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Let’s Rewrite UCITS
By Paul Amery | 15 November, 2011

Francis Candylaftis, former chief executive of Italian fund manager Eurizon, was one of the 70 respondents to the European Securities and Markets Authority’s (ESMA’s) recent discussion paper on exchange-traded funds (ETFs) and structured UCITS. It’s time for a fundamental rethink of the legal framework regulating the sale of funds in Europe to retail investors, says Candylaftis in an interview with editor Paul Amery Please summarise your response to ESMA’s discussion paper on ETFs and structured UCITS.

Candylaftis: I think that European regulators should distinguish between the ETFs that are on sale to retail investors and those that are sold to institutions. In particular, synthetic ETFs and some structured funds are not suitable for sale to retail investors, in my opinion.

Essentially, I believe that UCITS ETFs—those that are designed for sale to the man in the street—should be brought back to using physical replication only.

I also think it’s important that the various participants involved in issuing any UCITS fund—that is the sponsor, the market maker (in an ETF) and the depositary bank—should not belong to the same financial group.  If these roles are not separated, I believe there is a lack of safeguards to protect investors’ interests.

And, assuming that we go back to physical replication only, I believe that securities lending should be prohibited. This should apply to all UCITS, not just to ETFs, even if ETFs are particularly active in lending. If regulators feel this is too drastic a step, I believe they should at least prevent fund sponsors or their agents from retaining a portion of the lending revenues, which is currently common practice.

Generally, I believe that there’s a mismatch between perception and reality when it comes to ETFs. Issuers have managed to portray them in public as transparent and simple, when as a matter of fact they are the opposite. And they are much more profitable for issuers than you might imagine, possibly even more so than actively managed funds. Why do you see the involvement of multiple counterparties within UCITS as important?

Candylaftis: It’s worth remembering that the principle of diversification underlies UCITS. So it’s basically an abuse of that principle to have a single counterparty, particularly when you’re talking about entities belonging to a single financial group both issuing the fund and also providing the swap to give the index exposure.

Under the current interpretation of UCITS, regulators focus on the mark-to-market value of swap exposures (which have to stay within a limit of 10 percent of NAV for a single counterparty), rather than the gross, notional value of such swaps. This is an oversight, in my view, and some limit should be introduced for such notional exposures, even for off-balance sheet transactions.

I’m also concerned that when a single counterparty is used by a synthetic ETF, you put the investment management function outside the ETF itself. This role is effectively delegated to the swap counterparty. But, when operated in this way, the management function is not subject to the control procedures provided for in UCITS, and which are supposed to be the responsibility of the depositary bank. The depositary plays a crucial role within UCITS. So would synthetic ETFs that use multiple counterparties be preferable?

Candylaftis: In an ideal world, I’d prefer that synthetic funds don’t have the UCITS label. If they continue to be permitted to have it, then having multiple counterparties can help reduce risks and prevent a single banking group benefiting too much from the ETF set-up at the expense of investors. For example, in some European investment banks, the head of the ETF issuer and the head of the single swap counterparty report to the same boss at the top of the bank, presenting a possible conflict of interest.

One example is the way dividend distributions are managed in tracker products. It’s hard enough for institutional investors to understand how this operates, let alone retail clients. Some ETFs may track price-only indices, in which case it can be very unclear what happens to the dividends on the underlying shares. Practices here are very opaque, and this is something I wrote about in detail in my submission to ESMA.

It also worries me when ETF sponsors are involved in the design of indices. There are many opportunities to embed costs at the expense of investors. In your submission to ESMA, you said that you find it surprising that securities lending by UCITS funds is permissible, when regulators spent a lot of time a few years ago trying to abolish soft commission payments. Why the comparison, and why do you think this is allowed?

Candylaftis: I think regulators have taken the view that there are some additional activities that are part of securities lending that deserve some remuneration, whereas in the case of soft commissions, kickbacks were being paid to institutions to persuade them to direct business to one broker rather than another.

Clearly institutions need to use brokers, but it wasn’t fair to direct business according to the level of soft commissions paid.

In the case of securities lending, you don’t have to do it, but if you do, sponsors say that this is undertaken to give some additional benefits to investors, and regulators seem to have supported this view, so far. I find this debatable.

Clearly, there are some additional risks involved if securities are lent out: it may be difficult to recall them from borrowers. Imagine that you need to get back lent stocks to meet redemption requests when markets are falling. This is just the kind of market when investors are eager to borrow stocks to go short, as well as the kind of market where counterparty risk is likely to be increasing.

But even if regulators don’t want to ban lending, I believe that they should ensure that all the benefits are passed back to investors. Let’s not forget that the fund manager is already remunerated for his work by the fund’s management fee. And I think limits should be placed on the amount of a portfolio’s stock that can be lent out. Such limits should be set by security, not as a percentage of the overall fund. Otherwise you could have a situation where the issuer closes the liquid positions to meet investor redemption requests, leaving illiquid ones for those still invested in the fund. What has been the role of fund boards in monitoring these questions—are they looking after investors’ interests adequately?

Candylaftis: In the UK a fund has a management company as a separate legal entity, entrusted with looking after investors. In continental Europe this function is typically performed at the level of the asset management company. However, there have to be independent directors in place, charged specifically with looking after investors’ interests.

However, the way those directors are selected may mean that they are not really independent. Often they may be chosen from among the friends of the investment company’s operating management. In summary, I don’t think investors’ interests are properly represented at fund level. But even in the UK, where there is a board of directors at the management company, this may be largely a formality, with certain individuals also serving on many other fund company boards.

For ETFs, there are other questions of fiduciary responsibility to consider, especially in synthetic structures.

Collectively, the shareholdings of ETFs are a significant percentage of many companies around the world. At least with physical ETFs you can check how BlackRock, for example, has voted on a particular issue. But with synthetic ETFs you don’t even know where in a particular organisation the shares are held. The voting power might be used by some counterparties—usually investment banks—for their own benefit. I’m not suggesting this happens, merely that it is possible.


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