Last Updated: 20 March 2023
It’s surely not a surprise that Europe’s financial market rulemakers are turning their attention to ETFs. After all, exchange-traded funds have been a hot topic for US regulators for a while. But what do recent comments from the Bank of England and the head of CESR portend?
In its latest Financial Stability Report, issued two weeks ago, the UK’s central bank fired a shot across the bows of the ETF industry by warning against “overreach” in ETF innovation.
Then Eddy Wymeersch, the chairman of the Committee of European Securities Regulators (CESR), called for more transparency in both ETFs and alternative UCITS funds (often labelled “Newcits”) at last week’s Fund Forum in Monaco, according to Baptiste Aboulian of the Financial Times.
In the FT’s report, Wymeersch is quoted as saying that he’d like to see further information about the assets underlying ETFs. “I’m not saying you can’t find [the information], but it’s difficult. There should be more explanation about what the [ETF providers] are doing. It is an issue that could easily be addressed by the industry.”
One ETF specialist I spoke to earlier this week took issue with the wording of some of the Bank of England’s comments. In particular, he wondered why the Bank should highlight that “commodity ETFs are most prone to deviations [between the funds’ share prices and underlying net asset values].”
“Is this a reference to the market dislocation that occurred in September 2008 with some of ETF Securities’ ETCs, then backed by AIG?” he asked. “If so, then it’s not an ETF issue and not a commodity issue either.”
Furthermore, he argued, the Bank’s comments that “market makers are not obliged to make markets at all times” may not be true, while the assertion regarding leveraged funds that “the leverage offered may amplify dislocations between fund value and the underlying index” is rather loosely worded. Leveraged ETFs do track their (daily leveraged) indices, he said, while the issue of return drift over time between a leveraged index and the relevant multiple of the underlying index is another matter.
That said, in my opinion it’s hard to argue against the Bank’s central point regarding the dangers of excessive innovation and complexity. And the report’s authors do seem to strike a balanced note when comparing the possible risks built into funds involved in securities lending and those using swaps.
Returning to Eddy Wymeersch of CESR, his argument about the difficulty of obtaining the relevant information on ETF providers’ websites is surely right.
For example, some providers don’t allow you to download daily data for both their funds’ NAVs and the underlying indices (they usually provide only the fund data). Without both data series you can’t measure tracking differences or tracking error.
There’s inconsistency in the use of language regarding fees, with “management fee”, “all-in fee”, and “total expense ratio” all used, and all potentially meaning different things. You need to go to the relevant prospectus to check what is or isn’t included.
In my view one of the worst offences is – for funds tracking a total return index – the general lack of information on whether the index total return is calculated net or gross of withholding taxes. If the total return is net of tax, then what tax rate has been used? You’ll have to delve deep into the index providers’ websites to work that out, while it could be disclosed as a matter of course. And for funds distributing income, why not state upfront what percentage of gross dividends or bond coupons has been paid out, rather than leaving it to the investor to piece this information together? The difference between gross and net index returns can be significant – often a percent or so in annual terms.
And – as we’ve regularly argued on Index Universe – a great deal more information could easily be given on counterparty exposures and collateral. Why not publish the daily collateral basket for swap-based ETFs on the provider’s website? And why not – for funds involved in securities lending – name the counterparties used, show the percentage of the fund on loan, and list the collateral received?
Wymeersch’s comment, also reported by the FT, that it’s the industry’s responsibility to improve transparency, rather than the regulator’s role to impose rules, should be welcomed by those involved in the European ETF business. But it usually takes only one scandal for everyone to then suffer from more heavy-handed control. Better disclosure would help everyone spot potential problems before they occur.