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EDHEC RESEARCH: Lending their views

blocksIn the second ETF article, Edhec's Felix Goltz looks at investor views about regulatory guidelines on stock lending and the overall outlook for the products in Europe.

In July 2012, the European Securities and Markets Authority (Esma) published guidelines aimed at “strengthening investor protection and harmonising regulatory practices across the EU fund sector”.

One of the issues in the debate was that investors do not receive the full revenue generated through securities lending. Instead, this revenue partly accrues to the exchange-traded fund (ETF) provider.

The final Esma guidelines are focused on the disclosure of revenues, fee-sharing agreements, and operational costs.

To ascertain the views of respondents with regard to securities lending revenue, we posed two new questions in the Edhec European ETF Survey 2012, supported by Amundi ETF as part of the Core-Satellite and ETF Investment research chair at Edhec-Risk Institute.

Investors are overwhelmingly (84%) in favour of the requirement to return securities lending revenue net of costs to the ETF investor. We can see from an analysis of the responses that the level of support was quite strong. Almost 46% of respondents selected the “strongly agree” response compared with almost 39% who just agreed.

The second question, which related to transparency with regard to the costs and revenues associated with securities lending, was answered even more strongly. Here, around 90% of investors agreed with the notion. Close to 51% of those strongly agreed.

This is interesting, because it suggests that investors are more concerned about regulatory requirements concerning transparency about costs and revenues than about the receipt of net profits. This is an indication that investors are firstly concerned with regulation on transparency suggesting that transparency is expected to lead to a more efficient outcome concerning the distribution of revenues to investors. However, a large majority of investors go even further by calling for regulatory requirements concerning the distribution of net profits to investors.

It has been stipulated that providers of physically replicated ETFs have been using securities lending fees as a subsidy to allow them to charge lower ETF management fees and that the new guidelines will thus decrease their competitiveness. However, we believe that transparency on these costs and revenues will only serve to increase the level of information investors have about the true cost of following different replication strategies. Moreover, as securities lending revenue includes a compensation for counterparty risk, transparency on securities lending revenues will also allow investors to make an explicit trade-off between the risks they have had to assume and the returns they are getting.

Esma has tackled the issue of investor protection from a number of different standpoints including guidelines stipulating increased disclosure for index tracking Ucits, increased clarity with regard to use of ETF identifiers, increased disclosure for actively managed Ucits ETFs, management of collateral for over-the-counter derivative transactions and guidelines for indices tracked by ETFs.

Hence, in order to assess the perception amongst investors of the effectiveness of the Esma guidelines as a whole, we ask them if they thought the guidelines had been effective in improving investor protection, which was the stated aim of the guidelines.

The overall reception of the Esma ETF guidelines has been favourable amongst our survey participants with 77% of investors agreeing that the guidelines have achieved their stated aim of improving investor protection.

We asked survey respondents whether they invest in alternatives for ETFs, such as futures, total return swaps, and index funds and ask them to rate exchange-traded funds and their alternatives according to various criteria. First, in terms of liquidity, transparency and cost, ETFs are considered advantageous although on some criteria they are less well regarded than futures. Second, ETFs are ranked highest for the available range of indices and asset classes. Therefore, European investors and asset managers seem to be well aware of the diversity of ETFs, which has grown dramatically in recent years.

Third, futures are the most serious alternative to ETFs, but ETFs are perceived as superior with regard to minimum subscription, operational constraints and the tax and regulatory regime. Therefore, it appears that implementation concerns with futures (such as margin calls and applying exact allocations even for small-sized portfolios) give ETFs an advantage.

Fourth, the respondents believe that ETFs perform generally much better than total return swaps.

Overall, we find that ETFs and futures receive the highest scores among the four products, while total return swaps receive the lowest score that is even below two (fairly good). For individual criteria, ETFs are rated as outstanding in terms of ease of use product range, minimum subscription and operational constraints.

The results also show us that most respondents are planning to increase their investments in ETFs (67%), while only 4% of investors plan a decrease.

Similarly we can see that 28% of respondents are planning to increase their use of futures, compared with just 9% who plan to decrease their usage of this type of product.

However, the situation is more balanced for index funds which came in third place in terms of an overall quality score, with approximately the same number of investors planning an increase as there are invetors planning a decrease (26% and 24%, respectively).

For total return swaps, which came in last place in terms of an overall quality score, we can see that the outlook in terms of future usage is much more negative with only 11% of investors planning an increase in usage compared with a far greater 30% of investors planning a decrease in usage. Thus in comparison with other indexation vehicles, we can see that ETFs are the preferred vehicle in terms of future usage.

Our results suggest that the ETF market is still growing and that it has potential for further growth. We observe increased levels of usage, satisfaction and demand for product development across a variety of asset classes, especially so for ETFs on emerging market equities, ETFs on fixed income indices, as well as ETFs on new forms of indices. We also find that recent launches of ETFs tracking strategy indices or smart beta indices seem to be blurring the traditional boundaries between active and passive investment. The key requirement for most investors is that an ETF tracks a systematically constructed index rather than implementing discretionary investment decisions. However, the increasing breadth of systematic indices now includes strategies which move quite far away from traditional broad-cap-weighted market indices.

Felix Goltz is head of applied research at the Edhec-Risk Institute

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