EDHEC-Risk Institute welcomes the Principles for the Regulation of Exchange Traded Funds (ETFs) released by the International Organisation of Securities Commissions (IOSCO) on 24 June 2013, which are broadly consistent with EDHEC-Risk Institute’s research on ETFs and recommendations, but deplores the timidity of the organisation’s proposals on index transparency and calls on regulators and index providers to adopt standards on par with those recently defined for European Undertakings for Collective Investment in Transferable Securities (UCITS).
IOSCO’s final report has taken into account the feedback received during the consultation process and attempted to focus on issues that are specific to ETFs or otherwise underline the wide-applicability of recommendations framed in the context of ETFs. It has also clarified the distinctions between investment strategies, replication techniques and investment tools and thus avoided the pitfall of using irrelevant structural or instrumental characteristics, rather than underlying risk differences, when making recommendations.
From the point of view of investor protection, EDHEC-Risk Institute applauds IOSCO’s call for disclosures that clearly differentiate ETFs, which have to comply with applicable Collective Investment Scheme (CIS) regulation, from other Exchange-Traded Products that do not offer the same protections (Principle 1) and has no issue with the differentiation of ETFs from non-exchange listed CIS (Principle 2).
EDHEC-Risk Institute also endorses the proposed disclosures of the replication method(s) used for index-tracking (Principle 3) and of information on tracking performance (Principle 4); of fees and expenses (Principle 5) and revenues and costs of securities lending (Principle 6).
EDHEC-Risk Institute also finds merit in the suggestion that the risks of investment strategies, especially complex ones, be presented in an accurate, complete and understandable manner (Principle 7) and wishes to underline that although complexity in this context should be appreciated via the risk-return profile of the strategy, regulators should require the disclosure of the non-financial risks deriving from structural and instrumental choices.
By this respect, EDHEC-Risk Institute welcomes IOSCO’s call to manage counterparty and collateral risks arising from securities lending operations or the use of OTC derivatives (Principle 9).
In appreciating whether applicable legislation adequately addresses potential conflicts of interests (Principle 8), EDHEC-Risk Institute invites regulators to recognise that such conflicts exist across the industry, to avoid condoning irrelevant distinctions between providers (e.g. self-indexers vs. self-styled “independent index providers”) and to firmly establish transparency, rather than internal controls and governance, as the primary tool to combat abuse.
EDHEC-Risk Institute regrets that, in the face of index provider opposition and concerns about the necessities of confidentiality or intellectual property protection, IOSCO has side-stepped the issue of index transparency, leaving it to each regulator to determine its desirable level. This approach is likely to result in an unlevel cross-border playing field and in insufficient index-user protection and information in multiple jurisdictions. Against this backdrop, EDHEC-Risk Institute reaffirms that informed use of indices requires not only clear summary information on index objectives and key construction principles, but also complete transparency on both index methodology and historical data on index values, constituents and weights. While the former allows for cursory screening of indices against a user’s objectives and constraints, the latter permits independent index replication on a (historical and) non-commercial basis, which allows for multilateral verification of the integrity of track records and assessment of the systematic character of methodologies andfor advanced analysisof the relevance and suitability of indices according to the specific needs of each index-user. The European Securities and Markets Authority (ESMA) has recently edicted rules for the use of financial indices by UCITS, which inter alia, require such transparency to be provided on a complimentary basis. To foster industry competition that is not based on jurisdictional arbitrage and promote a high level of consumer protection, EDHEC-Risk Institute recommends that regulators adopt transparency standards on par with those of ESMA and calls on index providers to willingly supply the transparency required for informed investment decisions.
As a general rule and to avoid increasing the risks of regulatory arbitrage by issuers and adverse selection by investors, EDHEC-Risk Institute recommends that regulators implement the IOSCO principles in a horizontal way across the widest possible range of instruments rather than in a vertical way limited to ETFs.