ETFs, UCITS and the Asian mutual funds market

At the end of July 2012 there were, in Asia ex Japan, 400 ETFs/ETPs having their primary listings in the region with a total of 518 overall. With respect to the primary listing ETFs this amounted to an AUM of US$69 billion offered by 88 product providers over 14 exchanges.  The compounded annual growth rate (“CAGR”) has been 31% over the last 10 years and year to date is up 21.8%.

To view this then in a global context the CAGR over the last 10 years has been 26.6% and this and the year to date growth of 12.9% reflects how well the Asia ex Japan region is performing. Globally the industry has 4,722 products and 9597 listings. These products represent assets of US$1.72 trillion from 203 providers and available across 54 exchanges.

For non local products the preferred vehicle to access the Asian markets has been UCITS funds which are funds offered in member states of the EU and through harmonisation to the requirements of the Directive allowed then to be sold throughout the EU on a passported basis.

For product promoters the relative ease with which EU member states’ funds authorised as UCITS may be passported for distribution into other EU member states has been a considerable benefit since the permitting Directive was first introduced in 1985.

In the intervening years the badge of quality, both in terms of retail investor suitability and inherent safeguards, of the UCITS brand has seen its appeal grow beyond Europe and it is now widely acceptable for registration – and in the case of ETFs listing –  in jurisdictions in Latin America and Asia and beyond.

The success of the UCITS story has extended to ETFs with Asia a key target growth market for several local and international providers.

The development of UCITS over the years has seen a move from a conservative range of permitted investments and policies to more sophisticated strategies. These so called “Newcits” have caused some concern in Asia and beyond with local Regulators increasingly scrutinising these funds that use more sophisticated strategies in their investment policy to achieve their investment objectives.

There have also been some concerns around the UCITS ETF brand which concerns may have been amplified by the vocal debate around physical and synthetic models of ETF replication and to which supra national bodies like the Financial Stability Board, the Bank of International Settlements and the International Monetary Fund contributed with systemic risk concerns allied to the investor risk concerns aired at local regulator level.

In the EU the pan European regulatory body ESMA engaged in a wide-ranging consultation on ETFs and UCITS issues culminating in a recent publication of Guidelines around ETFs, which are binding on promoters. While the replication methodology is not a requirement for inclusion in the ETF name it must use the label “UCITS ETF” to distinguish itself from the effectively unregulated exchange traded notes and exchange traded commodities and it must provide a full description of the replication method in the Key Investor Information Document (“KIID”). This approach contrasts with the more rigorous requirement of the Hong Kong SFC that synthetic ETFs must identify themselves as such and use an asterix to signify their replication style.

The KIID for all UCITS will serve as a valuable information document for investors but with regards to ETFs specifically it will in addition to the replication method require effective disclosure around securities lending activities of physically replicating funds. It will also require details of any factors that might cause the fund to deviate from its index tracking which in physical funds will require disclosure of the impact of sampling strategies and rebalances of the index while for synthetic funds would require disclosure of the swap spread  – not currently required to be disclosed. The funds will also have to publish a predicted tracking error and explain any deviations from the published predictions in the annual and semi-annual accounts.

Interesting and all as the ESMA Guidelines are the more interesting development from the perspective of the Asian Regulator may lie in the European Commission Consultation document published the day after these guidelines and seeking to address “Product Rules, Liquidity Management, Depositary, Money Market Funds, Long Term Investments”.

Opening the consultation questions with the blunt interrogation – “Do you consider there is a need to review the scope of assets and exposures that are deemed eligible for a UCITS fund?”- it is apparent  that some of the more sophisticated strategies permitted under UCITS are causing concern to European as well as Asian Regulators.

We are in an early stage of the process and many promoters will be attached to the distribution capability of their “Newcits” – though that term itself is almost a forbidden word for promoters now, such are the risk connotations – and there remains a valid argument that it is surely preferable that retail investors seeking access to more sophisticated strategies should have them within the wrapper of a well regulated structure. With this is mind it is possible we may see the reintroduction of the complex/non-complex designation for certain UCITS meaning that those which use leverage or complicated strategies may be limited in terms of their distribution to the advised investor. Certainly such a labelling might make it easier for non EU Regulators to identify to which funds seeking to access their market they should focus the most attention.

The focus on ETF regulation and reform should not detract from the fact that ETFs structured, as funds are already highly regulated vehicles with a focus on suitability and with the in-built protections that are to be expected in investments deemed suitable for retail investors. To that end debates around styles of replication, levels of disclosure and suitability of exposures should be seen in the context of raising an already high bar of excellence further. In ETF, in UCITS and in other regulated fund space it will be a well-attended and valuable debate to the end investors ultimate benefit.

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