EDHEC-Risk Concept Industry Analysis Featured Analysis Latest EDHEC-Risk Surveys Features Interviews Indexes and Benchmarking FTSE EDHEC-Risk Efficient Index Series FTSE EDHEC-Risk ERAFP SRI Index EDHEC-Risk Alternative Indexes EDHEC IEIF Quarterly Commercial Property Index (France) Hedge Fund Index Research Equity Index Research Amundi "ETF, Indexing and Smart Beta Investment Strategies" Research Chair Rothschild & Cie "Active Allocation to Smart Factor Indices" Research Chair Index Regulation and Transparency ERI Scientific Beta Performance and Risk Reporting Hedge Fund Performance Performance Measurement for Traditional Investment CACEIS "New Frontiers in Risk Assessment and Performance Reporting" Research Chair Asset Allocation and Alternative Diversification Real Assets Meridiam Infrastructure/Campbell Lutyens "Infrastructure Equity Investment Management and Benchmarking" Research Chair Natixis "Investment and Governance Characteristics of Infrastructure Debt Instruments" Research Chair Société Générale Prime Services (Newedge) "Advanced Modelling for Alternative Investments" Research Chair CME Group "Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation" Strategic Research Project Asset Allocation and Derivative Instruments Volatility Research Eurex "The Benefits of Volatility Derivatives in Equity Portfolio Management" Strategic Research Project SGCIB "Structured Investment Strategies" Research ALM and Asset Allocation Solutions ALM and Private Wealth Management AXA Investment Managers "Regulation and Institutional Investment" Research Chair BNP Paribas Investment Partners "ALM and Institutional Investment Management" Research Chair Deutsche Bank "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" Research Chair Lyxor "Risk Allocation Solutions" Research Chair Merrill Lynch Wealth Management "Risk Allocation Framework for Goal-Driven Investing Strategies" Research Chair Ontario Teachers' Pension Plan "Advanced Investment Solutions for Liability Hedging for Inflation Risk" Research Chair Non-Financial Risks, Regulation and Innovations Risk and Regulation in the European Fund Management Industry Index Regulation and Transparency Best Execution: MiFID and TCA Mitigating Hedge Funds Operational Risks FBF "Innovations and Regulations in Investment Banking" Research Chair EDHEC-Risk Publications All EDHEC-Risk Publications EDHEC-Risk Position Papers IPE EDHEC-Risk Institute Research Insights AsianInvestor EDHEC-Risk Institute Research Insights P&I EDHEC-Risk Institute Research for Institutional Money Management Books EDHEC-Risk Newsletter Events Events organised by EDHEC-Risk Institute EDHEC-Risk Smart Beta Day Amsterdam 2017, Amsterdam, 21 November, 2017 EDHEC-Risk Smart Beta Day North America 2017, New York, 6 December, 2017 Events involving EDHEC-Risk Institute's participation EDHEC-Risk Institute Presentation Research Programmes Research Chairs and Strategic and Private Research Projects Partnership International Advisory Board Team EDHEC-Risk News EDHEC-Risk Newsletter EDHEC-Risk Press Releases EDHEC-Risk in the Press Careers EDHEC Risk Institute-Asia EDHEC Business School EDHEC-Risk Executive Education Yale School of Management - EDHEC-Risk Institute Certificate in Risk and Investment Management Investment Management Seminars New Frontiers in Retirement Investing Masterclass, Milan, 16 October, 2017 Contact EDHEC-Risk Executive Education Contact Us ERI Scientific Beta EDHEC PhD in Finance
Industry News
Regulation - July 05, 2012

Comments from EDHEC-Risk Institute on the IOSCO Consultation Report CR05/12 concerning the principles for the regulation of Exchange Traded Funds

By Noël Amenc, Director of EDHEC-Risk Institute, and Frédéric Ducoulombier, Director of EDHEC-Risk Institute—Asia

The International Organization of Securities Commissions (IOSCO) Consultation Report titled “Principles for the Regulation of Exchange Traded Funds” (CR05/12, March 2012) was prepared by IOSCO Technical Committee Standing Committee on Investment Management (TCSC5).

The report presents what it describes as “proposed common investor-protection principles or guidelines on Exchange Traded Funds (ETFs)” and “touches on certain market structure and financial stability issues.”

TCSC5 requests comments on these principles and guidelines, as well as comments on a number of specific concerns.

Below, EDHEC-Risk Institute comments on this work whose stated ambition is to serve as a benchmark against which “both the industry and regulators can assess the quality of regulation and industry practices concerning ETFs.”


General comments and remarks

  • On the scope of the principles and guidelines

    ETFs vs. other ETPs

    The proposed principles and guidelines are meant to address only Exchange-Traded Products (ETPs) that are organised as Collective Investment Schemes (CIS). Vehicles marketed as ETFs without being organised as CIS and other ETPs (e.g. ETCs, ETNs and ETVs) that are not organised as CIS are not meant to be covered by the principles and guidelines put forward by IOSCO.1

    As recognised by IOSCO in this consultation report (e.g. on page 2 and in Appendix C), there is a difference to be made between ETFs and other ETPs. In a recent EDHEC-Risk Institute Position Paper on the risks of UCITS ETFs (Amenc et alia, 2012), we show in detail how the risks in ETFs differ from risks in other ETPs.

    ETP is a generic term designating a wide array of products that are covered by different regulations and have little in common except that they are listed on exchanges. Within ETPs, only ETFs offer the high level of protection afforded by CIS regulation (e.g. the United States Investment Company Act of 1940 (ICA) or the European Undertakings for Collective Investment in Transferable Securities (UCITS) directives.) Other ETPs are typically unsecured debt securities exposing their holders to full uncollateralised counterparty credit risk of their issuers (whether public companies or special purpose vehicles).

    While it is legitimate to discuss the extent to which holders of ETFs (and other CIS) face counterparty risk (due to possible securities lending and repurchase agreement transactions or investment in instruments that contain such risk) and how any counterparty risk present in ETFs (and other CIS) should be mitigated, one should keep in mind the extreme level of unmitigated counterparty risk typically assumed by holders of other ETPs. This is all the more relevant in that ETPs are sometimes imprudently described as “close substitutes” to ETFs in the own words of such institutions as the Financial Stability Board (FSB, 2012).

    ETPs structured as debt securities rather than funds escape the CIS rules in terms of such things as governance, segregation and protection of assets, investment and risk management policies, and disclosure; as a result and in relation to ETFs, they also “bear very different diversification and risk management properties” to use the mild formulation of the Consultation Report.

    ETFs vs. other CIS

    TCSC5 rightly notes that ETFs are CIS and that “work done by IOSCO with respect to other areas of CIS regulation are also applicable to the management and operations of such products.” Indeed, ETFs are not special entities distinct from other CIS, but merely wrappers for CIS that need to comply with additional listing rules set by exchanges.

    For this reason, the Consultation Report aims to primarily identify “proposed principles that address unique issues, or concerns, posed by ETFs” or to adapt “existing IOSCO principles to the specifics of ETFs that are organised as CIS.”

    However, the principles and guidelines set forth in the Consultation Report that are truly about issues or concerns specific to ETFs are the exception: out of fifteen principles, thirteen2 are relevant to CIS at large, if not to both CIS and non-CIS vehicles, and one is concerned with trading venues (principle #15). This leaves only one principle that is unequivocally and solely about ETFs (principle #6).

    Recommendation

    Assets under management by ETFs are only a fraction (less than 6% worldwide) 3 of overall assets within the CIS industry, not to mention the investment industry as a whole (banks, insurance companies, exchanges, and other financial intermediaries market various investment vehicles which, while offering a level of substitutability with CIS, do/may not offer the same protections).

    While we understand that, in its efforts at early detection of risks in the financial system, IOSCO wishes to examine rapidly developing market segments and emerging financial trends, additional regulation of exchange-traded CIS would do little to promote a more level playing field across the fund management or investment management industry.

    We feel that the vertical approach adopted by IOSCO, which focuses on the narrow segment of CIS products listed on exchanges (i.e. ETFs), runs contrary to the promotion of a horizontal approach to regulation calling for a coherent treatment of economically equivalent products irrespective of their legal form or channel of distribution.

    We consider that tightening product rules in what can be shown to be the most regulated segment of the investment industry with respect to the issues at hand does nothing to level the playing field across the industry and adds further incentives to regulatory arbitrage.

    Furthermore, presenting issues that are present across the investment industry as specific to CIS (or exchange-traded CIS) may frighten investors away into products that have not “enjoyed” the same regulatory or media attention but offer lower levels of protection.

    We thus trust that the overarching objectives of IOSCO members in terms of securities regulation4 would have been better served by developing principles and guidelines for both CIS and non-CIS securities, or by generalising to non-CIS securities some of the protections afforded by CIS regulations. Admittedly, this would have required involvement of committees other than those, such as TCSC5, whose mandates relate solely to CIS and similar products.

    With respect to this Consultation Report and reasoning within the strict purview of TCSC5, we feel that it is possible and would have been preferable to approach the issues across all CIS whenever possible.

    We therefore recommend that IOSCO provide more clarity on which of the guidelines presented in this Consultation Report could apply to the investment industry as whole5, which guidelines are relevant to CIS only, and which guidelines are specific to ETFs.6

  • On fact-based regulation

    We welcome IOSCO’s due consideration of academic studies and enforcement cases in its comments upon concerns related to potential liquidity shocks, market integrity, and upon the financial stability issues highlighted by the FSB. As underlined in the Consultation Report, these issues are not at all exclusive to ETFs, “recent enforcement-related regulatory actions brought by market authorities and other regulators have not revealed widespread ETF-related wrongdoing”, and there is no conclusive evidence on ETFs creating specific financial stability problems or negatively impacting price formation on the underlying market.

    A number of recent reports on the risks of ETFs prepared by regulators and international organisations concerned with financial stability, particularly on the topic of systemic risk, contain multiple instances of speculative remarks on liquidity spirals and contagion effects, which are not backed by any theoretical framework or empirical evidence.

    With respect to the fears, voiced in the same quarters, that the development of ETFs may have hurt the underlying markets, there exists a rich theoretical and empirical literature indicating that the introduction of ETFs has improved price-efficiency (see Amenc et alia, 2012).

    We strongly believe that higher standards should be expected from international and domestic regulators and any discussion on the risks posed by ETFs should have a sound theoretical base and be backed with empirical evidence. Avowal of such standards by IOSCO in the final section of this Consultation Report thus brings a measure of comfort.

  • On the confusion between investment strategies and investment techniques in relation to complexity

    In portfolio as well as fund management, an investment strategy is a set of procedures that guides the investment process with a view to meeting investment objectives while respecting investment constraints in the context of current and projected economic and financial conditions. Asset allocation, security selection, and portfolio construction will determine the economic exposure and corresponding payoff structure (or risk/return profile) of the investment strategy.

    The Consultation Report uses the word strategy in a loose7–and therefore confusing manner–to refer both to the above and to instruments or techniques used to implement the above and achieve its targeted economic exposure and corresponding payoff (e.g. derivatives) or produce ancillary revenues without changing the investment strategy (e.g. securities lending8).

    The Consultation Report also appears to put the complexity of the investment strategy on par with the complexity of the techniques used to implement the strategy or produce ancillary revenues. While this probably arises out of concern for the counterparty risk created by securities lending and over-the-counter (OTC) derivatives used to establish the sought economic exposure, this is misguided as the risks of the investment strategy are typically larger by many orders of magnitude.

    When it comes to categorising investments or assessing their complexity, we strongly believe that the focus needs to be on the economic exposure achieved or the payoff generated by the investment strategy and not on the methods or instruments used to engineer this exposure or payoff.

    By this token, we consider it key to recognise the difference between passive instruments tracking indices managed in a transparent and systematic way and instruments whose payoffs depend on risk-taking and portfolio management models that may neither be systematic nor transparent. Simplicity, and a contrario complexity, should be understood as the investor’s ability to understand the source of performance and the systematic character of the exposure to an index. This, rather than the use of derivatives to establish exposure or the reliance on securities lending and other efficient portfolio management techniques to increase revenues, could serve as basis for distinctions.

    By disregarding the nature of the payoff generated by the investment strategy to focus on the techniques it uses or the instruments it holds to generate this payoff, regulators could create a false sense of security vis-à-vis “simple”, “plain-vanilla” or “mainstream” products which in fact can include large and, more worryingly, hard to predict extreme risks. This could reduce the incentives for investors to perform effective due diligences on the actual risks of products and exacerbate adverse selection and moral hazard phenomena, whose mitigation should be a major and ongoing preoccupation for the regulator.

  • On the use of derivatives by ETFs and other CIS

    TCSC5 appears to harbour strong reservations about the use of derivatives by ETFs, some of which may be due to preconceptions or misconceptions. For example, the Consultation Report (on page 6) associates derivatives with “credit, liquidity, currency, or interest rate risks” with no further explanation.9

    Derivatives can be used to leverage or magnify movements in their underlying and take on more risk than would be possible by investing comparable resources in the underlying markets (when such markets exist). Trading in derivatives can be used as a value-adding substitute for trading in the underlying to establish the targeted economic exposure, or to hedge a variety of risks associated with existing or projected investments in primitive markets. As underlined by BlackRock (2011b) in a letter to the United States Securities and Exchange Commission: “Derivatives allow a fund to increase, decrease or change the levels of risk to which the portfolio is exposed in a manner that may be more cost-effective, tax-efficient or provide greater liquidity than replicating the same exposures through traditional securities.”

    There is no reason to attach stigma to the use of derivatives by CIS and non-CIS in general, or in particular when they primarily implement their investment strategies through derivatives. There is likewise no basis to deny ETFs, whether index-tracking or not, the benefits of derivatives usage that CIS (and non-CIS) enjoy.

  • On counterparty risk and its mitigation

    The debate on the counterparty risk present in ETF structures has initially centred on the use of over-the-counter (OTC) derivatives that are required in synthetic replication ETFs prior to engulfing the securities lending activities that are typical of physical-replication ETFs. Neither OTC derivatives nor securities lending are in any way specific to ETFs, or even CIS, and it would thus be preferable to approach issues related to these practices in a horizontal manner spanning the finance industry as a whole.

    The Consultation Report rightly recognises that transactions in over-the-counter derivatives and securities lending both generate counterparty risk although it appears to be much more concerned by the former.

    Leaving aside OTC transactions, securities lending and repurchase agreement activities (all of which are typically secured transactions), counterparty risk also arises from purchases of fixed income securities, certificates, warrants, exchange-traded notes, and contracts for differences (all of which are typically unsecured transactions).10

    Our strong view and recommendation is that uniform guidelines should apply irrespective of the manner in which counterparty risk is assumed. These would cover counterparty risk limits, disclosure, and mitigation (up to the quality, marketability and diversification of the assets performing the economic role of collateral).

    In the context of UCITS, we have documented (see Amenc et alia, 2012) that portraying synthetic replication vehicles as presenting counterparty risk not present in physical replication vehicles is particularly misleading since, unlike the former, the latter commonly engage in securities lending activities through which they can legally take on more unmitigated counterparty risk than what is allowed in the context of OTC derivatives transactions, and because, as a group, managers of physically-replicated ETFs provide investors with significantly less transparency on counterparty risk and counterparty risk mitigation than managers of synthetically-replicated ETFs (as reported by Bioy (2011) and Johnston et alia (2012)). Against this backdrop, we have advised for EU-wide consistent regulation of counterparty risk mitigation and recommended that the Committee of European Securities Regulators (CESR) guidelines related to the collateralisation of OTC derivatives by UCITS be used as a reference to improve collateralisation of all transactions exposing UCITS and non-UCITS investment vehicles to counterparty risk. The proposed European Securities Market Authority (ESMA) guidelines (ESMA, 2012) are in line with our conclusions and recommendations.

    Applying different counterparty risk rules to investment vehicles on the basis of the manner in which they are expected to primarily take on counterparty risk would create artificial distinctions that may lead investors to pay less attention to first order issues that determine the effective mitigation of counterparty risk: the quality of the assets performing the economic role of collateral and the ability of the investment vehicle to enforce its rights against collateral in the case of default by the counterparty. It would also condone communication about alleged differences between index-replication methods that is not based on relevant risk characteristics.

  • Are there other areas that TCSC5 should address?

    In the context of the acceleration of the growth of passive investment, we feel that more attention should be given to the quality of index governance and the auditability of decisions made by index committees.

    We already mentioned that we considered it key to recognise the difference between passive instruments tracking indices managed in a transparent and systematic way and other products.

    The proposed distinction however requires (i) that the word index be given a legal definition and that regulators decide on the transparency and auditability requirements of indices; (ii) that a clear-line be drawn between index-based products and non-index-based products.

    With respect to the former, we feel that more attention should be given to the quality of index governance and the auditability of decisions made by index committees. Index ground rules must be pre-determined, objective, and leave no leeway or ambiguity for discretionary choices. The use of indices in passive management is justified by the transparent and systematic nature of their management and the simplicity of their payoffs. The exercise of discretion in the implementation of ground rules blurs the distinction between passive and active management. Ground rule changes bear comparable risks and deserve comparable attention.

    With respect to the latter, we recommend that regulators provide a formula for tracking error to be used across all index tracking products and impose a maximum tracking error for a vehicle to qualify as passively-managed / index-based.

    Our recommendation is for IOSCO to update its work on index funds and the use of indices (IOSCO, 2004)11 to foster progress in the information of index-products and end-investors in a number of areas and notably: (i) information on the type of index being tracked and the implications for the quality of tracking; (ii) transparency, quality, governance, and auditability of indices that can be used by index vehicles; (iii) tracking performance and minimal standards.


Specific comments

Chapter 2 Principles Related to ETF Classification and Disclosure

1. Disclosure regarding ETF classification

Principle 1 Regulators should encourage disclosure that helps retail investors to clearly differentiate ETFs from other ETPs.

We support such disclosures, as well as specific classifications, differentiating ETFs and other ETPs, and in general CIS and non-CIS.

EDHEC-Risk Institute supports disclosures that allow investors to perform their due diligences as well as product identification based on first-order risk-based distinctions. We consider that whenever the CIS structure offers investors protections not provided by non-CIS structures, encouraging disclosure that helps investors to clearly differentiate CIS from non CIS vehicles would be protective.

We are thus fully supportive of this principle and of the types of disclosures described in the Consultation Report (“Disclosure by ETFs should describe the distinguishing characteristics and regulatory requirements applicable to ETFs in a particular jurisdiction that are not applicable to other ETPs, including any requirements related to diversification, underlying asset liquidity, or risk management”).

In the context of UCITS ETFs, we voiced (see Amenc et alia, 2012) our support for an identifier to be used in an ETF name, rules, prospectus and marketing material to signal that it is UCITS compliant and thus more protective of the investor than other ETPs. We also underlined that we believed that all UCITS compliant funds, and not just UCITS ETFs, should be clearly identified to signal their high level of protection, e.g. through the use of the UCITS acronym in the identifier.

Finally, we note that although the proposed disclosures target a differentiation of ETFs vs. other ETPs, the principle could be applied to differentiate between CIS and non-CIS.

Principle 2 Regulators should seek to ensure a clear differentiation between ETFs and traditional CIS, as well as between index-based and non index-based ETFs through appropriate disclosure requirements.

On the differentiation between ETFs and other CIS

We see no basis to seek a “clear differentiation” between ETFs and other CIS and instead recommend disclosure of issuance, redemption and trading arrangements as well as high uniform standards on fee and cost transparency across the investment industry for both providers and distributors.

ETFs have been around for close to twenty-five years and, as underlined by the Consultation Report, are nothing more (and nothing less) than (open-end) CIS that are traded on an exchange. As such ETFs have to comply not only with all the rules applicable to CIS, but also with the additional rules set by the exchanges on which they are listed. In this context, the pitting of ETFs against “traditional” CIS is surprising.

The ESMA Securities and Markets Stakeholder Group (2011) notes that while ETFs are a “very low cost alternative” to other UCITS funds, they are “very rarely, if at all, marketed for European individual investors” due to “differences in remuneration of the distribution channels.” The cosy conflicts of interests that have prevented wider adoption of ETFs in lieu of their more expensive unlisted counterparts are a well-entrenched “tradition” that is now being questioned, via regulatory initiatives such as the bold Retail Distribution Review in the United Kingdom or the less daring draft revision of the Markets in Financial Instruments Directive (MiFID) at the European-Union level.

We understand that IOSCO is interested in whether an ETF may sell or redeem individual shares to or from retail investors in the fashion of an unlisted open-end CIS (which typically impose fees on such transactions12) or whether retail investors must buy and sell shares on a secondary market (where they incur trading costs) while authorised participants can deal directly with the ETF to create and redeem shares in bulk quantities.

We consider that all vehicles should be subjected to uniform standards of disclosure in relation to fees and that, where vehicles are traded on secondary markets, investors should be informed of the direct and indirect costs of trading on these markets and of the mechanisms in existence to keep these markets liquid and minimise trading costs, especially the indirect costs arising from deviations between net asset value (NAV) and market prices.

It should be underlined that the liquidity of an ETF stems not only from the exchange’s order book and general market making activity but also from direct creation and redemption of ETF shares by so-called authorised participants. In the traditional in-kind creation model, which is typical of physical replication ETFs but is also used by their synthetic replication peers, an authorised participant, typically a large bank, will purchase the basket of assets underlying the ETF as specified by the custodian and exchange it with the custodian for the corresponding number of ETF shares – this creates new ETF shares; redemption takes place when the authorised participant exchanges ETF shares for the underlying. In the cash creation model, which is typical of synthetic replication but is also used by physical replicators, the authorised participant exchanges cash for ETF shares. Increasingly, hybrid in-kind/cash models are used. Authorised participants are approved by the ETF and are the only ones who impact the outstanding number of ETF shares. The creation and redemption of shares is central in the arbitrage activity that (should) keep the traded price of an ETF close to the net asset value of its underlying. For this reason, the price formation of an ETF should not be assumed to be comparable to that of stocks or closed-end CIS, for which supply and demand forces on the secondary markets are the primary determinant of prices. Risk-free arbitrage activity by the authorised participants closely ties ETF prices to the value of their underlying. The spread on an ETF is determined by the liquidity of the ETF on the secondary market and the liquidity and volatility of the underlying portfolio. It is perfectly possible for an ETF that has low market volume to display a narrow spread because of the predictable nature of the arbitrage (and vice-versa). The trading volume of an ETF should not be equated with liquidity; here again the stock comparison is misleading.

We see no need for a clear differentiation between ETFs and other CIS and suggest regulators promote higher standards of fee/charge/cost transparency across the investment industry, targeting both investment providers and intermediaries.

On the differentiation between index-based and non-index-based products

We consider that there is significant basis for differentiating between index-based and non index-based products. We note that the relevance of such a differentiation is general and in no way limited to ETFs, or even CIS.

We indeed consider it key to recognise the difference between passive products that track transparent and systematic indices and other products. With the former, investors choose a linear and constant exposure to an index, which is managed in a transparent and systematic manner and boasts a published track record. With the latter, the payoff depends on risk-taking and portfolio management models that may neither be systematic nor transparent. A multiclass fund engaging in global tactical asset allocation will have a non-linear track-record, which will be difficult to explain or replicate, and a higher risk to underperform its benchmark in case its tactical bets turn out to be wrong. Likewise, a fund that tries to outperform its benchmark by taking risks of different economic nature than those implicit in its benchmark will exhibit a performance that will be hard to understand or replicate when the investor performs its due diligences.

We note however that the proposed distinction requires (i) that the word index be given a legal definition and that regulators decide on the transparency and auditability requirements of indices; (ii) that a clear-line be drawn between index-based products and non-index-based products.

With respect to the latter, we recommend that regulators provide a formula for tracking error to be used across all index tracking products, impose a maximum tracking error for a vehicle to qualify as a passively-managed / index-based (different limits could be applied to different underlying), and enforce initial and ongoing disclosure of targeted and realised tracking error.

With respect to the former, we feel that more attention should be given to the quality of index governance and the auditability of decisions made by index committees. Index ground rules must be pre-determined, objective, and leave no leeway or ambiguity for discretionary choices. The use of indices in passive management is justified by the transparent and systematic nature of their management and the simplicity of their payoffs. The exercise of discretion in the implementation of ground rules blurs the distinction between passive and active management. Ground rule changes bear comparable risks and deserve comparable attention.

Finally, we note that the relevance of the proposed differentiation is general and in no way limited to ETFs, or even CIS.

2. Disclosure regarding ETF strategy

Principle 3 Regulators should encourage all ETFs, in particular those that use or intend to use more complex strategies, or other complex techniques, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with such strategies or techniques.

We welcome disclosures allowing investors to perform their due diligences on the first-order and second-order risks associated with investment strategies and investment techniques. We note that appropriately controlled investment techniques do not alter the risks that drive an investment strategy’s performance. We thus warn against the possible confusion between strategies and techniques and against distinctions based on second-order risks that may shroud first-order issues. We also note that the relevance of the proposed disclosures is general and in no way limited to ETFs, or even CIS.

EDHEC-Risk Institute supports disclosures that allow investors to perform their due diligences as well as product identification based on first-order risk-based distinctions.

We thus welcome more regulatory scrutiny with respect to the “accuracy and completeness” of disclosure, especially with respect to the nature of risks associated with the investment strategies of investment vehicles as well with the specific risks that the investment techniques used to implement these strategies may entail.

However, we warn against the confusion that the wording of this principle may introduce to the extent that it puts investment strategies and investment techniques on a par (as in “those that use or intend to use more complex strategies, or other complex techniques”); as mentioned in our introductory comments, we recommend that when categorising investments or assessing their complexity, the focus be on the economic exposure achieved or the payoff generated by the investment strategy and not on the methods or instruments used to engineer this exposure or payoff.13

Simplicity, and a contrario complexity, should be understood as the investor’s ability to understand the sources of performance (or risk drivers), the systematic nature of the exposure to these risks (or sources of performance), and the resulting risk-return profile of the investment strategy. To the extent that the investment techniques used to engineer this risk-return profile are properly controlled and do not alter or change the nature of the investment strategy and its resulting payoff profile, their complexity (or lack thereof) is a second-order issue.14

By disregarding or de-emphasising the main risk drivers and the payoff profile generated by the investment strategy to focus on the techniques the investment vehicle uses or the instruments it holds to generate this payoff, regulators could create a false sense of security vis-à-vis “traditional”, “simple”, “plain-vanilla” or “mainstream” products which, by virtue of their investment strategies may expose investors to large as well as hard to predict risks. This could reduce the incentives for investors to perform effective due diligences on the first-order risks of products and exacerbate adverse selection and moral hazard phenomena, whose mitigation should be a major and ongoing preoccupation for regulators.

Finally, we note that the relevance of the proposed disclosures is general and in no way limited to ETFs, or even CIS.

3. Disclosure regarding an ETF portfolio

Principle 4 Regulators should consider imposing disclosure requirements with respect to the way in which an ETF will replicate the index (or the asset basket or the reference portfolio) it tracks (e.g., physically holding a sample or full basket of the securities composing the index (or the asset basket or the reference portfolio) or synthetically).

We support full-disclosure of replication methods (full-physical, statistical, synthetic, hybrid) along with detailed description of their specific rationales, investor benefits, costs, and risks. These disclosures should appear in every replicating vehicle’s prospectus, offering and ongoing disclosure documents, as well as in marketing material.

In general, we support full-disclosure of investment techniques used by all vehicles, whether replicating or not, whether exchange-traded or not, whether organised as CIS or not. We feel that the wording of the principle should be modified as there is no basis to restrict best practices to the narrow segment of ETFs replicating an index, asset basket, or reference portfolio.

Principle 5 Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio or other appropriate measures in order to provide adequate information to investors concerning: i) the index (or the asset basket or the reference portfolio) tracked and its composition; and ii) the operation of performance tracking in an understandable form.

We fully support such disclosures and recommend regulators to apply them in a horizontal manner to all tracking vehicles and not just ETFs or even CIS.

With respect to the underlying, we recommend that regulators require that details on the type of underlying that is tracked be disclosed, along with assumptions made on such issues as the timing or tax treatment of distributions, which may cause systematic deviations between the underlying and the tracker. We also recommend that regulators require that all information concerning indices–notably, their historical composition–be made freely available to the public.

With respect to the quality of tracking, we recommend that regulators impose the use of standard formulae to compute performance measures along with ex-ante (i.e. targeted) and ex-post (i.e. realised) tracking error disclosures. We also recommend that regulators require product providers to disclose information on how the tracking method(s) chosen will impact tracking error.

Last but not least, we recommend that regulators give a definition of tracking that would be framed in terms of a limit on the maximum level of tracking error acceptable. Information on underlying – type of index and implications for tracking

We recommend that regulators require that details on the type of underlying that is tracked be disclosed. For example, index products should precisely describe their specified indices and specify whether the index tracked is a price index, a gross dividend (or total return) index, or a net dividend index. Assumptions made by the index provider on such issues as the taxation and reinvestment of distributions15, which may cause systematic deviations between the index and the tracker , should be presented and their impact on the tracker’s ability to track the index , in the context of the tracking method(s) used, should be underlined.

Information on underlying – transparency, quality, governance, and auditability

The Consultation Report considers that the transparency of the underlying being tracked results in a high degree of transparency in the tracking vehicle. We remark that the transparency of the underlying is not a given.

The Consultation Report refers to IOSCO’s previous work on index funds which, back in 2004, explored the main regulatory issues surrounding the growth of index funds and indexation in the asset management industry, and concluded that “most, if not all of these issues” were “being adequately dealt with” and that investors in index funds were not subject to any greater risk than other CIS investors. That earlier report observed: “Most CIS regulators impose requirements for index funds to describe their specified indices in CIS disclosure documents. Most CIS regulators do not otherwise require public disclosure of the content and rules of the indices.”

We recommend that regulators require that all information concerning indices– notably ground rules and historical composition–be made freely available to the public. Historical composition information is difficult to obtain for traditional indices, even though the rules of the latter are typically simple, and in the case of strategy indices, it is almost impossible to procure at reasonable cost. Such information is required to check how ground rules are implemented and to independently calculate the track records of indices in terms of risk and performance.16 Free public disclosure of this information, for all types of indices, would not only allow tracking vehicles and end-investors to perform their due diligence at minimal cost, but also foster the development of independent research on indices that would contribute to market efficiency. We thus suggest that IOSCO develop principles on indices and indexing and recommend full transparency and free public disclosure of all information on the composition of indices over time as well as the basis for index changes and supporting documentation.

In the context of the acceleration of the growth of passive investment, we also feel that more attention should be given to the quality of index governance and the auditability of decisions made by index committees. ESMA (2012) underlines that index ground rules must be pre-determined and objective and proposes to require UCITS to determine whether there is an independent audit of index quality and what is the scope of such an audit. These high-level principles are welcome but much more work is required on these issues and should be undertaken at the IOSCO level, if possible. For example, ground rules may be ambiguous enough to implicitly allow for discretionary decisions and they may also explicitly provide for the possibility of discretionary choices. Such decisions can have a very significant impact on the composition of an index and there are many more dimensions to conflicts of interest in this regard than recognised in the ESMA or IOSCO consultations. Inter alia, it may be tempting for an index promoter to use the leeway provided by the ground rules to try and select or weight components with a view to improving the return performance of the index – this temptation is of course magnified when there is perfect hindsight about the subsequent performance of components i.e., when these decisions are made to simulate an historical track record.17

However, the use of indices in passive management is justified by the transparent and systematic nature of their management and the simplicity of their payoffs. The exercise of discretion in the implementation of ground rules blurs the distinction between passive and active management. Ground rule changes bear comparable risks and deserve comparable attention. Our recommendation is for (ESMA and) IOSCO to start working on these issues and launch a consultation on indices and indexing that will pave the way for major progress in the information of index-tracking vehicles and end-investors with respect to the quality, governance, and auditability of indices.

Definition and performance of tracking

With respect to tracking, it is startling to realise that most regulators have failed to provide a legal definition of what it means to be a tracker, have failed to impose a standardised measure of tracking error, and have failed to mandate disclosure of the quality of tracking.

Regulators should provide a formula for tracking error to be used across all index tracking products, impose a maximum tracking error for a fund to qualify as a tracker (different limits could be applied to different underlying), and enforce initial and ongoing disclosure of targeted and realised tracking error (and tracking difference18).

A widely accepted definition of the tracking error is the standard deviation of the difference between the fund’s return and the return of the index it tracks (Fabozzi and Markowitz, 2011); this is the definition presented in the Consultation Report and we endorse it.

We also recommend that the product prospectus present the targeted tracking error range along with results of back tests of this objective (including Relative VaR, i.e. the potential loss from the deviations of the tracker in respect of the index computed from historical data and Monte Carlo simulations). As part of ongoing disclosures, we recommend that all tracking products be required to present their realised tracking errors and tracking differences. These should be computed in an unambiguous and standardised manner for the relevant reporting period(s). As proposed by ESMA (2012), disclosures could also include an explanation of any divergence between the target and actual tracking error for the relevant period.

For clarity, we underline that we regard tracking performance as central to tracking and view tracking error as a risk. In relation to principle 5, we thus recommend that regulators require product providers to disclose information on how the tracking method(s) chosen will impact tracking error. In particular and in the spirit of IOSCO (2004), we consider that the risks of sampling replication, which is not always robust, notably in diversified geographical universes, be fully documented (for a detailed presentation of the various replication techniques, please refer to Amenc et alia, 2012).

Principle 6 Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio or other appropriate measures in order to facilitate arbitrage activity in ETF shares.

As far as trackers are concerned, requiring transparency of the tracked underlying could probably suffice to guarantee competition between authorised participants and other arbitrageurs.

For actively managed ETFs, we see a much stronger need for portfolio transparency requirements (or other appropriate measures) to facilitate arbitrage (and promote liquidity). We note that the proposed principle goes against the wishes of a number of asset managers who seek exemptions from existing transparency requirements to offer non-transparent active ETFs.19 In reviewing these proposals, regulators should consider the conflicts of interests and market abuse implications of specific models.

4. Disclosure regarding ETF costs, expenses and offsets

Principle 7 Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.

We strongly feel all instruments should be subjected to the same high standards of disclosure with respect to fees and expenses as this would promote a level playing field across the investment industry and, along with risk and performance disclosures, help investors to make informed decisions.

Selectively applying higher standards to one type of instrument – even if, as is the case with ETFs, such instruments are typically associated with low fees and expenses relative to comparable unlisted CIS or other vehicles – may put these instruments at a competitive disadvantage.

Principle 8 Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities.

We observe that securities lending is in no way specific to ETFs or CIS and should be approached in a horizontal manner.

As underlined by ESMA (2012), the concerns arising in relation to securities lending are also present when vehicles engage in sale and repurchase agreements (repos) and purchase and resale agreements (reverse repos). We thus recommend the principle be generalised to also cover these closely comparable transactions.

We see no basis to restrict the proposed disclosure to the material lending or borrowing of securities or to cases where the activity represents a significant source of revenues to the vehicle.20

As mentioned in our introductory comments, we strongly believe that uniform guidelines should apply irrespective of the manner in which counterparty risk is assumed. These would cover counterparty risk limits, disclosure, and mitigation (up to the quality, marketability and diversification assets performing the economic role of collateral).21

Disclosure of total returns and total costs is one way to mitigate conflicts of interest and promote value enhancement for investors. With respect to the conflicts of interest that may arise in relation to the sharing of the revenues linked to securities lending, we recommend that fee sharing arrangements be disclosed and that information on how fees collected compare to relevant performance indicators in the industry be provided.

Furthermore, we advocate the promotion of a new measure allowing investors to measure what share of the total return generated through the risks assumed on their behalf by funds is passed through to them. The calculation of this Total Return (pass-through) Ratio (TRR) would capture the returns to counterparty risk arising from securities lending operations. By highlighting the share of returns that does not accrue to the investor, such a ratio would permit an assessment of the true cost of asset management, beyond the picture given by the total expense ratio. Mandated disclosure of the ratio would help reduce the aforementioned conflicts of interest.

Chapter 3 - Principles Related to Marketing and Sale of ETF Shares

Principle 9 All sales materials and oral presentations used by intermediaries regarding ETFs should present a fair and balanced picture of both the risks and benefits of such products, and should not omit any material fact or qualification that would cause such a communication to be misleading.

Principle 10 In evaluating an intermediary’s disclosure obligations, regulators should consider who has control over the information that is to be disclosed.

Principle 11 Before recommending the purchase, sale or exchange of an ETF, particularly a non-traditional ETF, an intermediary should be required to take reasonable steps to ensure that recommendation is based upon a reasonable assessment that the product is consistent with such customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.

Principle 12 Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any ETF.

We consider that customer protection, including the responsibilities of intermediaries e.g. with respect to product suitability are in no way specific to ETFs, or even CIS, and should be approached in a horizontal manner across the investment industry.

We thus find this chapter to have little relevance at best and to be alarming at worst e.g. when the Consultation Report proposes that sales material regarding ETFs should be “fair and balanced” and “not omit any material fact or qualification that would cause such a communication to be misleading”, is it just stating the obvious or is it implying that violations of these high-level principles are particularly rife in the ETF industry and thus call for a particular level of attention?22

We take exception to the use of the wording “non-traditional ETFs” as we consider it to be ill-defined and thus subject to interpretation risk – while leveraged and inverse ETFs23 are mentioned twice in the documents as examples of non-traditional ETFs, no definition is given and it is unclear what constitutes a traditional ETF for IOSCO and where an how to draw the line between traditional and non-traditional products: securities lending and repos have been going on for decades, synthetic-replication ETFs appeared over a decade ago and are the majority in Europe, the United States Securities and Exchange Commission released a concept paper on active ETFs in 2001 (SEC, 2001), etc. We are concerned the Consultation Report may be assessing today’s environment against a traditional ETF world that is long gone or never was… after all, the 2004 IOSCO paper on index funds and the use of indices was already discussing leveraged index vehicles, the use of derivatives to achieve exposure, or concerns about sampling replication or securities lending.

Chapter 4 - Principles Related to the Structuring of ETFs

1. Conflicts of Interest

Principle 13 Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETFs.

We consider that the proposals we have made about the transparency, quality, governance, and auditability of all indices suitably address the potential conflicts of interests issues raised by the Consultation Report in the context of custom indices.

We endorse the disclosure of standardised metrics allowing investors to gauge the performance of the vehicle operator in negotiating the best terms and conditions for a variety of operations with the potential to impact revenues and expenses including, but not limited to, securities lending and OTC derivatives transactions. We consider that such disclosures should be mandated whether or not they involve an affiliated party but also recommend that all dealings with affiliated parties be disclosed.

We remark that none of the issues above are in any way specific to ETFs or even CIS and again recommend that they be approached in a horizontal way across the investment industry.

We support measures promoting competition on the authorised participant market and are in broad agreement with the suggestions in the Consultation Report; we consider that affiliated parties should not be prevented from participating in the market, including as primary authorised participants, and recommend instead formalisation of contracts and introduction/strict implementation of rules to avoid, disclose and manage conflicts of interest.

The Consultation Report is concerned with a number of areas that may offer breeding ground for conflicts of interest: the agent/principal relationship; custom indices provided by affiliated parties; securities lending services provided by affiliated lending agents; affiliated authorised participants and control over the authorisation of non-affiliated authorised participants; and transactions in over-the-counter derivatives with an affiliated counterparty. Note that, with the exception of possible issues related to authorised participants, none of these concerns is specific to ETFs, or even CIS.

With respect to the conflicts of interest that may arise in the context of the agent/principal relationship, the Consultation Report correctly reports that these are due to the nature of CIS and that, as CIS, ETFs share “the general CIS conflicts of interests.” The principal-agent problem arises when a principal and agent are distinct entities and the interests of the (self-interested) agent are not aligned with those of the principal which has hired the agent to pursue the principal’s interests and to which it has delegated control over resources. This problem exists between share/unit-holders and managers in CIS just as in any other organisation managed by agents on behalf of principals and is likely to be exacerbated by widely-dispersed ownership.24

Naturally, conflicts of interest also arise in relation to investments in non-CIS vehicles and this is more of a concern when the investor does not benefit from the same level of fiduciary protection as when it is a share/unit holder.

The Consultation Report is concerned about market abuse when a custom index is designed and/or serviced by a party that is affiliated with the sponsor of the vehicle using the index. Against this backdrop, it recommends transparency of ground rules, curbs on rules changes, firewalls, reliance on an unaffiliated calculation agent (or additional firewalls), and stability of component securities over a specified period. We endorse firewalls and consider that the proposals we have made about the transparency, quality, governance, and auditability of all indices correctly address the key issues raised by IOSCO in the context of custom indices. We do not see the need to restrict the flexibility of index providers with respect to component securities as long as all changes derive from the strict application of pre-determined, objective, and unambiguous ground rules, which have been made freely available to the public.

With respect to securities lending by an affiliated agent, we endorse the suggestion made by the Consultation Report to “require the CIS operator to obtain quotes from non-affiliates or otherwise ensure that fees are fair and reasonable and that the affiliate can provide services equal to those provided by non-affiliates.” Along with our proposed disclosure of all fees, fee sharing arrangements, and the reporting of our proposed Total Return (pass-through) Ratio, we welcome the disclosure of standardised metrics allowing investors to gauge the performance of the vehicle operator in negotiating the best terms and conditions (for the vehicle holders) for a variety of operations with the potential to impact revenues and expenses, including but not limited to securities lending/borrowing and repo/reverse-repo operations.25 We consider that such disclosures should be mandated whether or not they involve an affiliated party and that all dealings with affiliated parties should be disclosed.

The Consultation Report describes ways in which an affiliated authorised participant could restrict competition with negative impacts on liquidity and bid-ask spreads on the secondary market. It suggests that regulators should promote competition in the authorised participant market by such measures as requiring a minimum number of authorised participants; prohibiting the use of an affiliated party as primary authorised participant; and/or formalisation of authorised participants contracts. We support measures promoting competition on the authorised participant market and are in broad agreement with the suggestions in the Consultation Report; however, we consider that affiliated parties should not be prevented from participating in the market, including as primary authorised participants, and recommend instead formalisation of contracts and introduction/strict implementation of rules to avoid, disclose and manage conflicts of interest.

Finally, the Consultation Report mentions possible conflicts of interest when a vehicle deals in OTC derivatives with an affiliated party and refers to the concerns on the quality of the assets posted by the affiliated party to mitigate the counterparty risk assumed by the vehicle. The Consultation Report notes that this scenario, which has swap counterparties parking low quality assets into the collateral portfolio or the substitute basket playing the economic role of collateral, was presented in a working paper of the Bank for International Settlements (BIS, 2011) and that these suspected incentives have yet to be confirmed. The Consultation Report remains silent on appropriate measures to deal with conflicts of interest in relation to OTC derivatives. As with possible conflicts of interest in relation to securities lending, our recommendation for transactions in OTC derivatives is for regulators to require the disclosure of standardised metrics allowing investors to gauge the performance of the vehicle operator in negotiating the best terms and conditions. As for the quality of the assets posted by the counterparty in the context of an OTC derivatives transaction or a securities lending operation, we want to point out that, for these transactions to take place, the assets posted must be less economically appealing to the counterparty than what it gets in return. This does not mean that these assets are intrinsically of a lesser quality or that they cannot properly perform their risk mitigation mission. Requiring these assets to be of the same nature as the underlying in the derivatives transaction or the securities lent out would defeat the economics of these transactions. We turn to the important question of counterparty risk exposure and collateral management with the next principle.

2. Portfolio Strategies

Principle 14 Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.

We agree with IOSCO that counterparty exposure and collateral management are in no way specific to ETFs in spite of the much publicised regulatory concerns about the counterparty risks of ETFs. Again, we recommend that these issues be approached in a horizontal manner by IOSCO members and in close cooperation with other competent regulators where relevant.

Our strong view and recommendation is that uniform guidelines should apply irrespective of the manner in which counterparty risk is assumed. These would cover counterparty risk limits, disclosure, and mitigation (up to the quality, marketability and diversification of the assets performing the economic role of collateral).

Thus, we find merit in the Consultation Report’s suggestions on counterparty risk mitigation provided they are reframed to encompass all sources of counterparty risk and apply to all instruments. We notably agree with the report proposal to limit net exposure to counterparty risk from a specific issuer although we also recommend an overall limit to net counterparty risk exposure. As far as collateralisation is concerned, we have previously (Amenc et alia, 2012) suggested the use of the Committee of European Securities Regulators guidelines (CESR, 2010) as a benchmark and note that this is one of two references used in the Consultation Report. We also endorse the imposition of a diversification requirement to the assets playing the economic role of collateral as well as their appropriate segregation with a third party custodian.

Finally, we support high standards of transparency and disclosure with respect to counterparties, counterparty exposures, and the composition of the portfolio serving as collateral.

The recent debate on counterparty risk within the investment industry has initially focused on the OTC derivatives operations of synthetic replication ETFs, but the securities lending transactions that are an essential source of revenues for physical replication ETFs have subsequently faced similar scrutiny; this is fair to the extent that these are economically equivalent operations. The use of OTC derivatives and securities lending are not only legal (in most jurisdictions) but also legitimate to the extent that they facilitate the implementation of a fund’s strategy or generate ancillary revenues that benefit investors. However, these activities entail assuming counterparty risk. In the context of UCITS, the net counterparty risk from OTC derivatives is strictly limited to 10% of the fund’s net asset value; counterparty risk arising from securities lending does not benefit from such a high level of scrutiny but is nevertheless limited to 20% of the fund’s net asset value through the issuer concentration limit of UCITS.

The association of counterparty risk with ETFs may have misled investors into believing that the issues raised were specific to ETFs, or even worse, to synthetic-replication ETFs. In fact and in general, all CIS, whether exchange-traded or not, whether index-tracking or not, can trade in OTC derivatives and engage in securities lending. Furthermore, other vehicles available to investors may engage in the same transactions without affording the same protections as CIS.

Against this backdrop, and provided the counterparty risk arising from securities lending is mitigated to the same extent as that arising from OTC derivatives transactions, it makes little sense to pit physical-replication against swap-based replication. We thus consider that the negative allegations made by ETF providers on both sides of the replication divide about the risks in each other’s products are a disservice to the index-tracker industry and the ETF brand.

In particular, we find that portraying synthetic replication vehicles–which are predominantly UCITS–as presenting counterparty risk not present in physical replication vehicles to be misleading since, unlike the former, the latter commonly engage in securities lending activities through which they can legally take on more unmitigated counterparty risk than what is allowed in the context of OTC derivatives transactions, and because, as a group, managers of physically-replicated ETFs provide investors with significantly less transparency on counterparty risk and counterparty risk mitigation than managers of synthetically-replicated ETFs. It is thus most surprising to find physical replication providers denouncing the counterparty-risk or lamenting the opacity of their synthetic replication competitors.

We strongly believe that regulators should regulate counterparty risk mitigation in a consistent and horizontal way. Against this yardstick, we have welcomed and endorsed (Amenc and Ducoulombier, 2012) the recent work of ESMA (2012) which approaches counterparty risk in a horizontal way and proposes to generalise the high standards of risk mitigation applicable in the context of OTC derivatives transactions to securities lending and comparable operations.

Given the above, we regret that TCSC5 has approached the issue of counterparty risk and collateral management in the context of what it describes as “ETF-specific replication strategies” and suggests applying different standards on the basis of how counterparty risk is assumed by vehicles.

Nevertheless, we find merit in the Consultation Report’s suggestions on counterparty risk mitigation in the context of the use of OTC derivatives by synthetic ETFs provided they are reframed to encompass all sources of counterparty risk and apply to all instruments:

  • The report recommends appropriate risk management procedures regarding use of derivatives citing as one of two references the guidelines developed by the Committee of European Securities Regulators (CESR) for the collateralisation of OTC derivatives by UCITS (CESR, 2010). As we have before (see Amenc et alia, 2012), we recommend that such guidelines be used as a reference to improve collateralisation of all transactions, exposing investment vehicles to counterparty risk.

  • The report recommends limits with respect to net exposure to counterparty risk posed by a specific issuer; we fully endorse this but also recommend a limit to overall net exposure to counterparty risk.

  • The report also recommends additional checks and filters to those assets playing the economic role of collateral to ensure diversification. This is also something we endorse as a principle.

  • The report also mentions “other safeguards to mitigate potential operational and legal risks arising from collateral management (e.g., restrictions to ensure that non-cash collateral not be sold, re-invested or pledged). Such safeguards are present in the CESR guidelines which we have endorsed.

  • Finally, the report suggests that regulators could also require periodic reassessments of the value of any collateral as well as appropriate segregation with a third party custodian to protect against counterparty bankruptcy or default. We are fully supportive of such requirements.26
We also agree with the Consultation Report’s suggestion that counterparties, exposures, and amount and composition of the collateral (in the economic sense) be periodically disclosed. Along with best practices27, we recommend daily disclosure.

We disagree with the Consultation Report’s suggestion that it may be appropriate to put a cap on the extent to which a vehicle can lend securities; we believe a vehicle should be allowed to lend up to 100% of its portfolio as long as it suitably controls counterparty risk and makes the appropriate disclosures.

Chapter 5 – Issues Broader than ETFs

1. Risks arising on secondary markets (risk of shock transmission)

Principle 15 ETF exchanges should consider adopting rules to mitigate the occurrence of liquidity shocks and transmission across correlated markets (e.g. automatic trading interruption mechanisms).

We agree with the Consultation Report that this issue is not particular to ETFs.

We consider that the Consultation Report correctly identifies some of the issues to consider prior to implementing trading halts. However, we cannot endorse trading interruption mechanisms as “a pragmatic step towards managing risks” on secondary markets and underline that trading halts may instead increase liquidity shocks and facilitate transmission across markets. There has been little theoretical or empirical research on this issue and we would advise caution.

2. ETFs and market integrity (risk of abusive behaviour)
3. Risks to financial stability and avenues for future FSB work
a) Securities lending
b) Counterparty risks
c) Impacts on underlying market price formation

Question for the consultation: Are there particular financial stability concerns raised by ETFs that are not addressed by this paper?

Question for the consultation: Are there particular counterparty risks raised by ETFs? If so, should the FSB or the Joint Forum carry out further work to address counterparty risks?

Question for the consultation: Should the FSB or the Joint Forum, acting on the basis of their broader mandates, further study these concerns?

Recent reports by regulators and international organisations concerned with financial stability have trumped up the systemic risks of ETFs. On closer inspection (see Amenc et alia 2012), the case is woven from broad brush parallels and dubious assumptions and there is little in the way of a sound theoretical framework, let alone supporting empirical evidence.

We thus welcome IOSCO’s due consideration of academic studies and enforcement cases in its comments upon concerns related to potential liquidity shocks, market integrity, and upon the financial stability issues highlighted by the FSB. As underlined in the Consultation Report, these issues are not at all exclusive to ETFs, “recent enforcement-related regulatory actions brought by market authorities and other regulators have not revealed widespread ETF-related wrongdoing”, and there is no conclusive evidence on ETFs creating specific financial stability problems or negatively impacting price formation on the underlying market.

The assets controlled by ETFs are but a sliver of the assets under management in the fund management industry. They are dwarfed by the capitalisation of listed equity, by the notional amount of equity futures and swaps, and their securities lending activities are marginal in comparison to the size of this industry. In this context, it is doubtful that risks specific to ETFs could cause major disruptions to these market segments.

US ETFs and European UCITS ETFs are not less regulated than Mutual Funds and other UCITS, and the tools that index-tracking ETFs use to implement their strategies are also available to other CIS and products. We thus see no reason to single out these highly-regulated vehicles and attach stigma to their activities.

This notwithstanding and to the extent that securities lending and OTC derivatives transactions, while typically collateralised, increase the connectedness of financial institutions with one another, we believe that improved disclosure about counterparties, exposures, and risk mitigation would be useful to improve the monitoring of systemic risk. However, we suggest such disclosures be implemented in a horizontal rather than piecemeal way.

With respect to the fears that the development of ETFs may have hurt the underlying markets, there is a rich theoretical and empirical literature pointing in the opposite direction.28



Bibliography:

  • Ackert, L., and Y. Tian. 2008. Arbitrage, Liquidity, and the Valuation of Exchange Traded Funds. Financial Markets, Institutions & Instruments 17(5): 331–362.
  • Amenc, N., F. Ducoulombier, F. Goltz, and L. Tang. 2012. What are the Risks of European ETFs? EDHEC-Risk Institute Position Paper (January).
  • Amenc, N., F. Ducoulombier. 2012. EDHEC-Risk Institute comments on ESMA Consultation Paper, ESMA/2012/44. EDHEC-Risk Institute (25th March).
  • Bioy, H. 2011. Physical ETFs: A call for transparency. Morningstar (22nd September).
  • BIS. 2011. Market structures and systemic risks of exchange-traded funds. BIS Working Papers No. 343 (April).
  • BlackRock. 2011a. Application for exemptive relief filed before the USA Securities and Exchange Commission (Form 40-App). BlackRock (1st September).
  • BlackRock. 2011b. Comments of BlackRock, Inc. Use of Derivatives by Investment Companies Release No. IC-29776, File No. S7-33-11 (4th November).
  • CESR. 2010. CESR’s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (28th July).
  • Deutsche Bank. 2011. ETF Research – Industry Perspective - In the ETF labyrinth, where does the thread begin? Deutsche Bank (7th July).
  • Deutsche Bank. 2012. 2011 ETF Market Review & 2012 Outlook Data, Expansion past market turbulence & regulatory challenges. Deutsche Bank Global Equity Index & ETF Research (11th January).
  • Deville, L. 2005. Time to efficiency in options markets and the introduction of ETFs: Evidence from the French CAC 40 Index. Working paper. Paris-Dauphine University.
  • Deville, L., and F. Riva. 2007. The determinants of the time to efficiency in options markets: A survival analysis approach. Review of Finance 11 (3): 497-525.
  • Deville, L., Gresse, C. and de Séverac, B. 2012. Direct and Indirect Effects of Index ETFs on Spot-Futures Pricing and Liquidity: Evidence from the CAC 40 Index. European Financial Management (forthcoming).
  • ESMA. 2011. ESMA’s policy orientations on guidelines for UCITS exchange-traded funds and structured UCITS. European Securities and Markets Authority (22nd July).
  • ESMA. 2012. ESMA’s guidelines on ETFs and other UCITS issues. European Securities and Markets Authority (30th January).
  • ESMA Securities and Markets Stakeholder Group. 2011. Advice on ESMA’s public consultation on UCITS Exchange-traded funds in the European Union. European Securities and Markets Authority Securities and Markets Stakeholder Group (29th November).
  • Fabozzi, F., and H. Markowitz. 2011. The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies. Wiley.
  • FSB. 2011. Notes on potential financial stability issues arising from recent trends in ETFs. Financial Stability Board (April).
  • Hasbrouck, J. 2003. Intraday price formation in US equity index markets. Journal of Finance 58: 2375-400.
  • Hegde, P., and J. McDermott. 2004. The market liquidity of DIAMONDS, Q’s and their underlying stocks. Journal of Banking and Finance 28 (5): 1043-67.
  • ICI. 2012. Worldwide Mutual Fund Assets and Flows, Fourth Quarter 2011. Investment Company Institute (12 April 2012).
  • IOSCO. 2004. Index Funds and the Use of Indices by the Asset Management Industry. International Organisation of Securities Commissions (February).
  • IOSCO. 2010. Objectives and Principles of Securities Regulation. International Organisation of Securities Commissions (June).
  • Johnson, B., Bioy, H., Garcia-Zarate, J., Choy, J., Gabriel, J., Rose, G., Kellett, A. 2012. Synthetic ETFs Under the Microscope: A Global Study. Morningstar (May).
  • Kurov, A., and D. J. Lasser. 2002. The effect of the introduction of cubes on the Nasdaq-100 Index spot-futures pricing relation. Journal of Futures Markets 22 (3): 197- 218.
  • Madura, J., and N. Richie. 2007. Impact of the QQQ on liquidity and risk of the underlying stocks. Quarterly Review of Economics and Finance 47 (3): 411-27.
  • SEC. 2001. SEC Concept Release: Actively Managed Exchange-Traded Funds. United States Securities and Exchange Commission (8th November).
  • Tse, Y., P. Bandyopadhyay, and Y. P. Shen. 2006. Intraday price discovery in the DJIA Index markets. Journal of Business Finance & Accounting 33:1572-85.



Footnotes:

1Consistent with the terminology used by IOSCO, when used in this note, the term “ETFs” refers only to ETFs organised as CIS.

2We include principle #1 here as the (very relevant) distinction between ETFs and other ETPs can be generalised in a distinction between CIS and non-CIS. We also include principle #2 which not only includes a proposed distinction between ETFs and other CIS, which would not stand in the absence of ETFs, but also a proposed distinction between index-based and non index-based ETFs, which could apply to all CIS instead of ETFs only. Principle #13 is also included here since only the conflicts of interests related to authorised participants are specific to ETFs.

3ICI (2012) reports that the global mutual fund industry had USD23.78 trillion of assets under management at the end of 2011 and Deutsche Bank (2012) puts end-of-year assets controlled by all types of ETFs at USD1.35 trillion.

4The three objectives of securities regulations from which IOSCO high-level principles derive are to (i) protect investors; (ii) ensure fair, efficient and transparent markets; and (iii) reduce systemic risk (IOSCO, 2010).

5While the purview of many IOSCO members is restricted to securities and exchanges, there has been a global movement towards the creation of integrated financial sector regulatory and supervisory agencies. In any case, guidelines and recommendations can be couched in the most general terms to promote a level-playing field and high-levels of investor protection across the financial services industry.

6Interestingly, in late July 2011, the European Securities Market Authority (ESMA) announced that, responding to the concerns voiced by the FSB and the Bank for International Settlements (BIS), it had reviewed the regulatory regime applicable to UCITS ETFs and “structured UCITS”, concluded that it was not sufficient to “take account of the specific features and risks associated with these types of funds,” and had decided to start developing new guidelines for these funds. ESMA laid out its policy orientations in a consultation paper, and invited reactions from the industry. In January 2012, having taken into consideration the feedback from the industry, ESMA released another consultation paper titled “ESMA’s guidelines on ETFs and other UCITS issues” which goes a long way towards approaching important issues in a horizontal way across all UCITS rather than in a vertical way limited to UCITS ETFs.

7As in “synthetic ETFs pursue a range of investment strategies partially or wholly through the use of swaps, futures contracts, and other derivative instruments. (…) Overall, this strategy may reduce high rebalancing costs and may help diminish tracking error generally associated with physical replication.”

8Sale and repurchase agreements (repos) and purchase and resale agreements (reverse repos) are not mentioned in the Consultation Report.

9It also repeatedly fails to distinguish between exchange-traded and OTC derivatives when discussing counterparty risk (e.g. on pages 18, 20, 21, and 22), which fuels confusion.

10For more on this, refer to Deutsche Bank (2011).

11This ground-breaking work had correctly identified some of the key investor protection issues potentially raised by index funds and indexation. It surveyed IOSCO members on (i) What kind of CIS can hold itself out as an index fund? (ii) Should restrictions apply to the type of index that can be used by an index fund? If so, what are those restrictions? (iii) Should index funds be subject to any investment restrictions and practices? What should CIS regulators do when CIS investment restrictions and practices limit the ability of an index fund to track its target index? (iv) Should CIS regulators regulate the fees charged to index funds? (v) What should index funds tell their investors - at point of sale and continuously thereafter? - when a material change occurs?

12When investors rely on intermediaries to transact, additional charges or fees will typically be levied.

13Prior work by IOSCO had correctly identified the difference between strategies and techniques, for example its last report on index funds and the uses of indices (IOSCO, 2004) states that “index funds (…) use the cash or derivatives markets to achieve their investment objectives.”

14The Consultation Report appears to harbour specific concerns with derivatives-based investment techniques and securities lending, especially in relation to counterparty risk. We refer to our introductory comments above.

15Typically, the index will assume that dividends are paid and reinvested as soon as the stock goes ex-dividend. However, the average time between the ex-dividend date and the payment date is typically in weeks and sometimes in months.

16The focus of indices is increasingly shifting from representativeness to performance. Since index providers share in the commercial success of the vehicles tracking their indices (via licence fees linked to assets under management by these vehicles), would-be investors may question the reliability of track records presented by index providers.

17Hence, a provider promoting a tracker on an index that does not provide full and free disclosure of historical composition should not be allowed to mention performance for periods starting before the index went live.

18The tracking difference is the (non-risk adjusted) under- or over-performance of the tracker compared to the tracked underlying over a given period. We agree with the definition of tracking difference presented in the Consultation Report and agree that information on ex-post tracking difference should be disclosed.

19The reluctance on the part of active managers to disclose their holdings to the market at a high frequency is natural. BlackRock (2011a) has sought exemptive relief from the SEC to be allowed to manage active ETFs that would not disclose their holdings beyond what is required for open-end mutual funds. A calculation agent would be made privy of the required information to compute an indicative intraday value (IIV) throughout the day and authorised participants would create and redeem each day at the NAV. Other market makers and arbitrageurs would have to rely on the vehicle’s investment objective and principal investment strategies and the IIV. The manager underlines that, by preserving the confidentiality of their underlying portfolios, non-transparent active ETFs would not be susceptible to “’front running’ and ‘free riding’ by other investors and/or managers which can harm, and result in substantial costs to, shareholders.” Instead, they would preserve the benefits of the proprietary management strategies developed by the manager.

20We recognise that securities lending and repurchase agreements are critical lubricants of financial markets and that there may be a dangerous undersupply of securities available for these activities in the light of shift towards central clearing of derivatives and collateralised lending. The destabilising potential of stepped-up demand for collateral is compounded by the shortening of the rehypothecation chains, which restricts supply. This notwithstanding, we do not believe that hiding the risks to the investor or demanding less than full transparency on sharing agreements (e.g. when these activities are not material or revenues accruing to ETF investors not significant) will have a positive impact. Greater transparency may lead to better rewarding ETF holders for securities lending and repo operations undertaken with their funds. This would not only be a service to investors but may also force agents to offset the higher share of revenues transferred to investors by more actively seeking to develop the pool of securities available for securities lending and repo activities.

21There too, we believe that the promotion of high standards of transparency and risk controls could benefit the securities lending and repo industries.

22While we have alluded (e.g. in Amenc et alia, 2012) to misleading communications by ETF providers that, for example, portrayed synthetic replication trackers as being exposed to counterparty risk not present in physically replicated products, we have no evidence showing that ETF providers have a monopoly on misleading statements or deserve more attention than other investment managers.

23See Amenc et alia (2012) for a detailed analysis of these products and policy recommendations.

24EDHEC-Risk Institute is conducting research on the nature and external as well as internal governance structures of CIS in relation to CIS performance and investor protection issues.

25We have made this proposal before in the context of securities lending (Amenc et alia, 2012) but consider that there should in general be information on the performance of the operator in negotiating the best terms and conditions on the major items impacting investment management fees, brokerage commissions and trading expenses, and administrative fees.

26CESR guidelines impose daily basis and prohibit stale prices. CESR guidelines and UCITS rules require collateral and the substitute basket, respectively, to be held by a third party custodian.

27As implemented by most providers employing synthetic replication in Europe according to Bioy (2011).

28Hasbrouck (2003) and Tse et al. (2006) show a clear price leadership of the ETF market over the spot market, which suggests that ETFs process information faster than the spot market and contribute to price discovery. Furthermore, there is evidence (Hegde and McDermott, 2004; Madura and Richie, 2007) from the Diamonds and the QQQ funds suggesting that the liquidity of the underlying index market increased after ETFs were introduced because of a decline in the cost of informed trading. Ackert and Tian (2001), Kurov and Lasser (2002), Deville (2005), Deville and Riva (2007), and Deville et al. (2012) show that the introduction of ETFs significantly improved price efficiency in the index spot-futures market.