ESMA Publishes Proposed New Guidelines for UCITS Exchange-traded Funds
Sarah Jane Leake | Bloomberg Law
On 30 January, the European Securities and Markets Authority (ESMA) launched a consultation seeking views on its proposals for guidelines (Draft Guidelines) on UCITS1 exchange-traded funds (ETFs) and structured UCITS. These proposals have been developed out of feedback to ESMA’s discussion paper published last summer.2
The Draft Guidelines are designed to tighten up the regulation applicable to UCITS ETFs and structured UCITS as, in ESMA’s view, the existing regulatory regime has failed to keep pace with market developments and, as such, does not give due regard to the specific features and risks associated with these funds. Owing to the investment freedoms given to UCITS under UCITS III3 and the Eligibility Assets Directive,4 UCITS funds started developing new, innovative strategies previously prohibited to them, similar to those employed by the hedge fund industry. In ESMA’s view, the inadequacies of the existing regime may have a negative impact on investor protection and market integrity.
The Draft Guidelines cover synthetic and physical UCITS ETFs and set out further requirements for UCITS ETFs, index-tracking UCITS (including those employing leverage), efficient portfolio management (EPM) techniques, total return swaps (TRS), and strategy indices for UCITS.
Although most European ETFs are authorised as UCITS, they have some unique features not present in traditional open-ended funds (e.g., investors do not always receive the fund documentation when they acquire UCITS ETF units directly on-exchange). Despite this, ETFs are frequently confused with other exchange-traded products, such as exchange-traded commodities, as well as with listed closed-end funds.
To avoid further confusion, Guidelines include a definition of an UCITS ETF 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.”5
This definition is consistent with that set out in the European Commission’s MiFIR proposal,6 while at the same time taking into account the unique features of UCITS products. Should the MiFIR definition change substantially during the course of legislative negotiations, this definition will be revised to ensure further alignment between both definitions.
Moreover, while stakeholders generally do not see merit in further specifying the type of structure of the ETF in the name,7 ESMA suggests that ETFs should use, at a minimum, the identifier “ETF.” UCITS that do not fall within the definition set out above should not therefore use this identifier in their name, fund rules, prospectus, key investor information document (KIID), or any other form of marketing.
— Enhanced Transparency for Actively-managed UCITS ETFs
While most European-traded ETFs are passively managed, some are actively managed, typically with a view to outperforming an index or other benchmark. Although actively-managed UCITS ETFs use the traditional ETF structure, the composition of the portfolio is left to the manager’s discretion. The Draft Guidelines therefore set out a number of disclosure requirements for UCITS ETFs, for example to clearly describe the fund’s policy regarding portfolio transparency and where this information may be obtained.
— Protecting Investors on Secondary Markets
Owing to the diversity of stakeholder opinion as to what level of protection should be afforded to investors trading on the secondary market,8 ESMA asks stakeholders whether it would be sufficient to require the prospectus of all UCITS ETFs to contain an explicit warning to unit-holders that ETF units are generally not redeemable from the fund itself. If not, ESMA asks whether investors acquiring their units or shares on the secondary market should have a right to ask for the redemption of their holding directly from the UCITS ETF at any time, subject to higher redemption fees.
The Draft Guidelines set out a number of proposed disclosure requirements for the better protection of investors.
Under the proposals, the prospectus of an index-tracking UCITS9 would be required to disclose the following information:
- Details of the index, including its underlying components;
- How the index will be tracked;
- The way in which the fund will measure how closely the portfolio has followed the index to which it is benchmarked (i.e., tracking error);
- Details of factors likely to affect the fund’s ability to track the performance of the index; and
- Whether the fund will use a full replication model10 or follow a sampling policy.11
Moreover, the UCITS ETF’s annual report would need to explain any difference between the fund’s target and actual tracking error for the period under review.
Index-tracking Leveraged UCITS
Subject to the restrictions set out in the UCITS Directive (as amended), and its implementing measures (together, the UCITS Framework), index-tracking UCITS may be leveraged.
Based on positive feedback last year’s discussion paper, ESMA suggests that the prospectus of an index-tracking leveraged UCITS should provide the following details:
- The fund’s leverage policy, including information on how this is achieved, and associated costs and risks;
- The likely effect of any reverse leverage (this should also be provided in the KIID); and
- How the frequency of calculating leverage affects investors’ medium- to long-term returns.
While both the UCITS Directive and the Eligible Assets Directive set out rules on the use of certain techniques and instruments for EPM (i.e., sale and repurchase agreements, purchase and resale agreements, and securities lending), ESMA considers it necessary to impose additional requirements on UCITS that use these techniques. The Draft Guidelines set out a number of further disclosures that a UCITS employing EPM techniques should make in its prospectus and annual report. Also of note is the proposed requirement for UCITS to have in place a clear and well-documented haircut policy for each class of assets received as collateral, so that it is clear in which circumstances a specific haircut should or should not be applied to a certain class of assets.
Total Return Swaps
In many cases, UCITS use financial derivatives, typically TRS, to provide investors with a guaranteed payout at the end of a fixed period. In ESMA’s view, more and more UCITS are “gaining exposure to complicated investment strategies using TRS” and use “more complex investment strategies which incorporate long/short equity, absolute return, complex macro, arbitrage and commodity strategies through commodity indices only.”12 As with UCITS using EPM techniques, ESMA similarly suggests introducing further disclosure requirements for UCITS that use TRS. Moreover, the Draft Guidelines lay down specific standards in relation to collateral in the context of TRS, primarily to ensure that any collateral received is of good quality and is sufficiently diversified.
Where a UCITS gains exposure to a financial index using a financial derivative, it must comply with the rules set out in the UCITS Framework in relation to the construction and publication of the index.
In view of the growing number of indices appearing on the market, ESMA believes it is necessary to provide further guidance on the eligibility criteria to qualify as a financial index under the UCITS Directive. This is to ensure that strategy indices13 can be properly defined and treated as financial indices under the Directive. To this end, the Draft Guidelines tighten up the requirements on eligibility. The extensive proposals made in this regard could, however, prove controversial, particularly given that several stakeholders have already expressed concern that the high level of transparency required would “pose a major problem for nearly all index providers.”14
The consultation closes for comment on 30 March. All feedback received will be taken into account by ESMA in finalising the guidelines, which are anticipated to be adopted by the Commission before July.
1 Undertakings for collective investment in transferable securities.
2 ESMA’s policy orientations on guidelines for UCITS Exchange-Traded Funds and Structured UCITS – ESMA Discussion Paper ESMA/2011/220 of 22 July 2011. For an overview, see ESMA Discusses Regulation of UCITS Exchange-traded Funds, Bloomberg Law Reports® – UK Financial Services Law, Vol. 3, No. 9 (Sept. 2011).
3 UCITS III comprises Directive 2001/107/EC (Management Company Directive) and Directive 2001/108/EC (Product Directive), which together amend the original UCITS Directive, Directive 85/61/EEC.
4 Directive 2007/16/EC.
5 ESMA/2012/44 at 12.
6 Proposal for a Regulation on OTC derivatives, central counterparties and trade repositories, COM(2010) 484 final of 15 Sept. 2010 (EMIR), as amended by Proposal for a Regulation on markets in financial instruments and amending Regulation [EMIR] On OTC derivatives, central counterparties and trade repositories – COM(2011) 652 final of 20 Oct. 2011.
7 Supra note 5 at 11.
8 Supra note 5 at 14-15.
9 Index-tracking UCITS track a wide range of indices, including equity, bond, commodity, currency, sector-specific, and strategy indices.
10 Where a fund invests all of its assets proportionately in the securities underlying an index.
11 Where a fund invests a proportion of its assets in the securities underlying an index and the remainder in other holdings.
12 Supra note 5 at 22.
13 These indices seek to replicate a quantitative strategy or a trading strategy and, in most cases, the strategy is maintained by the index provider, not by the UCITS.
14 Supra note 5, at 28.
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