Exchange Traded Funds And The UCITS Framework - November 2014

Author:Mr Brian Kelliher, Jeff Mackey and Tara O'Callaghan
Profession:Dillon Eustace
 
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Introduction

An exchange traded fund ("ETF") is a form of collective investment scheme which is structured to facilitate the trading of its shares on an exchange throughout the day in a similar manner to the way in which an equity security may be traded on an exchange. This feature distinguishes it from traditional collective investment schemes which only provide for direct subscriptions and redemptions of their shares.

European ETFs are established as Undertakings for collective investment in transferable securities ("UCITS") which benefit from the strong global UCITS brand and the efficient passport regime which allows UCITS to be sold on a retail basis throughout the EU. Although non-UCITS EU funds ("AIFs") may also avail of an EU passport regime under the AIFM Directive where such AIFs are marketed to professional investors, the establishment of such AIFs as ETFs is not currently practical given operational issues involved in ensuring investors are limited to professional investors. EU AIFs marketed to retail investors cannot avail of the EU passport under the AIFM Directive but it is hoped that this may change in the future. To date, ETFs have generally been structured as passively managed index tracking funds (passive ETFs). Such passive ETFs seek to provide their investors with a return closely aligned to the return of the relevant index which they track. This may be done through physically holding a portfolio of securities in the same weighting as that held by the relevant index. This would commonly be referred to as a physical ETF. Alternatively, an ETF may seek to track an index through the use of derivatives (such as a total return swap) or a mix of derivatives and securities. This structure is sometimes referred to as a synthetic ETF. The use of derivatives will give rise to leverage and counterparty exposure and therefore such derivatives will be required to be managed and monitored in accordance with the UCITS requirements. Please refer to our UCITS brochures for details on the regulatory requirements which apply to Irish UCITS funds.

http://www.dilloneustace.ie/download/1/A%20Guide%20to%20UCITS%20in%20Ireland.pdf

There has been dramatic growth in recent years both in terms of the size of the ETF market and the number of products available in the market. It is estimated that as of April 2014, there was approximately Euro 444 billion invested in European ETFs and that Irish domiciled ETFs accounted for 43% of these ETFs1 (making Ireland the leading European domicile for these types of funds). The breadth of ETF products available to investors has expanded considerably as the market has grown. ETFs are now based upon a wide range of equity and fixed income indices which cover a broad range of industry sectors. We also have seen the introduction of Smart Beta ETFs which although they track a passive index like other passive ETFs, they do so in ways besides the traditional market cap weighted approach. We are also now beginning to see the emergence of actively managed ETFs (i.e. a UCITS ETF where the manager has discretion over the composition of its portfolio subject to the stated objectives and policies as opposed to a passive ETF which tracks an index). However, it remains to be seen whether we will see growth in actively managed ETFs given concerns around transparency requirements which apply to ETFs, i.e. disclosure of the composition of the ETF portfolio on a daily basis to enable the Authorised Participant to value the ETF portfolio on an intra basis which in turn enables it to take steps to ensure the market price does not vary significantly from the net asset value per share price of the ETF and to hedge its intraday risk.

Trading in an ETF

Primary market

One or more market makers (referred to as "Authorised Participants") are appointed by an ETF to (i) subscribe for and redeem ETF shares directly from the ETF but usually only in large blocks called creation units and (ii) make a market in the ETF shares in the secondary market.

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