July 1, 2013 - 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[1] and recommendations[2], 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.[3]
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.[4]
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.[5] 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 and for advanced analysis of 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[6], 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.[7]
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.
[1] What are the Risks of European ETFs?, EDHEC-Risk Institute Position Paper, January 2012.
[2] e.g. Public Comment on Principles for the Regulation of Exchange Traded Funds, EDHEC-Risk Institute contribution to IOSCO Consultation Report CR05/12, EDHEC-Risk Institute, June 2012.
[3] On the question of non-financial risks and their management, refer to our press release titled EDHEC-Risk Institute Puts Forward a Series of Proposals to Limit Non-Financial Risks in the European Fund Management Industry and EDHEC-Risk Institute's Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry (December 2012).
[4] On issues of conflicts of interest in indexing and the relevance of transparency vs. internal controls or governance mechanisms to address these, see EDHEC-Risk Institute's Public Comments on Financial Benchmarks Consultation Report CR01/13 or the summary presentation made in Index transparency—A European Perspective (Journal of Indexes, May 2013). On the dangers of backtracking on index transparency, see also EDHEC-Risk Institute's press release on the false promises of governance (March 2013).
[5] This appears to partly derive from a confusion between the requirements of live ETF replication for the purpose of arbitrage and historical replication for the purpose of index evaluation. In related work on financial benchmarks, IOSCO has backtracked on transparency requirements: while its initial consultation report (CR01/13) had included "the ability to replicate a published Benchmark level" in its discussion of transparency, the notion no longer appears in its draft principles (CR04/2013) and the extent of transparency it recommends therein is subject to interpretation: "The Published Methodology should provide sufficient detail to allow Stakeholders to understand how the Benchmark is derived and to assess its representativeness, its relevance to particular Stakeholders, and its appropriateness as a reference for financial instruments."
[6] Chapter XIII of ESMA/2012/832EN.
[7] Providing the public with the information required to independently replicate an index for evaluation or research purposes should not be misrepresented as denying index providers the right to protect and enforce their intellectual property rights. There are legal as well as contractual tools (e.g. licenses) to defend index providers against unauthorised uses of their methodologies and data (not to mention the "natural" protections afforded by the added value (e.g. brand or services) that index providers provide to the lawful users of their products.) The transparency required for the said purposes can accommodate important time lags in the release of the underlying data, thus greatly reducing opportunities for free-riding and front-running, which third parties could engage in at the expense of index users. Opacity (typically) increases the scope for conflicts of interest to play out as abuse and, worse, practically denies the public the ability to assess the relevance and suitability of indices; it should not be tolerated as blanket protection against intellectual property infringements or, in the context of indexing, presented as a way to protect the interests of investors.
