At the end of July ESMA issued its Guidelines on ETFs and other UCITS issues following a detailed consultation process which started over a year ago. The Guidelines deal with a variety of matters and will impact all UCITS funds and not just ETFs.
The Guidelines include updated, and in some cases additional, requirements regarding index-tracking UCITS, ETFs, the use of derivatives, stocklending and other efficient portfolio management techniques, the treatment of collateral and requirements for UCITS eligible financial indices.
The Guidelines have been presented to member states and we expect that they will be finally published at the end of Q3 or the beginning of Q4 of 2012. They will come into effect two months after the date of that publication (and not two months from the end of July 2012). There are certain limited grandfathering provisions which will give existing funds twelve months to align portfolios and meet certain other requirements in certain instances.
The main takeaway for managers is that the Guidelines will impact on a broad range of UCITS funds and not just those styled as ETFs. On the positive side, ESMA have not brought forward some of the more controversial draft proposals published in their earlier consultation paper which will be a relief to certain managers.
One of the most controversial changes in the Guidelines is a requirement that all revenues arising from efficient portfolio management techniques, net of direct and indirect operational costs (which are undefined), have to be returned to the Fund. This could have a significant economic impact on managers and promoters, particularly as regards stocklending. One small ray of light, though, is that ESMA have decided to further consult on repo and reverse repo arrangements (that consultation forms part of the document that set out the Guidelines) and comments are requested by 25 September 2012. Specifically, ESMA are considering permitting arrangements whereby a certain percentage of assets of a UCITS fund could be subject to repo and reverse repo agreements on terms that do not allow the assets to be recalled immediately on demand.
There is some good news for providers of short term money market funds in that they will be deemed suitable investments when a UCITS fund invests cash collateral. Currently UCITS funds can only invest cash collateral in risk free assets which would not include short term money market funds.
IN GREATER DETAIL
The guidelines (ESMA/2012/474) set out detailed requirements which need to be considered by managers of affected funds. They include:Index-tracking UCITS:The Guidelines include more detailed prospectus disclosure requirements, requirements for the KIID and disclosure requirements in the annual and half yearly reports.
Index-tracking leveraged UCITS:
The Guidelines provide that such funds must calculate global exposure using either the commitment approach or the relative VaR approach (which sounds reasonable) and must comply with the limits on global exposure. Again there are additional prospectus and KIID disclosure requirements, particularly regarding the leverage policy, any impact of reverse leverage (i.e. short exposure) and a description of how the performance of the fund may differ significantly from the multiple of the index performance over the medium to long term (which has been a significant disclosure issue for regulators globally regarding leveraged and, in particular, reverse leverage, index-tracking funds).
The Guidelines introduce an identifier which must be used in the fund name and related documentation and also a prohibition on funds that do not come within the definition of a “UCITS ETF” as provided in the Guidelines from using the identifier “ETF” or “Exchange-Traded Fund”. Again there are additional disclosure requirements set out.
Actively managed ETFs are subject to further disclosure requirements as regards the prospectus, KIID and marketing documentation.
Secondary Market issues for ETFs
The Guidelines include additional requirements regarding secondary market investors. This has been an area of much discussion and the Guidelines provide for a risk warning to be included (which will not be a problem per se) but also requires that if the stock exchange value of units or shares in the ETF significantly varies from its net asset value, investors who acquire their units or shares on the secondary market should be allowed to sell them directly back to the ETF. In addition, the ETF is obliged to communicate the fact that it is open for direct redemptions to the regulated market in question. An ETF is permitted to charge costs, provided these are not excessive and are disclosed in the prospectus. How this will work in practice has yet to be seen and may take a certain amount of interaction with market makers and others. One point of relief is that ESMA has decided not to recommend a minimum number of market makers for ETFs.
ESMA has noted in their Feedback Statement, that accompanies the Guidelines, that they are concerned with the use of the “ETF” name in other exchange traded products and ESMA believes that appropriate action should be taken to address this, though no detail has been provided as yet.
Efficient Portfolio Management techniques
Again the Guidelines provide for additional disclosure requirements and also clarify that the risks arising from EPM techniques should be addressed in the risk management process of the fund. In addition, there are requirements regarding disclosure of fees including identifying entities to whom direct and indirect costs and fees are paid and whether these parties are related to the management company or depository.
Crucially, as noted above, the Guidelines provide that all revenues arising from EPM techniques, net of direct and indirect operational costs (which are undefined), should be returned to the fund. This could have a material economic impact on managers and promoters.
The Guidelines confirm that the fund must be able to recall any security that has been lent out or terminate any securities lending agreement into which it has entered, at any time. ESMA have commenced a separate consultation process in respect of repo and reverse repo arrangements which may ultimately allow for a certain percentage of assets of a fund being subject to repo and reverse repo agreements on terms that do not allow the assets to be recalled immediately on demand.
Finally, there are disclosure requirements for the annual report in respect of EPM techniques, counterparties, types of collateral and costs and fees.
Financial Derivative Instruments
The Guidelines include additional detail regarding disclosure requirements for funds using total return swaps or other financial derivative instruments with the same characteristics. In addition, assets held by a fund and swapped out under such arrangements must comply with the UCITS investment limits and the underlying exposure provided by the FDIs must also be taken into account for the 5/10/40 and related diversification requirements.
Where the counterparty to such FDIs has discretion over the composition or management of the fund’s investment portfolio or of the underlying of the FDI itself, the agreement between the fund and counterparty should be considered as an investment management delegation arrangement and must comply with the UCITS requirements in that regard.
The Guidelines provide for various disclosures in the annual report regarding exposure, identity of counterparties and the types and amount of collateral received.
When calculating counterparty exposure for UCITS investment restriction purposes, exposure arising from both OTC FDIs and EPM techniques should be combined. This modifies the current ESMA requirements set out in their 2010 Guidelines on Risk Measurement and Global Exposure.
The Guidelines replace the existing requirements regarding collateral that may be taken into account by a fund to reduce counterparty exposure for the purposes of UCITS investment restrictions. For non-cash collateral, the Guidelines provide more detailed criteria as well as a specific diversification limit. This limit provides that maximum exposure to an issuer of collateral received by a fund from its counterparties (measured on an aggregate basis across counterparties) cannot exceed 20% of the net asset value of the fund in question. Thankfully, ESMA did not proceed with earlier suggestions which would have required collateral to respect the detailed UCITS investment restriction limits (e.g. the 5/10/40 rule etc) and would have required that collateral be combined for such measurement purposes with assets already held in the fund. In any case, the more limited diversification requirement introduced is new and so will need to be monitored.
On a more positive note, the Guidelines have removed the requirement that cash collateral can only be invested in risk free assets which had a very limited scope. The Guidelines provide significantly more detail and, in particular, provide that cash collateral can be invested in short term money market funds which will be a significant boost to that industry. Reinvested cash collateral has to be diversified in accordance with the diversification requirements applicable to non-cash collateral as discussed earlier.
The Guidelines also provide for the fund to have in place stress testing where it receives collateral for at least 30% of its assets. In addition, funds are obliged to have a clear haircut policy adapted for each class of assets received as collateral though no quantitative or prescriptive rules have been set out for such haircuts. Finally, the Guidelines set out additional prospectus disclosure requirement regarding collateral.
The Guidelines set out more prescriptive requirements for financial indices to be considered UCITS eligible. In particular, indices which rebalance on an intra-day or daily basis will not be eligible (though the Guidelines do make allowance for technical adjustments made to financial indices such as leveraged indices or volatility target indices according to publicly available criteria).
A UCITS will not be allowed to invest in financial indices for which the full calculation methodology is not disclosed by the index provider. This could prove difficult for certain UCITS funds. The financial indices will also need to publish their constituents together with their respective weightings though the weightings can be published after balancing on a retrospective basis.
The Guidelines reconfirm that the methodology for selection and rebalancing of components must be based on a set of pre-determined rules and objective criteria, that the index must have a single clear objective in order to represent an adequate benchmark for the relevant market and the universe of index components should be clear. Interestingly, the Guidelines provide that an index should not be considered as being an adequate benchmark if it is created and calculated on the request of one or a very limited number of market participants and according to the specifications of those market participants.
The Guidelines include other requirements, a number of which are already applied to certain types of financial indices (e.g. hedge fund indices) which will now apply more broadly.
The Guidelines provide that sub-categories of one commodity should be considered to be the same commodity (for diversification purposes) unless they are not highly correlated. As regards correlation, two components of the commodity index are not highly correlated if 75% of the correlation observations are below 0.8 calculated (i) on the basis of equally-weighted daily returns of the corresponding commodity prices and (ii) from a 250-day rolling time window over a 5-year period.
Effective Date and Transitional Provisions
Finally, the Guidelines set out limited grandfathering provisions for existing funds.
Any new UCITS fund created after the date of application of the Guidelines (which itself is likely to be Q4) are obliged to comply with the Guidelines immediately.
UCITS that exist before the application date and that invest in financial indices that do not comply with the Guidelines are obliged to align their investments with the Guidelines within 12 months of the application date of the Guidelines. There are certain exceptions for structured UCITS which do not accept new subscriptions after the application date of the Guidelines. Again funds that exist before the application of the Guidelines are obliged to align their portfolio collateral within 12 months of the application date of the Guidelines (by end of 2013). However, reinvestment of cash collateral after the application date of the Guidelines must comply with the Guidelines immediately, even for existing funds.
UCITS funds that have entered into revenue sharing arrangements for EPM transactions prior to the application date of the Guidelines must comply with the Guidelines (particularly as regards all fees net of direct and indirect operational costs being paid to the Fund) within 12 months of the application date of the Guidelines.
UCITS ETFs have 12 months from the application date of the Guidelines to include the identifier in their name (they are obliged to do so earlier if before that date the fund name is changed for another reason).UCITS ETFs that exist before the application date of the Guidelines must comply with the provisions relating to the treatment of secondary market investors from the application date of the Guidelines (no 12 month grace period here).
Requirements regarding content of a fund’s prospectus, KIID, marketing documentation and constitutional documents do not come into effect until 12 months after the application date of the Guidelines or, if earlier, the first occasion after the application date of the Guidelines upon which the relevant document is revised or replaced for another purpose.
Requirements to publish information in the report and accounts of an existing fund do not apply in respect of any accounting period that has ended before the application date of the Guidelines.
Again to recap on timing:
- We expect the final Guidelines to be finally published on the ESMA website in late Q3 or early Q4 of 2012.
- The application date of the Guidelines is two months after that publication so the application date is likely to be sometime in December 2012.
- The 12 month grace period (where applicable) will then run out at some point in December 2013.
We will update this note once we get more specific timings from ESMA.