Your IndustrySep 26 2013

Regulatory requirements for ETFs

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In the UK, there are no rules that prohibit the distribution of exchange-traded products to retail customers.

Nevertheless, Frank Spiteri, executive director and head of retail distribution strategy for ETF Securities (UK), says retail intermediaries considering services relating to ETPs must ensure that they have the necessary FCA permissions.

ETFs are considered units of collective investment schemes so are generally considered non-complex, as are physically-backed ETCs. On the other hand, certain Ucits ETFs that track so-called ‘strategy’ indices, that is proprietary indices that involve active investment strategies, may be deemed complex.

Physically-backed exchange-traded commodities are considered to be debt securities, according to the current FCA policy. Swap-backed exchange traded commodities, exchange traded currencies and other exchange traded notes under FCA policy are also considered to be securities.

Swap-backed ETPs that are not Ucits funds are generally deemed complex and are within the scope of the RDR rules on commissions.

Similar to other investment vehicles, Morningstar’s European passive fund analyst team argues exchange-traded funds require that you do your homework and evaluate them properly, looking a five basic elements: suitability, fundamental view, index construction, product construction, and costs.

“A product that is suitable for a fast-trading hedge fund may not be appropriate for a retiree. Many ETFs can be used as either core building blocks or as tactical tools, but there are some products that have very limited suitability, such as volatility-linked products.

“Words like ‘oil,’ ‘inverse,’ and even ‘Brazil’ on an ETF’s label should not be taken at face value. It is vital to closely examine a product’s underlying benchmark to isolate the most relevant economic drivers that investors should consider when forecasting a product’s performance.”

The team states that it is important to consider issues such as weighting methodologies, rebalancing frequency, caps, and a host of other factors that will all have implications for performance, costs, and how the fund will fit within a broader portfolio.

Further, while costs are a key attraction of ETFs, expense ratios reflect just one of the many costs of ETF ownership, which also includes costs of buying, selling, and potential hidden charges or earnings.

Nick Blake, head of retail at Vanguard, warns ETFs require the same scrutiny as any other investment and that advisers need to make sure they understand how the ETF generates returns and that it fits into their client’s overall investment strategy.

“Two seemingly similar ETFs can also have very different risk profiles, especially if one is physically-backed and the other is synthetic.

“As part of your suitability report you will need to demonstrate that the ETF you recommend meets your client’s demands and needs. If you recommend, for example, a well-managed, passive ETF, it would meet the needs of a client looking to track the relevant market.”