On 31 January 2012, we circulated a brief update referring to the publication by the European Securities and Markets Authority (“ESMA”) of a consultation paper setting out draft guidelines on exchange traded funds (“ETFs”) and other UCITS issues. The draft guidelines for the most part follow the policy orientations set out in ESMA’s earlier discussion paper on ETFs and Structured UCITS of 22 July 2011 (“Discussion Paper”) (see our updates dated 26 July 2011 and 3 August 2011), with the notable difference that many of the recommendations now extend to all UCITS, and not just ETFs or structured UCITS. We set out below further detail on the content of the draft guidelines.
“Retailisation” of Complex Products
The Discussion Paper raised concerns in relation to the current treatment of all UCITS as automatically non-complex instruments for the purposes of the appropriateness test for clients under MiFID. The EU Commission’s proposals for the review of MiFID suggest removing structured UCITS from the scope of instruments which are automatically non-complex. The Commission’s proposal to treat as complex all structured UCITS as defined in the Key Investor Information Document (“KIID”) Regulation (Commission Regulation (EU) No 582/2010) would appear to view all such UCITS as intrinsically complex, which may not be correct in all cases. ESMA has decided to await the outcome of the MiFID considerations rather than providing any further input on that point at this stage.
The draft guidelines in relation to index-tracking UCITS focus on disclosure requirements in respect of such funds and, based on responses received to the Discussion Paper, propose that such requirements should be applied to all index-tracking UCITS rather than solely index-tracking ETFs as originally proposed. In particular, ESMA recommends that the prospectus of an index-tracking UCITS should include:
- a clear description of the index, including details of the underlying components (the draft guidelines do provide for investors to be directed to a website for details of the exact index composition);
- information on how the index will be tracked and implications for investors;
- the UCITS’ policy regarding tracking error including its target level; and
- details of whether the UCITS will follow a full replication model or use, for example, a sampling policy.
ESMA also recommends that the annual and half-yearly reports of the index-tracking UCITS state the size of the tracking error as at the end of the period under review, and that any divergence between the target and actual tracking error for the relevant period should be explained in the annual report.
ESMA have asked for responses on whether further guidelines on tracking error should be developed and, if so, views on the criteria to be used.
Index-tracking leveraged UCITS
ESMA’s guidelines would also require index-tracking leveraged UCITS to disclose in their prospectus the leverage policy, how it is achieved, the costs of leverage and the risks associated with the policy. The prospectus and KIID should also disclose the impact of any reverse leverage (ie, short exposure). The guidance paper notes that the use of leverage by index-tracking UCITS should not be a means to circumvent the relevant limits on UCITS global exposure and the UCITS should comply with the requirements on global exposure under the UCITS Directive and the rules set out in CESR’s (ESMA’s predecessor) Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS.
ESMA have again adopted the view that these proposals should apply to all index-tracking leveraged funds, rather than ETFs alone.
UCITS Exchange Traded Funds
While ESMA’s draft guidelines deal with UCITS ETFs in particular, it is of the view that further consideration should be given to the development of harmonised definitions at European level of all exchange traded products, to include ETFs, exchange traded notes (“ETNs”) and exchange traded commodities (“ETCs”). Such a move may address concerns expressed within the ETF industry regarding the need to distinguish the highly regulated UCITS ETF product from other instruments such as ETNs and ETCs.
As suggested in its earlier Discussion Paper, ESMA recommends the use of an identifier for all UCITS ETFs in the fund’s name, its fund rules or instrument of incorporation, prospectus, KIID and marketing communications. The identifier should be “ETF”. The guidelines provide a definition of a UCITS ETF which must comply with this requirement as follows:
“A UCITS exchange-traded fund (UCITS ETF) is a UCITS at least one unit or share class of which is continuously tradeable 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.”
ESMA recognises that this definition is not entirely consistent with the definition of ETFs contained in the Commission’s MiFID proposals, which seek to extend the transparency rules to ETFs. In this regard, ESMA has indicated that further alignment may be necessary.
Contrary to the expectations of many in the industry, ESMA’s draft guidelines do not propose categorising ETFs according to their complexity and nor do they propose classifications based on the physical or synthetic nature of ETFs. ESMA have, however, separately indicated that classification of synthetic ETFs as complex products remains an issue for debate.
Actively Managed UCITS ETFs
In line with the policy orientations set out in its Discussion Paper, ESMA recommends that an actively-managed UCITS ETF should clearly set out in its prospectus, KIID and marketing communications that it is not an index tracker, how it will meet its stated investment policy, and its policy regarding portfolio transparency and where this information may be obtained. It also recommends that the prospectus include details of the methodology and frequency of calculation of the iNAV, if applicable.
Secondary Market Investors
ESMA believes that protections are required for investors dealing in ETFs on the secondary markets and the draft guidelines set out two options with regard to secondary market investors.
Option 1 requires a UCITS ETF or its management company to ensure that the market maker(s) of the listed units/shares of the UCITS ETF continue(s) to offer redemption rights to secondary market investors whenever the market is open for trading. Under this first option, the UCITS ETF would be required to take appropriate action to replace a market maker which wa no longer willing to act in that capacity and to ensure the protection of unitholders during such replacement or any disruption of the secondary market. ESMA contemplates that this will be dealt with by way of a contractual arrangement with the market maker. The prospectus should set out clearly that ETF units/shares are generally not redeemable from the fund other than by authorised participants holding creation units and should contain a warning in a prescribed form that units cannot be directly sold back to the fund.
The second option would permit investors to redeem their units/shares directly from the UCITS ETF at any time. ESMA invites comments as to which option should be adopted.
Efficient Portfolio Management Techniques
This section of the consultation deals with securities lending and repurchase agreements entered into by all UCITS. These efficient portfolio management (“EPM”) techniques were also dealt with in the Discussion Paper in the context of UCITS ETFs. A number of respondents to the Discussion Paper believed that any proposals in relation to such EPM techniques should apply to all UCITS and ESMA has accepted this view.
ESMA recommends that the prospectus should make it clear to investors that the UCITS intends to employ these techniques and should include a detailed description of the risks involved, including counterparty risk and potential conflicts of interest, and the impact such techniques will have on the performance of the UCITS.
The prospectus should also set out the UCITS’ collateral policy, to include permitted types of collateral, the level of collateral required, and, in the case of cash collateral, the reinvestment policy. Fees arising from EPM techniques should be disclosed in the prospectus and, “as a general rule”, returned to the UCITS. ESMA recommends that where a UCITS has fee-sharing arrangements in place in respect of such techniques, this should be disclosed to investors together with details of the maximum fees payable and any fees deducted from the return generated. Where the lending agent is a connected party of the UCITS or the investment manager, ESMA is of the view that this should be disclosed in the prospectus.
Collateral received in the context of EPM techniques should comply with the criteria for collateral received in the case of OTC derivatives and the collateral posted should be sufficiently diversified so that the portfolio composed of the collateral and the assets not subject to the EPM techniques complies with the UCITS diversification rules. The UCITS should have in place a clear haircut policy for each class of assets received as collateral. ESMA requests feedback on whether qualitative criteria regarding collateral should be supplemented by an indicative list of eligible assets for collateral purposes. ESMA also proposes the disclosure of certain details in relation to EPM techniques, counterparties and collateral in the UCITS’ annual report and seeks feedback on whether more frequent identification of EPM counterparties should be required.
Almost all of the respondents to the original Discussion Paper had rejected the proposal that a specific limit be set on the amount of a portfolio which could be lent as part of a securities lending transaction. ESMA have again sought feedback on this proposal in the draft guidelines and have indicated that such limit may be set at the portfolio level or a limit imposed on the amount which any one entity could borrow.
Total Return Swaps
Structured UCITS are UCITS which use financial derivative instruments, in most cases a total return swap (“TRS”), to provide a predefined payout to investors based on the return of the assets underlying the swap. The draft guidelines follow the approach set out in the original policy orientations, although they extend the guidelines to all UCITS using TRS, not just to “structured UCITS”.
ESMA’s guidelines recommend that in the case of a UCITS using an unfunded swap both the UCITS’ investments and the underlying portfolio of the swap to which the UCITS will be exposed must comply with the UCITS diversification rules. The prospectus of a UCITS using TRS should provide information on the underlying strategy and composition of the investment portfolio or index, the counterparty, and, where relevant, the type and level of the collateral required. The annual report should also include disclosure in relation to the underlying exposure, the identity of the counterparty and the collateral received from the counterparty.
ESMA also recommends the imposition of similar rules in terms of collateral received in respect of the TRS to those proposed in respect of collateral received in respect of EPM techniques.
Safeguards relating to the role of the counterparty in respect of the TRS include requiring that the offering documents for those UCITS which allow an element of counterparty discretion in terms of the UCITS portfolio should include disclosure in respect of the extent of the counterparty’s control over the investment policy and any limitations imposed. In such instances where the counterparty has any discretion in relation to the composition or management of the UCITS portfolio, the agreement with the counterparty should be deemed to be an investment management delegation arrangement and the counterparty should be treated and disclosed as an investment manager.
In relation to the use of strategy indices, ESMA recommends that in the case of an index-replicating UCITS, the prospectus should, where relevant, inform investors of the intention to avail of the increased diversification limits permitted under the UCITS Directive together with a description of the exceptional market conditions which justify the investment. A single component of the index must not have an impact on the overall index return which exceeds the relevant diversification requirements (ie 20%/35%). Therefore, not only do the components need to respect the diversification requirements, where the index’s leverage factor may amplify the impact of a component, this also needs to be within the limits.
The guidelines also require that a strategy index must be able to demonstrate that it satisfies the index criteria, including that of being an adequate benchmark for the market to which it refers. In order to fulfil this requirement, the index should have a clear single objective and the universe of components and basis for selection should be clear to investors. The prospectus should disclose the rebalancing frequency and the rebalancing frequency should not prevent investors from being able to replicate the financial index (thus ESMA envisages excluding indices rebalancing intra-day or daily as eligible indices).
Following its approach in the Discussion Paper, ESMA recommends substantial disclosure requirements in respect of indices, including index constituents, calculation and performance. ESMA have disregarded the concerns expressed by a number of respondents to the Discussion Paper that requiring public disclosure of proprietary information in respect of proprietary indices was not appropriate and may result in such indices effectively being prohibited for use. Respondents had also highlighted the difficulties which all index providers may have with the transparency requirements, however, the draft guidance has generally retained the policy approach contained in the Discussion Paper.
Transition Period and Next Steps
ESMA has proposed transitional measures in respect of the implementation of the guidance which would not require existing investments to be unwound and the guidelines would generally only apply to new investments.
ESMA will take into account responses to the draft guidance paper, which are due by 30 March 2012, in finalising the guidelines for adoption. It is expected that the guidelines will be adopted by the middle of this year.
The consultation paper is available at the following link:ESMA Consultation Paper on ETFs and other UCITS issues.
Matheson Ormsby Prentice has advised many of the leading ETF and structured fund providers in the European market on the establishment of Irish domiciled ETFs and structured funds. While welcoming the guidance to the extent that it seeks to enhance investor protection and market integrity, we would also highlight that UCITS funds are already the subject of extensive regulation and therefore any additional regulatory requirements imposed should be proportionate and reasonable. The guidance raises a number of issues for the industry to consider, particularly in the context of the use of EPM techniques, categorisation of ETFs and disclosure in respect of strategy indices.
We believe that Irish domiciled funds already comply with many of the proposals contained in ESMA’s draft guidelines, reinforcing Ireland’s position as a market leading domicile for ETFs and structured UCITS in Europe. ESMA has indicated that it will reflect on the extent to which the new guidelines could be applied to non-UCITS funds marketed in Europe and we will monitor any developments in this regard.