On July 25, The European Securities and Markets Authority (ESMA) released its latest report and consultation paper outlining new guidelines for exchange-traded funds (ETFs). Here, we highlight what we believe to be three key “wins” for investors contained within the new guidelines.
1. Sharing of revenue generated via securities lending
The ESMA will now require fund managers to return all revenue, net of costs, generated via securities lending back to fund shareholders. This is a big win for investors.
Securities lending is a relatively unknown, but important, practice in the ETF industry. Securities lending refers to when an asset owner (or in this case, ETF manager) loans shares to other investors, usually hedge funds, who want to sell the assets short. Within a securities lending programme, the asset owner is exposed to some counterparty risk, but receives revenue for assuming that risk.
Now, the new guidelines stipulate that ETF investors will receive 100% of the revenue, net of costs, from this practice.
This is a positive development for investors, and is something that we initially called for last year in an in-depth study of securities lending practices amongst European ETF providers. At the time of writing her study, my colleague and ETF analyst Hortense Bioy, pointed out that different funds distributed revenue from securities lending in different ways: some funds passed along all the revenue to shareholders, while others did not. In her report, Bioy questioned this lack of consistency:
“These differences, which clearly show that some firms are much more generous than others, begs the question: shouldn’t all the providers funnel 100% of the revenues earned to the fund given that fund shareholders are ultimately assuming 100% of the risk associated with this practice? Undoubtedly, this would serve to provide a superior risk-reward trade-off and be in the best interest of investors.”
2. Availability and transparency of benchmark index information
The ESMA is now going to require greater transparency around the calculation and composition of the indices tracked by ETFs and other UCITS. This is another win for investors. This will allow current and prospective investors to make more informed decisions as well as to better understand the costs embedded within some of the more complex and exotic benchmarks tracked by ETFs. Greater index transparency will allow investors to better understand what they own (or are otherwise attaining exposure to, in the case of synthetic replication funds) and how much they are paying to own it.
This is what the ESMA report says regarding this issue:
“In light of the feedback received, ESMA extended the scope of the guidelines to all financial indices. Despite the strong pushback from stakeholders on the disclosure of the calculation methodologies of financial indices, the Authority decided to confirm the proposal that was set out for consultation. Indeed, ESMA is of the view that these elements are of utmost importance for investors and takes note that some market participants already disclose the full calculation methodology in the format of index rule books which are publicly available on the internet … Regarding the publication of index constituents and their respective weightings, ESMA strongly believed that this information should be provided to investors but recommends that it could be done with a certain delay.”
3. Labelling
As simple as it may seem, putting forth a clear definition and clear labeling guidelines for UCITS ETFs will go a long way in helping investors to make sense of the alphabet soup that is the broader exchange-traded products (ETP) universe. The new guidelines require very clear product labeling for ETFs, as you can see from the ESMA report:
“ESMA recommends that UCITS should use the identifier “UCITS ETF” to be more easily identifiable by investors and that this identifier should not be translated into national languages. Also, ESMA recommends that neither the words “UCITS Exchange-Traded Funds” nor ETF should be used by UCITS that do not comply with the definition of UCITS ETFs.”
Overall, we at Morningstar are glad to see these new guidelines. They are generally in line with the opinions we shared in March 2012, when we responded to the previous draft of the ESMA consultation.
To learn more about the differences between various ETP structures, you can click here to access our three part guide to understanding ETPs.
