Proposed new rules by Europe's main financial regulator, the European Securities and Markets Authority (Esma), could mean that funds and exchange-traded funds (ETFs) will have to be more open with investors about how they make their returns.
Funds governed by Ucits (undertakings for collective investment in transferable securities) legislation, which include many open-ended investment companies and ETFs will, among other things, have to disclose if they are lending out the underlying assets they invest in. Some funds and ETFs do this to raise revenue, but it introduces the risk that the borrower of the assets will not give them back.
Usually the fund holds some kind of collateral worth the value of the loaned assets, and Esma suggests investors should be given details of what this is. Esma also suggests that this collateral be sufficiently diversified to reduce risk if the borrower of the securities defaults.
Other suggestions include making clear which ETFs comply with Ucits legislation and how ETFs and other Ucits tracker funds track their indices, for example, whether they buys the shares or use a derivative swap, and the risks involved with each.
Esma also believes the prospectus of a Ucits ETF should include a clear description of the index being tracked including details of its underlying components; and factors that could affect the ability to track, such as transaction costs, small illiquid components and dividend reinvestment.
The regulator also suggests that annual and half-yearly reports of index-tracking Ucits funds state the size of the tracking error as at the end of the period under review, and explain the divergence.
Esma's chairman, Steven Maijoor, says the proposed guidelines will improve the quality of information available to investors, enabling them to make more informed decision. There were fears by some ETF providers that the regulator would clamp down on synthetic ETFs, reclassifying these as 'complex' products – a move that would have restricted the ability to sell them without financial advice.
While criticism of securities lending has been centred on ETFs, new research shows that such lending has been common practice across all types of funds for years. Read more about this and the issue of tracking error in this week's Big Theme: ETFs are no riskier than other funds.