Written on 30 July 2012.
These guidelines go further than the consultation document in two notable areas:
The first is securities lending, where ESMA indicates clearly that all profits from securities lending should be returned to the fund. It is clear that this subject comes as a surprise to industry participants. EDHEC-Risk had brought up the problem of transparency in its research, but nobody thought that ESMA would go as far as it did on the subject. This new rule clearly changes the situation and the business model of ETF providers who have chosen physical replication because securities lending represented considerable sources of revenue for the asset management firms.
These revenues did not correspond to disproportionate profits but allowed ETFs to show lower management fees. As a result of receiving all of the lending profits, the ETF can now expect its management fees to increase; the arrangement will nonetheless have the merit of clarifying the real costs of replication and the profits associated with the risk taken in the area of securities lending.
It also seems that the new rules on securities lending by UCITS will have a strong impact on the volumes handled on the securities lending market. This market is an important factor in ensuring a good level of liquidity and improving the efficiency of equity markets. It would therefore be important for an impact study to be produced in order to reinforce ESMA’s decision.
The second area is the new requirements in the domain of financial indices. EDHEC-Risk Institute is very satisfied that the European regulator has taken a major step towards transparency in an industry which up until now, with some exceptions, was characterised, under the pretext of protecting intellectual property, by the low level of information given to investors on index methodologies and compositions.
ESMA, through these recommendations, is putting a logical end to these practices, and is allowing all stakeholders to access details on the methodology, which should allow the investor to replicate the index and the composition of the indices without any additional cost.
ESMA's position is quite logical given the importance of indexed investment and the fact that it seems difficult for a provider to claim that their indices are a reference without giving exhaustive information on that reference. From that perspective, EDHEC-Risk Institute feels that it is important that any financial index that is marketed on the basis of its track record, which itself is produced on the basis not only of live performance but also of historical simulation, be able to justify that track record both through systematic ground rules that leave no room for ambiguity or discretionary decisions and through compositions that correspond to those ground rules.
It is clear that ESMA’s desire to make the compositions of indices freely available, if it materialises through the availability of all of the historical compositions of the indices, will have significant consequences for the business model of index providers, some of whom draw a considerable share of their revenues from the sale of data.
EDHEC-Risk Institute’s technical analysis of ESMA’s guidelines is available here: