A small, but significant section of ESMA’s new ETF consultation paper covers so-called strategy indices.
Strategy indices are widely used in Europe’s regulated UCITS fund sector and are becoming increasingly important. Whether the UCITS is an ETF or not, and whether it’s an active fund or an index tracker, strategy indices offer essentially the only way for a UCITS to gain exposure to asset classes outside equities and bonds. Outside the funds market, such indices are also widely used in bank-issued structured products.
ESMA’s definition of a strategy index is broad: “An index which aims at replicating a quantitative strategy or a trading strategy.” Strategy indices are at the forefront of the growing trend towards so-called risk premia investing, where investors seek to isolate specific risk factors via a systematic investment approach. Examples of this are equity strategies focused on growth, value, momentum and volatility, as well as FX and commodity carry strategies.
The UCITS rules specify three key requirements for a financial index (an index judged suitable to underlie a fund’s investment strategy): its composition must be sufficiently diversified; the index must represent an adequate benchmark for the market to which it refers; and it must be published in an appropriate manner.
Below, we look in detail at how the latest guidelines from ESMA may modify these “ground rules”.
Diversification
For an index-tracking fund, the diversification rules set by UCITS specify a maximum 20 percent weighting in securities issued by the same body. This limit may be raised to 35 percent for a single issuer, as long as that entity can be shown to be dominant in the market.
Where an index is composed of ineligible assets (for example, commodity derivatives) it must be diversified in an equivalent way. For a commodity index this would imply a maximum weighting of 20 percent for each raw material, but the limit may be raised to 35 percent for oil-based derivatives, due to their dominance of the commodity futures market.
ESMA is currently proposing two new guidelines on diversification. First, if the index uses leverage or any other adjustments to the underlying investment exposure, the diversification limits must be respected post-adjustment. Second, in the case of commodity indices, the diversification rules should be applied to each commodity rather than to each derivative contract (so the weighting for oil in a commodities index should consider both contracts for WTI and Brent crude, for example).
Adequate Benchmark
Based on the guidelines issued on eligible assets for UCITS by CESR, ESMA’s forerunner, as well as the approval by national regulators of hedge fund indices for use as financial indices, the existing criteria for an adequate benchmark boil down to three key points.
First, the index must measure the performance of the underlying market or group of index components in a relevant and appropriate way. Second, the index must be rebalanced periodically based on a set of objective rules that are publicly available. And, third, the underlying index components must be sufficiently liquid.
In its consultation paper, ESMA proposes to introduce a number of additional rules to ensure the adequacy of a financial index. Specifically:
- the index must have a clear, single objective;
- the universe of index components and the basis on which these components are selected must be clear. The guidelines also clarify that the selection and rebalancing methodology must be based on a set of predetermined rules;
- in the view of ESMA, daily or intra-day rebalancing of an index prevents investors from replicating the index and indices rebalancing this frequently would not be allowed;
- the index methodology must not permit retrospective changes to previously published index values; and
- the provider may not accept payment for the inclusion of index components.
Of these rules, the requirement for a single clear objective is probably the most significant. As an index’s rules cannot anticipate all possible changes of market circumstances, a clearly stated index objective provides the basis for consistency in approach.
It is interesting that the guidelines also call on the manager of the UCITS to carry out and document due diligence on the quality of the index, including on whether the methodology adequately explains the investment strategy and whether the index represents an adequate benchmark.
However, at first glance, the proposal to exclude those indices that rebalance daily seems inconsistent with the existing rules on leveraged funds, which typically reset their exposure at this frequency. According to ESMA’s summary of the feedback received from industry insiders to its earlier discussion paper, opinions were mixed on this point. Some viewed daily rebalancing as symptomatic of discretionary management, whereas others pointed out that the rebalancing policy should reflect investment practice in the underlying market, which varies widely.
