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Indexical Question: How Much Transparency is Enough?

transparencyThe International Organization of Securities Commissions issued a document last month on the principles that apply to the regulation of ETFs.

This has been in the works for a long time. In the period 2008-09, the IOSCO Committee on Investment Management did the preliminary work; it sent questionnaires to member jurisdictions and held hearings so that it could get testimony from industry representatives.

As its work on ETFs progressed, in 2010 the Committee on Investment Management sought the assistance of what was then known as the IOSCO Technical Committee, now the IOSCO Board, for a policy initiative.

Seeing Through the Index

An ETF is a collective investment scheme that trades throughout the day like a stock, but that seeks to replicate the performance of a target index. Much of the question of how ETFs ought to be regulated turns on the specifics (and the transparency) of those targeted indexes.

In an initial consultation report in January of this year, the IOSCO Board took an aggressive position on transparency, saying that transparency should be such that market participants, regulatory authorities, and others have “the ability to replicate a published Benchmark level to assess its plausibility and detect inaccuracies and potential manipulation.”

The new final statement doesn’t have that language.

EDHEC Risk has replied to IOSCO with a press release citing its own research. EDHEC says that IOSCO’s principles are more-or-less consistent with the conclusions of its own related papers, but that on certain points (especially index transparency) the IOSCO is being too timid.

The ETF Industry

What everybody agrees on is the ETF industry itself. It is large: at the end of January 2013 the AUM under ETF structures amounted to $1.9 trillion, or 7% of the global mutual fund market. It is growing, consolidating, and it is coming to be dominated by a few large players.

Also, perhaps more surprisingly, its nature is changing. For a long time the largest ETFs have been those based on broad market cap-weighted indexes. But in the last 3 to 4 years there has been a turn toward alternative weightings: equal weighting, sector weighting, risk weighting and so forth.

Further, it is becoming more transparent over time, largely in response to pressure from regulators.

Principles and Silences

The principles that IOSCO proposes include these:

  • Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other [exchange traded products].

EDHEC has no quarrel with this. After all, true ETFs are collective investment schemes, and are subject to CIS regulation. This may not be true of other ETPs.

Another principle:

  • Regulators should consider the disclosure of fees and expenses for investing in ETFs on a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a certain level of costs.

EDHEC-Risk says it finds “merit in this suggestion.”

But its problem is with the dog that didn’t bark in the night. It charges that IOSCO has side-stepped the issue of index transparency.  It is no longer saying that published information should allow the public to replicate a benchmark. It is simply saying that the published information “should provide sufficient detail to allow stakeholders to understand how the Benchmark is derived and to assess its representativeness, its relevance to particular Stakeholders, and its appropriateness as a reference for financial instruments.”

This, complains EDHEC, is “subject to interpretation.”