Ireland: ESMA Guidelines On ETFs And Other UCITS Issues

On 30 January, 2012 the European and Securities Markets Authority (ESMA) published a consultation paper on future guidelines for certain types of Undertakings for Collective Investment in Transferable Securities (UCITS), including UCITS Exchange-Traded Funds (ETFs), and other UCITS-related issues (the Consultation Paper). The Consultation Paper was published following a review by ESMA of the current regulatory regime and it's assessment that existing requirements were not sufficient to take into account the specific risks associated with such funds.

Following review of over sixty responses to the Consultation Paper from stakeholders including the Irish Funds Industry Association, ESMA published its Guidelines on ETFs and Other UCITS Issues (the Guidelines) on 25 July 2012. The Guidelines can be found here. The aim of the Guidelines is to strengthen investor protection and increase harmonisation in regulatory practices, with the concept of improved disclosure to investors running consistently throughout the Guidelines.

The Guidelines cover the following matters, each of which are summarised below:

• Index-Tracking UCITS
• UCITS ETFs
• Efficient Portfolio Management Techniques
• Management of Collateral for OTC Financial Derivative Transactions and EPM Techniques
• Total Return Swaps and Similar Financial Derivative Instruments
• Financial Indices

Application Date

The Guidelines apply from two months after the date of official publication of the Guidelines on the ESMA website (the Application Date). The Central Bank of Ireland (the Central Bank) has outlined it expects the official publication on the ESMA website at some stage in October, 2012.

All new UCITS created after the Application Date should comply with the Guidelines immediately.

Existing UCITS benefit from transitional provisions giving them in certain circumstances up to 12 additional months from the Application Date to comply. Any grandfathering provisions relating to existing UCITS which apply in specific cases are outlined in the applicable section below. Amendments required to the fund rules/instrument of incorporation, prospectus, key investor information document (KIID) and marketing communications that issued prior to the Guidelines do not come into effect until the earlier of (i) the first occasion after the Application Date on which the relevant document (having been revised or replaced for another purpose) is published, or (ii) 12 months after the Application Date. Requirements to publish information in the annual report do not apply in respect of any accounting period that has ended before the Application Date.

Index-Tracking UCITS

The Guidelines define an Index-Tracking UCITS as "a UCITS the strategy of which is to replicate or track the performances of an index or indices e.g. through synthetic or physical replication." In keeping with ESMA's enhanced disclosure focus, the Guidelines outline specific information which must be included in the prospectus, KIID, annual and semi-annual reports for such Index-Tracking UCITS.

A prospectus for an Index-Tracking UCITS will now need to include the following information:

(a) a clear description of the indices including information on their underlying components. To avoid the need to update the prospectus regularly, it is possible to include disclosure in the prospectus which directs investors to a website where the exact components of the indices are published;

(b) information on how the index will be tracked and the implications of the chosen method for investors in terms of their exposure to the underlying index and counterparty risk;

(c) information on the anticipated level of tracking error in normal market conditions;

(d) a description of factors that are likely to affect the ability of index-tracking UCITS to track the performance of the indices, including transaction costs, small illiquid components and dividend re-investment.

The KIID of the Index-Tracking UCITS should include the information provided in (b) above in summary form.

An Index-Tracking UCITS must include the size of the tracking error at the end of the period under review in its annual and semi-annual accounts. The annual report must also include an explanation of (i) any divergence between the anticipated and realised tracking error for the relevant period and (ii) the annual tracking difference between the performance of the UCITS and the performance of the index it is tracking.

Disclosure requirements for Index-Tracking leveraged UCITS are also outlined. The Guidelines define an Index-tracking leveraged UCITS as "a UCITS the strategy of which is to have a leveraged exposure to an index or exposure to a leveraged index." Where the Index- Tracking UCITS is leveraged, ESMA has confirmed it must comply with the limits and rules on global exposure outlined in Directive 2009/65/EC (the UCITS Directive). Global exposure should be calculated using either the commitment approach or relative Value at Risk approach in accordance with the Committee of European Securities Regulators (CESR) Guidelines on Risk Management and the Calculation of Global Exposure and Counterparty Risk for UCITS.

The global exposure limitation also applies to UCITS replicating leveraged indices.

The Guidelines state the following must be included in the prospectus and summarised in the KIID of the Index-Tracking leveraged UCITS:

(i) a description of the leverage policy, how this is achieved (i.e. at the level of the index or arising from instruments used to obtain exposure to the index), the cost of the leverage and the risks associated with the policy;

(ii) a description of the impact of any reverse leverage (i.e. short exposure);

(iii) a description of how the performance of the UCITS may differ significantly from the multiple of the index performance over the medium to long term.

UCITS ETFs

The Guidelines define a UCITS ETF as "a UCITS at least one unit or share class of which is traded throughout the day on at least one regulated market or Multilateral Trading Facility with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from its net asset value and where applicable its Indicative Net Asset Value."

A UCITS ETF will now need to use the identifier "UCITS ETF" in its name, fund rules/instrument of incorporation, prospectus, KIID and marketing communications. Where the UCITS ETF is passported across EU jurisdictions, the identifier "UCITS ETF" should be used in all EU languages. It is important to note that the Guidelines confirm that a UCITS which is not a UCITS ETF may not use the identifier "UCITS ETF", "ETF" or "exchange traded fund".

In terms of the disclosure requirements for UCITS ETFs pursuant to the Guidelines, the prospectus, KIID and marketing communications should clearly disclose the policy regarding portfolio transparency, where portfolio information may be obtained and details on where the indicative net asset value (iNAV), if applicable, is published. The prospectus must also disclose how the iNAV is calculated, if applicable, and the frequency of calculation.

For actively-managed UCITS ETFs, which the Guidelines define as "a UCITS ETF, the manager of which has discretion over the composition of its portfolio, subject to the stated investment objectives and policies (as opposed to a UCITS ETF which tracks an index and does not have such discretion). An actively-managed UCITS ETF generally tries to outperform an index ", the prospectus, KIID and marketing communications should clearly disclose this fact. Such documents should also disclose how the actively-managed UCITS ETF will meet the stated investment policy including, if applicable, its intention to outperform the index.

The Guidelines also deal with the treatment of secondary market investors of UCITS ETFs. In circumstances where the shares of the UCITS ETF are purchased on the secondary market but are generally not redeemable directly from the UCITS ETF, the prospectus and marketing communications of the UCITS ETF need to include the following warning:

"UCITS ETF's units / shares purchased on the secondary market cannot usually be sold directly back to UCITS ETF. Investors must buy and sell units / shares on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units / shares and may receive less than the current net asset value when selling them."

In addition, UCITS ETFs must also now allow secondary market investors to redeem shares directly from the UCITS ETF in circumstances where the stock exchange value of the shares significantly varies from its net asset value. In such situations the UCITS ETF is obliged to issue a communication to the regulated market indicating that the UCITS ETF is open for direct redemptions. The prospectus of the UCITS ETF must also clearly disclose the process to be followed in such circumstances together with indicative costs (which should not be excessive).

Transitional Provisions: Existing UCITS ETFs must comply with the Guidelines relating to identifiers on the earlier of (i) the first occasion after the Application Date on which the name of the fund is changed for another reason, or (ii) 12 months after the Application Date.

Note: Existing UCITS ETFs should comply with the provisions relating to the treatment of secondary market investors from the Application Date.

Efficient Portfolio Management Techniques

Pursuant to the UCITS Directive and the Eligible Assets Directive, UCITS are authorised to employ techniques and instruments relating to transferable securities and money market instruments under the conditions laid down by the applicable EU Member State provided that such techniques and instruments are used for efficient portfolio management (EPM) purposes. EPM techniques typically include repurchase and reverse repurchase agreements and securities lending. CESR has previously outlined in its "Guidelines for Eligible Assets in UCITS" that EPM techniques should not "result in a change of the fund's declared investment objective or add substantial supplementary risks in comparison to the concerned fund's general risk policy as described in the applicable sales document."

The Guidelines re-iterate CESR's above-mentioned requirement and introduce additional disclosure and operational requirements on UCITS which utilise these techniques. It is also important to note that the Guidelines state the use of EPM techniques should be in line with the best interests of the UCITS.

The additional disclosure requirements are as follows:

(i) The prospectus should inform investors of the intention to use EPM techniques including a detailed description of the risks involved (i.e. counterparty risk and conflict of interest risk) and the impact they will have on the UCITS performance.

(ii) The prospectus should also disclose the policy regarding direct and indirect operational costs/fees arising from EPM techniques that may be deducted from the revenue delivered to the UCITS. The costs/fees should not include hidden revenue and the identity of entities to which such fees are paid should be disclosed (also indicating if such entities are related to the UCITS management company or depositary).

(iii) The Risk Management Process document of the UCITS must adequately capture the risks arising from EPM techniques.

(iv) The annual report of the UCITS should also now include:

(a) the exposure obtained through EPM techniques;

(b) the identity of the counterparties to the EPM techniques;

(c) the type and amount of collateral received by the UCITS to reduce counterparty exposure;

(d) the revenues arising from EPM techniques for the entire reporting period together with direct and indirect operational costs and fees.

The operational requirements are as follows:

(i) All revenues arising from the EPM techniques, net of direct and indirect operational costs, should be returned to the UCITS.

(ii) The UCITS must ensure that it is able at any time to recall any security that has been lent out or terminate any securities lending agreement into which it has entered.

(iii) Certain of the stakeholder responses to the Consultation Paper outlined this requirement was against market practice and prevents a UCITS from entering into fixed term securities lending or repurchase agreements.

(iv) UCITS entering EPM transactions should take into account these operations when developing their liquidity risk management process in order to ensure they are able to comply at any time with their redemption obligations.

Transitional Provisions: Existing UCITS with revenue sharing arrangements relating to EPM must comply with the new disclosure rules within 12 months of the Application Date of the Guidelines.

Management of Collateral for OTC Financial Derivative Transactions and EPM Techniques

The UCITS Directive outlines that risk exposure to a counterparty of the UCITS in an Overthe- Counter (OTC) derivative transaction shall not exceed either (a) 10% of its assets when the counterparty is a credit institution as defined in the UCITS Directive, or (b) 5% of its assets in other cases. The Guidelines confirm that the risk exposures to a counterparty arising from OTC derivative transactions and EPM techniques should be combined when calculating the counterparty risk limits.

Collateral may be used by UCITS to reduce counterparty risk exposure provided the collateral complies with certain criteria. CESR's Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS outlines the criteria currently applicable for acceptable collateral. The Guidelines amend the criteria. The revised criteria are:

(a) Liquidity - any collateral received other than cash should be highly liquid and traded on a regulated market or multilateral trading facility with transparent pricing in order that it can be sold quickly at a price that is close to pre-sale valuation. Collateral received should also comply with the applicable provisions of the UCITS Directive.

(b) Valuation - collateral received should be valued on at least a daily basis and assets that exhibit high price volatility should not be accepted as collateral unless suitably conservative haircuts are in place.

(c) Issuer credit quality - collateral received should be of high quality.

(d) Correlation - the collateral received by the UCITS should be issued by an entity that is independent from the counterparty and is expected not to display a high correlation with the performance of the counterparty.

(e) Collateral diversification (asset concentration) - collateral should be sufficiently diversified in terms of country, markets and issuers. The criterion of sufficient diversification with respect to issuer concentration is considered to be respected if the UCITS receives from a counterparty of EPM and over-the-counter financial derivative transactions a basket of collateral with a maximum exposure to a given issuer of 20% of its net asset value. When UCITS are exposed to different counterparties, the different baskets of collateral should be aggregated to calculate the 20% limit of exposure to a single issuer.

(f) Risks linked to the management of collateral, such as operational and legal risks, should be identified, managed and mitigated by the risk management process.

(g) Where there is a title transfer, the collateral received should be held by the depositary of the UCITS. For other types of collateral arrangement, the collateral can be held by a third party custodian which is subject to prudential supervision, and which is unrelated to the provider of the collateral.

(h) Collateral received should be capable of being fully enforced by the UCITS at any time without reference to or approval from the counterparty.

(i) Non-cash collateral received should not be sold, re-invested or pledged15.

(j) Cash collateral received should only be:

All assets received by a UCITS in the context of EPM techniques will be considered as collateral and should comply with the criteria outlined above. In addition, re-invested cash collateral needs to be diversified in accordance with the diversification requirements applicable to non-cash collateral.

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