July’s decision by the US securities market regulator, the Securities and Exchange Commission (SEC) to loosen substantially the rules for launching exchange-traded funds (ETFs) based on indices managed in-house puts the whole ETF brand at risk, according to the head of one leading index firm.
In July the SEC decided to allow three new applications for “self-indexed” ETFs from US fund houses Guggenheim, Sigma and Transparent Value Trust to proceed, while removing most of the constraints historically required when a fund manager uses an affiliated index provider for an index-tracking ETF.
The SEC’s decision is summarised in a recent briefing note from US law firm Morgan Lewis.
In its new self-indexing ruling, the SEC argues that allowing the investing public to view the holdings of their ETFs on a daily basis should now be seen as sufficient to guard against potential abuses by those involved in managing a fund or its underlying index.
The earlier constraints in place for self-indexed ETFs were motivated by a provision in the 1940 Investment Company Act (the governing law for most US mutual funds) that places tight restrictions on fund managers’ dealings with affiliated parties.
As a result of concerns over potential conflicts of interest, the SEC previously required the public disclosure of the underlying index methodology, the use of a third-party index calculation agent and formal “firewall” procedures for any self-indexed ETF.
Such potential conflicts might include trading based on prior knowledge of index changes (known as “front-running”), allowing index changes that benefit the manager or other, preferred clients instead of the investors in the index-tracking ETF, and the manipulation of index pricing to present funds’ performance, or tracking ability, in a preferential light.
It’s now widely accepted that similar abusive practices occurred during the recent manipulation of LIBOR.
Last month the International Organisation of Securities Commissions (IOSCO), a body coordinating the efforts of the world’s securities regulators, released a new set of principles for those involved in benchmark and index provision, pointing to conflicts as a primary cause of the need for new global standards.
In its principles, IOSCO said that it aims to identify “generic risks to the credibility of benchmarks” as a result of “incentives stemming from conflicts of interests” amongst those running and calculating indices.
In Europe, several regulatory initiatives have been running in parallel to IOSCO’s work. These include the recently published principles for benchmark-setting in the European Union from the European Securities Market Authority (ESMA) and the European Banking Authority (EBA), a consultation document on benchmarks from the European Commission, and sections in ESMA’s recent ETF guidelines that require significantly more disclosure about the methodology and holdings of the indices used to underlie index-tracking ETFs.
With its new self-indexing ruling, the SEC seems to be flying in the face of these international efforts to promote greater transparency and better governance, the head of a leading benchmark firm told IndexUniverse.eu.
“This decision runs contrary to everything that’s recently come from IOSCO or from European regulators,” said Alex Matturri, chief executive of S&P Dow Jones Indices.
It’s insufficient, argues Matturri, to rely on daily portfolio holdings, as the SEC now appears to be doing, to judge whether potential conflicts of interest have been avoided.
“Relying only on the disclosure of the fund holdings defeats the objective of providing transparency, which is what ETFs are all about. You need some assurances about what you’re investing in, and portfolio holdings alone don’t give you that. You need the index methodology as well.”
“I can’t see how the SEC can allow something like this at the same time as IOSCO, in its guidelines, says that you should make indices, and therefore the funds that use indices, more transparent.”