ESMA Issues New Guidelines for ETFs

Much of the ESMA paper is rather unremarkable. In fact, many of the suggested policies have already been self-imposed by the industry. Industry self-regulation was prompted in large part by a flurry of warnings from regulators and institutions, like the IMF, last year around the use of derivatives and the resultant counterparty risks in synthetic ETFs. What was remarkable about the new guidelines was their treatment of the topic of securities lending. It seems as though, in the eyes of ESMA, that securities lending is now seen as being every bit an important an issue as the use of swaps in terms of the risk that it and other “efficient portfolio management techniques” pose to investors. In this regard, it is important to remember that securities lending has been common practice in the asset management industry for years, and is by no means unique to ETFs. As it stands today, ETFs already lead the way as it pertains to transparency around securities lending practices, and most should be relatively less affected by the new guidelines. However, actively managed funds, which also engage in securities lending, will be more affected by the new guidelines requiring additional disclosure.

Specifically, the new guidelines stipulate that UCITs will have to publish the identities of their counterparties in securities lending transactions in their semi-annual reports. We commend ESMA for recommending more stringent rules pertaining to the practice of securities lending as well as suggesting that 100% of associated revenues go to the fund in order to fully compensate investors for assuming the associated counterparty risk. So far, this practice is the exception rather than the rule. Only a few providers currently return 100% of the net revenue from securities lending back to fund shareholders. Amongst them are Comstage, Credit Suisse, and XACT ETF Lab. EasyETF and SPDR ETF return only 50% of the fees earned back to the fund. Market leader iShares, HSBC and Amundi return 60% and Powershares 70% of its revenue from securities lending. UBS does not disclose the details of its fee sharing arrangement (for a comprehensive look at current securities lending practices in ETFs click here).

New guidelines put forth in the document include requiring detailed disclosure of index replication techniques and specifying target tracking error. Moreover, ESMA proposes that ETFs must be labeled as such in the fund name. This is perhaps the most indicative example of how tame ESMA is with some of its proposed guidelines. On the issue of labeling of products, we believe that ESMA could have gone further than it has. In particular, ESMA did not consider an identifier in the ETF name to clearly distinguish between synthetic and physical products, even though some providers are doing it already. In our experience, many investors often ask how they can easily spot the replication method used. More comprehensive labeling guidelines would have been desirable in our view.

Industry stakeholders, investors and other interested parties have been asked to submit any feedback on the consultation paper to ESMA. In the second quarter of 2012 the final guidelines will be published and will then be incorporated in the EU directive.

SPDR Expands ETF Range in Germany and Switzerland
This week, SPDR listed sixteen exchange-traded funds (ETFs) on the SIX Swiss Exchange tracking emerging market equities, world equities and a wide array of fixed income indices. Within this range, two of the SPDR ETFs give investors the opportunity to track the performance of high dividend paying stocks in the US and emerging markets.

Also this week, SPDR launched an ETF on the Deutsche Börse tracking US mid-cap equities. The details for the newly launched ETF and new listings from SPDR can be viewed at the end of the article.

UBS Launches 2 New ETFs on Deutsche Börse
On Wednesday, UBS launched 2 share classes of a new ETF on the Deutsche Börse tracking infrastructure-related US equities. The new UBS ETFs track the MSCI US infrastructure index includes equities from the telecommunication services, utilities, energy, transportation, and social infrastructure sectors. The details can be viewed at the end of the article.

db X-trackers Lists 7 ETFs on Borsa Italiana
db X-trackers listed 7 new exchange-traded funds (ETFs) tracking credit derivatives and sovereign debt. Four of the ETFs allow investors to gain exposure for the first time to the positive or inverse performance of the iTraxx Europe and iTraxx Crossover indices with a leverage factor of two. The iTraxx Europe index consists of investment-grade European companies, while the iTraxx Crossover consists of European companies with a credit rating of Baa3/BBB minus or below. Of the remaining three ETFs, two ETFs track the iBoxx Sovereign Eurozone indices with maturity of one to three years and three to five years, respectively. The final ETF gives investors exposure to the Deutsche Bank Global Investment Grade Government index that comprises government bonds from 20 industrialised nations with an investment-grade rating.

As always, it is vital to understand that because the leverage ratio on these leveraged and inverse products is reset on a daily basis, their performance will likely diverge from their stated leverage ratio (2X, -2X, etc.) over holding periods lasting longer than a single trading day. This divergence will be especially pronounced during periods of market volatility. The details for the new suite of ETFs from db X-trackers can be viewed below.

Lee Davidson is an ETF analyst with Morningstar. Ali Masarwah, Ben Johnson, and Gordon Rose contributed to this article.