Exchange-traded funds (ETFs) are fast becoming the investment of choice and, while European ETF assets under management fell by 9.6% in US dollarterms during January and February 2009, the fall was less than the 20.7% drop experienced in the Morgan Stanley Capital Investment (MSCI) Europe Index during the same period.1
What is an ETF?
An ETF is an investment vehicle whose shares are actively traded on a stock exchange. ETFs generally deliver exposure to a particular sector or geographic region through tracking or replicating the performance of an index and are identifiable more by reference to their characteristics than falling within a neat legal definition.The essence of an ETF is the manner in which shares are acquired, the liquidity and ease of trading, the transparency of the ETF’s portfolio and the variety of uses to which an ETF can be put as part of an investment portfolio. This, together with the fact that ETFs generally offer a fixed, low-cost total expense ratio (TER), makes them an attractive investment option.
Dealing process
Shares of an ETF can be acquired and sold in one of two ways: firstly through subscription to (otherwise known as ‘creation’), and redemption of, a large number of shares directly from the ETF. These shares are known as a ‘creation unit’. Alternatively, shares of an ETF can be acquired or disposed of through trading on a stock exchange, ie through secondary market trading. The creation of shares is usually limited to large institutional investors known as authorised participants (APs), who meet the criteria for creations set out in the ETF’s prospectus. APs are usually members of stock exchanges and can thereby provide a secondary market in shares of the ETF. Shares representing a creation will be transferred to a clearing system for trading on a stock exchange at a bid-offer spread. The spread will be dependent upon whether the ETF shares are trading at a premium or a discount on the relevant stock exchange. Currently, the vast majority of ETFs operate an in specie creation model whereby the AP delivers a ‘basket’ of specific securities to the ETF, in return for which the ETF issues shares. Alternatively, where an ETF holds index components but operates on a cash-creation basis, the ETF will itself acquire index components. Associated with these creations are costs associated with re-registration of securities for the account of the ETF, stamp duties, and other taxes and charges relating to the transfer of the securities. In the case of in specie creations certain of these costs are usually borne by the AP who delivers the securities. However, where costs are borne by the ETF these are in addition to the TER and ultimately result in a tracking error (a mismatch between the performance of the ETF’s portfolio and that of the index).
Since the introduction of the UCITS III Directive, UCITS have seen a vast expansion in their ability to use derivatives for investment purposes. In the ETF space this has resulted in the establishment of a large number of swap-based ETFs. These ETFs generally operate on the basis of a cash creation and, rather than physically holding index components, the ETF will write a series of swaps to obtain the index performance. A swap-based model delivers efficiencies because the ETF does not hold the physical underlying and so does not suffer related costs. This type of ETF, however, will carry brokerage and costs associated with writing a swap and, as they are in addition to the TER, these costs will also result in a tracking error.
Ease of trading
Shares of ETFs are listed and traded on stock exchanges. Unlike the shares of a non-ETF mutual fund where listing on a stock exchange often provides little more than an additional regulatory wrapper, shares of an ETF can be purchased and sold on stock exchanges on an intra-day basis in the same way that ordinary stock is. This active trading provides genuine liquidity in the shares of the ETF that, when coupled with real-time pricing, is an attractive option for investors who would, in respect of trades placed with a non-ETF mutual fund, usually be limited to daily trading at a net asset value determined on an historic basis.
Transparency
One of the key features of an ETF is the transparency provided both in respect of portfolio holdings, pricings of the portfolio and fees charged to investors. This transparency affects three distinct areas:
1) Portfolio transparency
ETFs generally publish a daily portfolio composition file (PCF). The function of a PCF is to set out the type and weightings of securities that the ETF will accept from an AP in respect of a creation or redemption. PCFs are also published by and are relevant to ETFs that accept solely cash subscriptions, eg swap-based ETFs. These PCFs also contain the index constituents and weightings as this information is essential for swap counterparties and market makers to enable them to accurately price the swaps written with the ETF. Because an ETF tracks the performance of an index, the securities in the PCF will be representative of the securities contained in the index. Investors gain a clear picture from a review of the PCF, of the stocks to which they are gaining an exposure and this enables them to avoid overweighting their own portfolios with the same exposures.
2) Pricing transparency
One of the additional benefits of ETFs is the transparency provided through publication of indicative net asset values (iNAVs). An iNAV is an indication of the price at which shares of an ETF can be purchased on the secondary market and, where published, is constantly updated throughout the day to reflect the extent of trading in the ETF shares. An iNAV is not an indication of the price at which ETF shares can be created or redeemed but it does provide a good indication to secondary market traders of the value of the ETF’s portfolio.
3) Fee transparency
ETFs generally charge a fixed, ‘all in’ management fee that equates to the ETF’s TER, often an amount in the region of 0.25–0.75% of the ETF’s net asset value. In comparison to non-ETF mutual funds, this is an extremely low-cost base. The TER will generally be paid to the ETF’s manager with fees and expenses of the ETF (such as administration, custody and marketing fees and expenses) being paid by the manager. This provides investors with a clear indication of the fees that will affect the value of the ETF’s shares as accrued in its net asset value.
Uses for ETFs
As investors can obtain sectoral or geographical exposure through the acquisition of an ETF, ETFs are very often used as a key tool for investors. Amongst their uses are portfolio construction, cash equitisation and risk management. In terms of portfolio construction, for example, as ETFs seek to deliver an investment return corresponding to the composition of an index, an ETF investor can gain a diversified sectoral exposure without being required to purchase underlying securities. Furthermore, while investors such as mutual funds might prefer to be fully invested, they require sufficient cash reserves to fund redemption requests from underlying investors and to maintain flexibility in terms of investment decisions. Holding large cash reserves will result in a drag on performance, however, and so, through investment in a highly liquid instrument such as an ETF, the mutual fund can gain market exposure while holding assets that are easily converted to cash. ETFs are also a useful tool when used for risk management purposes and are often acquired for shorting or hedging purposes.
Establishing an ETF as a UCITS
UCITS are the most prominent structure for ETFs in Europe and establishment pursuant to the European UCITS Directive provides a solid basis for creation of a pan-European ETF platform. Through a process ofcross-registration, the UCITS Directive enables the passporting of an ETF established and authorised in one jurisdiction into another host European member state. Following registration of the ETF in the host member state, the ETF can be listed and shares can be actively traded. While the cross-registration experience can be cumbersome, the forthcomingUCITS IV Directive (due for implementation in member states by July 2011) is expected to streamline this process by introducing a simplified notification process to the host jurisdiction regulator.
Establishing a UCITS ETF in Ireland
The authorisation process for ETFs with the Irish Financial Services Regulatory Authority (IFSRA) is very well developed, with the IFSRA having been one of the first in Europe to authorise ETFs as UCITS. In terms of choice of structure, there are several options available when establishing a UCITS ETF in Ireland and, while the predominant structure for Irish domiciled ETFs is the limited liability public company, it is also possible to establish ETFs as unit trusts or common contractual funds. In establishing a UCITS ETF, there are certain specific items to be considered as part of the product structuring process. The primary questions asked by ETF promoters relate to the extent of permissible concentration in an ETF’s portfolio, the types of indices that are acceptable and the tools that can be used by the ETF in managing its portfolio. In addition, promoters should consider the likely investor base and, where shares are to be marketed to other UCITS, the ETF should have appropriate investment concentration limits (ie the ETF itslef should not be permitted to invest more than 10% in other mutual funds).
Portfolio concentration
Generally speaking, UCITS are subject to the same investment concentration limits, irrespective of whether they are established as ETFs or not, in that they must respect the ‘5/10/40 rule’. As they track the performance of indices, however, ETFs can benefit the additional flexibility afforded by the ‘20/35 rule’.
5/10/40 rule
The 5/10/40 rule provides that a UCITS may invest no more than 10% of its net assets in transferable securities or money market instruments issued by the same body, provided that the total value of such securities or instruments held in issuing bodies in each of which the UCITS invests more than 5% is less than 40% of its net assets. ETFs that utilise these concentration limits are known as ‘index tracking’ funds.
20/35 rule
The 20/35 rule provides that a UCITS may invest up to 20% of its net assets in transferable securities or money market instruments issued by the same body and that this limit can be raised to 35% in respect of a single issuer where this is justified by exceptional market conditions. ETFs that utilise these concentration limits are known as ‘index replicating’ funds.As ETFs will either track or replicate the performance of an index, the underlying indices must comply with the foregoing concentration limits. However, there are certain limited circumstances in which these limits can be exceeded at index level.
Acceptable indices
To constitute an acceptable index for a UCITS ETF, the index must be a ‘financial index’. This is a term coined by the Commission of European Securities Regulators (CESR) in its advice to the European Commission of January 2006, and means that an index must be sufficiently diversified, represent an adequate benchmark for the market to which it refers and be published in an appropriate manner. In implementing the 2006 CESR advice, the IFSRA’s guidance note 2/07 on financial indices has set out the following factors relevant for consideration in determining whether an index constitutes a financial index:
1) Sufficient diversification
An index is sufficiently diversified if its constituents respect the weightings of either the 5/10/40 rule or the 20/35 rule. As noted above, a more concentrated index may be acceptable in circumstances where the constituents of the index are combined with the portfolio holdings of the ETF so that at least the 20/35 rule is met. These concentration limits are designed to ensure that a single index constituent cannot unduly influence the index performance (and thereby the performance of the ETF tracking that index). Where indices have an exposure meeting the 20/35 rule on concentrations, a short application process must be undertaken to obtain the IFSRA’s approval for the index.
2) Representing an adequate benchmark for the market to which it refers
An index will represent an adequate benchmark where it measures the performance of a representative group of assets. The index methodology must be clear in its description of the index constituent selection process, how frequently rebalancing occurs, the process by which the index’s calculation methodology is verified and the extent of fees embedded in the index.
3) Publication in an appropriate manner
This is a requirement that the index methodology, constituents, weightings, rebalancings and calculation methodology are publicly available and accessible by investors, save where there is a concern in relation to commercial sensitivity.
4) Independent management
This provision seeks to ensure the index is calculated in an independent manner. This does not prohibit creation of an index by an entity related to the ETF but there is a requirement for effective controls to beput in place to ensure appropriate management of any conflicts of interest.In general, index constituents must be UCITS-compliant ‘eligible assets’. The categorisation of what constitutes an ‘eligible asset’ is set out in the 2007 European Eligible Assets Directive and in essence provides that they consist of:
- transferable securities and money market instruments;
- structured products with embedded derivatives;
- funds, both UCITS, non-UCITS and closed-ended;
- deposits;
- derivatives;
- financial indices.
This means that a UCITS cannot invest directly in non-eligible assets such as hedge funds or commodities.As a result, a UCITS ETF cannot directly hold the constituents of an index that is comprised of non-eligible assets. However, this does not prevent an ETF from gaining exposure to non-eligible assets. Therefore, where an index is capable of categorisation as a financial index, an ETF can gain exposure to it through the use of derivatives on the index.
While indices used by ETFs have traditionally been ‘long only’, in that they track or replicate a basket of long securities, in recent times there has been an international proliferation of ETFs delivering short or leveraged returns, the first of which were launched in 2006. Where an ETF proposes to deliver short or leveraged returns by tracking or replicating a short or leveraged index, this index must also be capable of being constituted as a financial index. As with indices delivering 20/35 exposure, short and leveraged indices will also undergo a short application process with the IFSRA to obtain pre-approval. The first suite of these indices has recently been approved by the IFSRA.
Portfolio management techniques
The scope of portfolio management techniques available to an ETF was originally determined by reference to whether an ETF was established as an index-tracking ETF or an index-replicating ETF, the two concepts being quite distinct. Tracking an index did not require an ETF to exactly reproduce the exact constituents of an index but enabled an ETF to utilise sampling and other optimisation techniques and to acquire stocks not in the index for the purposes of delivering the index performance. In contrast, replicating an index required either direct or indirect investment in index constituents in exactly the same weightings as the index.
The 2006 CESR advice took a rather pragmatic view of the purposes of an index replicating ETF and, rather than focusing on portfolio construction, instead concentrated on investor expectations when investing in an ETF. CESR noted that the investor would seek to achieve a performance that was:
‘As close as possible to the performance of the index, through an exposure to the risk-return profile of the index.’
This, coupled with an acknowledgement of the possibility of indirect replication of an index and the use of derivatives to increase the quality of replication, now enables ETFs to replicate the performance of an index using UCITS-compliant techniques such as investments in other mutual funds, securities and derivatives.The focus on delivering a return equivalent to the index performance rather than tracking or replicating the composition of underlying indices is presumably one of the drivers behind the suites of swap-based ETFs that have been established in Ireland and elsewhere in Europe to date. At a high level, swap-based ETFs are quite flexible in terms of the nature of their investments and, rather than holding physical index components, will often seek to deliver the performance of an index by writing swaps. Whether tracking or replicating an index, these ETFs may also acquire baskets of securities that are entirely unrelated to the index being tracked (or replicated) and swap the performance of these securities in return for the index performance.
Where ETFs hold excess uninvested cash they can also benefit from a variety of cash management techniques to assist in delivering performance to investors. These techniques are principally aimed at covering the costs and expenses incurred by an ETF from both a portfolio management perspective (covering transaction-related charges) and from a pure management perspective (covering expenses associated with the TER) and are not designed to deliver an enhanced return (that would result in tracking error). These techniques can involve the use of pooling, investment in money market funds and money market instruments, the use of repurchase and reverse repurchase agreements, and the use of derivatives.
Conclusion
There has been a recent proliferation of ETFs both in Dublin and in Europe that has seen not only the expansion of existing ranges of ETFs but also the entry of new players and strategies into the ETF market. This has resulted in the traditional strategies and exposures pursued by ETF promoters being abandoned in favour of strategic market positioning and concentration on the niche index and the ‘alternative’ space of short and leveraged products. Establishment of ETFs in Ireland also brings with it the ability to begin trading almost immediately through a relatively straightforward simultaneous admission to the ETF platform of the Irish Stock Exchange. The regulatory understanding of the ETF product and the flexibility available from the IFSRA in terms of ETF product structuring is one reason why Ireland has for many years been a jurisdiction of choice for the largest European ETF promoters, and why it continues to be among the most popular for new market entrants.
By Catharine Dwyer, associate, William Fry. E-mail: catharine.dwyer@williamfry.
Notes
1) Source: Barclays Global Investors ETF Landscape Industry Review, March 2009.