted from the revenue to the UCITS. In particular, the UCITS should disclose the identity of the entity/entities receiving the fees, and indicate whether they are related to the UCITS manager or the depositary. This requirement is attempting to shine light in a corner of fund costs that has been so far neglected: stock lending fees are not included in the UCITS ongoing charges shown in the KIID and may not even be captured in the fund expenses if the fund receives the net proceeds after subtraction of the stock lending fee. Unfortunately ESMA does not go so far as to require that all revenues from stock lending and repos should entirely be paid to the fund before payment of fees; it only requires that they should be returned to the UCITS “net of direct and indirect operational costs”, and the actual amounts of the direct and indirect operational costs and fees (as well as the revenues, of course) are only disclosed in the UCITS’ annual report, which is not available to investors before they invest in the fund.

With regard to disclosure of stock lending fees, the Kay Review — an independent review to examine investment in U.K. equity markets and its impact on the long-term performance and governance of U.K.-quoted companies published in the U.K. — goes further, and recommends that “all income generated from lending securities is rebated in full to the fund, with any related costs disclosed separately”.

A full credit to the fund and subsequent payment by the fund of all commissions and fees should be the best way of ensuring that all costs are clearly reported in the fund’s accounts, and better visibility of such costs (including possible retrocessions to the fund managers and/or other entities in the same financial group) should be a priority for regulators. Investors should be informed of such costs and any conflicts of interest related to them before investing in the fund. A mention in the KIID and in the marketing material would be the best way to make the disclosure, rather than burying it in the prospectus and the annual report.