On 30 January 2012 ESMA published a consultation paper which sets out ESMA's proposed guidelines on UCITS ETFs, index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices for UCITS. ESMA has requested responses to the consultation paper from interested parties in advance of the adoption of the finalised guidelines in the second quarter of 2012. A summary of the proposed guidelines follows.
Index-tracking UCITS and index-tracking leveraged UCITS
The prospectus must include a clear description of the index including details of its underlying components (the prospectus can direct investors to a website where the exact composition is published), information on how the index will be tracked, details of investor exposure to counterparty risk and a description of the factors that are likely to affect the UCITS' ability to track the performance of the index. Details of whether the index-tracking UCITS will follow a full replication model or use a synthetic or sampling model should also be set out in the prospectus.
The annual and half-yearly reports should state the size of the tracking error as at the end of the period under review. The annual report should explain any divergence between the target and the actual tracking error.
The prospectus and KIID of an index-tracking leveraged UCITS should include:
- a disclosure on leverage policy and how this is achieved, the cost and risks associated with the leverage and a disclosure on the impact of any reverse leverage (i.e. short exposure); and
- a description of how the frequency of calculation of leverage impacts on investor's returns over the medium to long term.
UCITS Exchange Traded Funds ("ETFs")
A UCITS ETF is defined as "a UCITS at least one unit or share class of which is continuously tradeable on at least one regulated market or multilateral trading facility with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value."
A UCITS ETF should use an identifier in its name and in its funds rules or instrument of incorporation, prospectus, KIID and marketing communications which identifies it as an exchange-traded fund. The identifier proposed by ESMA is "ETF".
A UCITS which does not satisfy the ETF definition should not hold itself out in any of its published documentation as an ETF or use the ETF identifier;
A UCITS ETF which is actively-managed should:-
- clearly inform investors in its prospectus, KIID and marketing communications of that fact and that it is not an index tracker. It should also disclose how it intends to meet the stated investment policy, including any intention to out perform a benchmark index;
- clearly disclose in its prospectus how the indicative Net Asset Value (iNAV) will be calculated and the frequency of the calculation.
One of the primary issues raised by ESMA is the need for protection of secondary market investors. The consultation paper identifies a difference of opinion among industry stakeholders in relation to the redemption rights of secondary market investors. The consultation paper proposes two possible options and seeks industry comment on each in advance of the finalisation of its Guidelines:-
Option 1: recognise primary investors/authorised participants (holders of "creation units") as the sole investors in the UCITS ETF for the purposes of the protections and rights afforded to investors pursuant to the UCITS Directive. Provide a specific warning that ETF units are generally not redeemable from the fund other than by authorised participants. Ensure an appropriate market maker or alternative arrangements are in place at all times to offer redemption options to secondary market investors.
Option 2: provide for a right of secondary market investors to seek a redemption of their holdings directly from the UCITS ETF. In such a circumstance the UCITS ETF should indicate, where applicable, the redemption fee applicable.
Efficient Portfolio Management Techniques ("EPM")
UCITS may employ techniques and instruments relating to transferable securities and money market instruments provided that their employment is for the purpose of efficient portfolio management. Such techniques include repo, reverse repo and securities lending transactions. ESMA notes that securities lending by UCITS is gaining in popularity but that investors are not always fully aware of how the process operates or the increased risks associated with borrower default. In particular the paper focuses on the need for adequate collateral regulation and diversification in circumstances where collateral is received in exchange for securities. In an attempt to clarify what it deems to be acceptable collateral for the purposes of EPM techniques ESMA has set out a list of eligible collateral assets. The list includes cash, shares or units of UCITS which offer daily dealing, sovereign debt issued by an EU or OECD member states and bonds issued by the European Central Bank.
The consultation paper proposes introducing the following rules:
- the prospectus should clearly inform investors of the UCITS' collateral policy, setting out the permitted types of collateral, the level of collateral required and in the case of cash collateral the re-investment policies. It should also identify any possible conflicts of interest;
- a UCITS should ensure that it is able at any time to recall any security that has been lent or terminate any securities lending or repo agreement into which it has entered;
- collateral received should comply with the criteria for collateral received in the case of OTC derivatives set out in CESR's Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk;
- the collateral posted by the relevant third party to mitigate the counterparty risk arising through EPM techniques should be sufficiently diversified in order that at any time, the portfolio composed of the collateral and the assets not subject to the EPM technique complies with the UCITS diversification rules. The UCITS should comply with the UCITS diversification rules in relation to entities at which cash is deposited, taking into account both the cash received as collateral and any other cash held within the fund;
- entities at which cash collateral is deposited should be EU credit institutions or credit institutions in non- EU countries subject to equivalent prudential rules;
- UCITS should have in place a clear haircut policy for each class of assets received as collateral. This policy should be documented and should justify each decision to apply a specific haircut, or to refrain from applying any haircut, to a certain class of assets; and
- the UCITS, annual report should contain details of the underlying exposure obtained through EPM techniques, the identity of counterparties to EPM techniques and the type and amount of collateral received by the UCITS to reduce counterparty exposure.
The final suggestion proposed by ESMA is that a limitation be imposed in relation to the proportion of a UCITS portfolio which can be employed for EPM purposes.
Although some Member States have imposed limits at a national level, there is no restriction on a UCITS' securities lending at a European level. ESMA suggests that quantitative limits could be set in relation to the amount of securities that can be loaned to an entity or in respect of the level of borrowing of the UCITS' portfolio as a whole.
Total Return Swaps ("TRS")
Similarly to EPM, ESMA has set down a list of assets which it deems are eligible for TRS collateral purposes. The list includes cash, shares or units of UCITS which offer daily dealing, sovereign debt issued by an EU or OECD member states, bonds issued by the European Central Bank and certain money market instruments.
In the case of an unfunded swap, both the UCITS' investment portfolio, the return of which is swapped, and the underlying to the swap, to which the UCITS obtains exposure, must comply with the relevant UCITS diversification rules. If collateral is posted by the swap counterparty to mitigate the counterparty risk, this collateral should be sufficiently diversified over the course of the swap in order that at any time, the portfolio composed of collateral and the other investments made by the UCITS comply with the UCITS diversification rules.
In the case of a funded swap, the collateral posted by the swap counterparty to mitigate the counterparty risk should be sufficiently diversified to comply with the UCITS diversification rules, taking into account both the investments made by the UCITS and the collateral. The UCITS should comply with the UCITS diversification rules in relation to entities at which cash is deposited, taking into account both the cash received as collateral and any other cash held within the fund.
UCITS should have in place a clear haircut policy for each class of assets received as collateral. This policy should be documented and should justify each decision to apply a specific haircut, or to refrain from applying any haircut, to a certain class of assets.
The prospectus should clearly inform the investors of information on the underlying strategy and composition of the investment portfolio, the risk of counterparty default, and where the counterparty assumes discretion over the UCITS portfolio the extent of that discretion.
The UCITS' annual report should contain details of underlying exposure obtained through financial derivative instruments, the identity of the counterparties to the financial derivative instruments and the type and amount of collateral received by the UCITS to reduce counterparty risk.
ESMA notes that strategy indices often include proprietary calculation models which index providers are unwilling to fully disclose. Consequently the failure to fully disclose the methodology behind the calculation renders the financial indices ineligible from a UCITS perspective.
The consultation paper states that information on index constituents, index calculation, re-balancing methodologies and index changes should be freely and continually available. The paper further emphasises the importance of establishing a conflict of interest policy in instances where the manager of the UCITS, the counterparty to the swap and the index provider are part of the same group.
The prospectus for an index-replicating UCITS must, where relevant, inform investors of the intention to make use of the increased diversification limits together with a description of the exceptional market conditions which justify this investment.
A single component of an index must not have an impact on the overall index return which exceeds the relevant diversification requirements i.e. 20%/35%.
A commodity indices must consist of different commodities which respect the 20%/35% limit in order to be considered an eligible index.
The index provider should disclose the full calculation methodology to, inter alia, enable investors to replicate the strategy.
The UCITS must carry out appropriate documented due diligence on the quality of the index. This due diligence should take into account whether the index methodology contains an adequate explanation of the weightings and classification of the components on the basis of the investment strategy and whether the index represents an adequate benchmark. The UCITS must also assess the availability of information on the index including whether there is a clear narrative description of the benchmark, whether there is an independent audit and the scope of such an audit, the frequency of index publication and whether this will affect the ability of the UCITS to calculate its NAV. The due diligence should also cover matters relating to the index components.
Implementation and Application
The Guidelines are due to be finalised and published in second quarter of 2012. ESMA proposes that that requirements in respect of marketing communications and prospectus contents will come into effect one year after publication of the Guidelines at the latest, or upon revision of any of the documents post-publication of the guidelines. The requirements in respect of collateral diversification will be phased in following publication of the guidelines as will the requirement for ETFs to use an identifier. Importantly ESMA proposes that the Guidelines will only apply to new investments made after the Guidelines come into effect
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.