According to a report in the Financial Times, the Dutch financial regulator, the AFM, has said that it stands by a study it issued last month in which it described the majority of European exchange-traded funds as “extremely difficult, if not impossible, to understand”. The regulator’s stance appears to pre-empt a ruling on the complexity of investment products that is expected from European lawmakers as part of the ongoing review of the 2007 Markets in Financial Instruments Directive (MiFID).

The AFM has recommended that what it views as complex index trackers should not be available for purchase by retail investors without the intermediation of an expert advisor or asset manager, acting in a fiduciary role. Under current European market practice, ETFs are freely available for sale throughout the region via execution-only brokerage services.

At first glance, notes the Financial Times, the AFM’s stance on product complexity also appears to differ from that of Europe’s securities market regulator, ESMA, which last week released a new set of guidelines for the region’s exchange-traded fund market.

In its guidelines, ESMA declined to recommend any formal split in the market for UCITS-compliant exchange-traded funds into “complex” and “non-complex” categories. (“UCITS” refers to a series of European directives regulating funds that are specifically authorised for distribution to retail investors within the European Union).

The AFM, however, says that there is “no conflict” between its own advice and the newly issued ESMA guidelines, the FT reports.

In an interview conducted earlier this year with IndexUniverse.eu, representatives of ESMA said that any decision on whether particular types of investment product, including funds, should be classified as complex and therefore unsuitable for direct sale to retail investors would be taken by the European Council and European Parliament as part of their ongoing review of MiFID (“MiFID II”).

However, the timetable for the approval of MiFID II is coming under increasing question. According to Global Risk Regulator, a specialist newsletter focussing on financial regulation, the review of the financial market directive is currently being held up as the result of intense lobbying and amidst major differences among European lawmakers.

While lobbyists’ focus is primarily the structure of Europe’s market for post-trade securities services rather than the regulation of investment products, GRR reports, the new directive, which was due to be published in late summer, may now not see the light of day for up to another year.

In its study of index-tracking funds the AFM said that derivatives-based (“synthetic”) ETFs and physically replicated ETFs that use optimisation, sampling or securities lending are all too complex to be understood by the average retail investor and therefore carry a major risk of mis-selling. In the case of synthetic ETFs, for example, the regulator said that “even a simplified representation of the structure is already so complicated that a consumer could not be expected to understand the operation and potential risks involved”. Collectively, these categories of ETFs represent a large majority of the 1300-plus funds currently on sale in Europe.

The Dutch regulator was also critical of the general standard of product information provided to investors via ETF issuers’ websites, saying that many firms provided incomplete or incomprehensible information on ETFs’ counterparty risks, tracking ability, performance and tax treatment of dividends. There was also often a lack of suitable information on the methodology of the index being tracked, noted the AFM.

IndexUniverse.eu asked the UK's Financial Services Authority (FSA) for its views on the subject of ETF complexity.

A spokesperson for the regulator replied that "when demand grows for new financial products, regulators pay close attention and Exchange Traded Funds (ETFs) are no exception. Over the last eighteen months, the FSA has visited a number of firms who account for over 70% of the EU market. We have required UK firms to address issues we have found. We are working closely with other EU regulators to mitigate risks on a pan-EU basis and to deliver a coordinated EU position. We also recently issued two factsheets for consumers and financial advisers to improve their understanding of the risks and benefits of Exchange Traded Products (ETPs) as a whole."

Tying together the different strands of the large number of ongoing initiatives is clearly proving a significant challenge for the politicians and officials involved in the re-regulation of Europe’s financial markets. But some participants in the regulatory debate are now showing a willingness to go it alone by setting tough national standards. For its part, the Dutch regulator warns that it expects ETF issuers to “adopt the recommendations of the AFM when developing products for, or offering products to, consumers in the Netherlands”.

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