Global regulators agree framework for exchange-traded funds rules

LONDON, June 24 Mon Jun 24, 2013 12:20pm EDT

LONDON, June 24 (Reuters) - Global securities regulators published a framework for further regulation of the $1.9 trillion Exchange Traded Funds (ETFs) market on Monday, seeking to make ETFs more consumer friendly as their index-based investment strategies grow in popularity.

The Madrid-based umbrella group International Organisation of Securities Commissions (IOSCO) wants national regulators to encourage more disclosure to help investors differentiate between the growing range of exchange-traded products and the specific risks of each ETF type.

ETFs track baskets of shares, bonds or commodities and can be traded in real time via an exchange unlike other mutual funds, which can only be traded once daily. Most ETFs offer to replicate the returns of a given index, without having to buy all its individual constituents.

ETFs attracted $243 billion in new money in 2012, compared with $161 billion a year earlier, data from independent research firm ETFGI shows, demonstrating the increasing demand for ETFs among investors looking for low-cost and liquid investments.

Among its top recommendations for regulation, IOSCO has asked watchdogs to consider imposing rules to force ETF managers to be more transparent about the counterparty risks raised by their securities lending activities.

Many funds lend out the shares they own to short-sellers like hedge funds in exchange for collateral and a fee. The extra revenue earned can improve slim profit margins for the fund manager, which can in turn keep costs low for investors.

Short-sellers make money by borrowing, and then selling, stocks they believe are poised to fall in value. If they have bet correctly, they can buy back the stock later at a lower price, return it to the lender and pocket the difference.

But critics argue that ETF investors are not reaping the full financial rewards of securities lending and are broadly unaware that they are liable to cover any losses, if the borrower defaults and fails to return the stock as agreed.

IOSCO has also encouraged improved disclosure of fees and expenses for investing in ETFs to complement enhanced transparency on securities lending.

If the ETF portfolio is modelled on an index, IOSCO has also called for standardised disclosure on the manner in which the fund will track that index, both in terms of composition and performance.

This recommendation reflects concerns of a potential conflict of interest between operators and ETF investors, particularly if index providers who compile custom-built indices for a particular ETF are affiliated with the ETF provider.

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