AIFMD regulation more suitable for some strategy ETFs, says EC official

EC asset management head proposes regulation of some strategy ETFs under the Alternative Investment Fund Managers Directive, instead of Ucits

The head of the European Commission’s (EC) asset management unit has hinted the Alternative Investment Fund Managers Directive (AIFMD) might provide an alternative framework for selling indexes that aim to replicate a hedge fund strategy, in a move that could catch a number of strategy exchange-traded funds (ETFs).

Strategy-based ETFs are currently regulated under Ucits legislation and use various criteria to identify promising stocks using proprietary methodologies created specifically for the purpose. However, strategy ETFs are increasingly coming under scrutiny. Regulators contend that conflicts of interest exist when ETF providers use indexes created to the specifications of individual market participants, and are considering rules requiring banks to publish the methodologies employed to generate the indexes.

The move to instil more transparency in financial benchmarks has gathered pace since Libor manipulation came to light last June, with a UK government-commissioned review of Libor, reports by the Bank for International Settlements and European Securities and Markets Authority (Esma) and proposals on benchmarks published by the International Organization of Securities Commissions. All focus attention on the transparency of information on which reference rates are derived, and have subsequently raised questions over the use of custom or strategy benchmarks employed by ETFs. Esma defines a strategy index as one “which aims at replicating a quantitative strategy or a trading strategy.”

Speaking last week at the Inside ETFs Europe Conference in Amsterdam, Tilman Lueder, the head of the EC’s asset management unit, suggested some strategy ETFs might, as of July 2013, be sold to institutional investors using the new passport in AIFMD, saying: “Certainly, those indices that would not comply with the new Esma rules on the composition of indices might be better placed in the alternative product sphere.” He added there was political will in the European Parliament to consider regulating some strategy ETFs under AIFMD. “If hedge funds are regulated in AIFMD, why not the index trackers that provide exposure to hedge fund performance?”

The products would then be subject to a more restrictive marketing regime. There are two methods that allow the managing and marketing of alternative investment funds (AIFs) in the European Union (EU). The first is a ‘passport’ that allows AIFs to be marketed to professional investors across the EU. The second method allows AIFs to be marketed in a specific member state in accordance with its private-placement regime.

The products would then be subject to a more restrictive marketing regime. There are two methods that allow the managing and marketing of alternative investment funds (AIFs) in the European Union (EU). The first is a ‘passport’ that allows AIFs to be marketed to professional investors across the EU. The second method allows AIFs to be marketed in a specific member state in accordance with its private-placement regime.

London-based Townsend Lansing, head of regulatory affairs at product provider ETF Securities, said: “Those types of products might be trickier to launch if you can't use the Ucits format. For me, putting exchange-traded products (ETPs) in AIFMD doesn’t make a lot of sense. How do you have an ETP that is in a fairly restrictive marketing regime? There’s tension there.”

Another ETF provider suggested regulators should adopt more of a wait-and-see approach. Michael John Lytle, chief development officer at London-based ETF provider Source, said: “To my mind Esma has already addressed the issue of the expansion of Ucits by recently firming up the index rules – in particular preventing daily rebalancing. Perhaps we are trying to crack a nut that has already been shelled? We should wait until the end of the implementation period for recent index rules and then assess if we have succeeded in addressing these definitional issues. Ucits are some of the best managed, diversified and least leveraged products available to retail investors. The clarity provided by the recent Esma review has further enhanced that reputation. ETFs, with their daily liquidity and transparency, should benefit most from any index clarifications.”

The head of design and development at an index provider, meanwhile, said he would prefer that product providers were given flexibility in deciding whether to comply under AIFMD or Ucits, “rather than being led down one particular direction, enforced by regulation”.