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Indexes and Benchmarking
ETFs and Indexing in European Markets

Authors: Editors: Brian R. Bruce, Deborah Fuhr
Editions: Institutional Investor Guides
Pages: 153 pages
Date: Summer 2012
 
 
 
Summary
The latest innovations in Exchange-Traded Funds and Indexing, written by leading practitioners using these instruments and by academics offering insightful research. Articles cover sector allocation, product options, the use and performance of ETFs in different market environments, and liquidity and fixed income in ETFs.

Frédéric Ducoulombier, Director of EDHEC Risk Institute—Asia, and Felix Goltz, Head of Applied Research at EDHEC-Risk Institute, have contributed an article to the guide entitled, "The True Risks of European ETFs", in which they make the following observations:

The vast majority of European exchange-traded funds (ETFs) are managed within the UCITS framework and as such have the same levels of security and the same risks as any UCITS fund. Highlighting the supposed risks of ETFs thus makes little sense because ETFs represent but a fraction of the products sold to the general public in Europe and competing investment vehicles typically do not benefit from the same level of protection provided by the UCITS framework. Securities lending is widely practiced by physical-replication ETFs and leads to counterparty risk, just as surely as the reliance on over-the-counter derivatives by synthetic replication ETFs. Investors should pay more attention to first-order issues that determine the effective mitigation of counterparty risk: the level of collateralization, the quality of the assets performing the economic role of collateral, and the ability of the fund to enforce its rights against collateral in the case of default by the counterparty. The issue of counterparty risk should be addressed through clear guidelines on counterparty risk mitigation as to the quality, marketability, and diversification of assets performing the economic role of collateral; these should apply irrespective of the manner in which counterparty risk is assumed or mitigated and to all UCITS and competing investment vehicles. Transparency should not be restricted to the problems posed by counterparty risk and its mitigation but should include disclosure of the revenues and costs from ancillary activities, such as securities lending. Although most ETFs are passive investment vehicles tracking indices, there is no standardization or mandatory information on tracking error risk currently in the European regulations. Regulators should give a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes, which remain the main drivers of the financial risks assumed by ETFs.