Look beyond the rules when choosing an ETF

What makes an ETF suitable for investment? The European regulators think the Ucits rules are the answer. Adam Laird, Hargreaves Lansdown’s head of ETFs, looks at how Ucits Guidelines are changing and what this means for ETF investors.

Laird-Adam

How do you assess an exchange traded fund? This summer the European investment regulator, Esma, has been strengthening its Ucits rules to make them more specific for index-tracking investments, and particularly ETFs. 

Ucits is often seen as an essential criterion for the suitability of an ETF for individual investors. However, as the rules are tightened, criticism is increasing.

The gold standard?

The Undertakings for the Collective Investment of Transferable Securities rules (a tricky acronym even for a jargon-heavy industry) have been around as long as ETFs have been available in Europe. 

They started life as a kite-mark for distribution – a set of standards that would allow funds to meet each European Union country’s regulatory framework and therefore ease marketing across borders. 

With each revision the guidelines have become more specific to different product types.

The rules are well intentioned. A Ucits ETF has strict limits on how it invests: portfolios must be diversified and Ucits restricts how much a fund can hold in a single stock, or how much counterparty risk they can take. 

Derivatives are permitted but no more than 10 per cent of a fund can be in a single issuer. 

Transparency is key – funds are obliged to declare all important facets of their structure and charges through a prospectus and Key Investor Information Document.

Specific rules now apply to index-tracking investments. Spooked by the Libor scandal, Esma now insists that financial indices meet strict conditions – clear rules, a single objective and independent valuation. 

Obscure indices created by an investor for a single product are no longer allowed.

Helping the individual

Generally the features ingrained by Ucits are sensible and desirable for individuals, but Esma wants to equate Ucits with simplicity. 

This has brought criticism. A recent release from the IMA rebuffed this, saying “many non-Ucits funds are in fact less complex than many Ucits”. It is not hard to find examples of Ucits ETFs that would be unsuitable for individual investors.Take the newly launched Source JP Morgan Macro Hedge Dual Vega Target 4% TR Ucits ETF (MHVT). This product takes (sometimes leveraged) positions in volatility derivatives on the S&P 500 and Euro Stoxx 50 indexes. This is not an ETF for the man on the street.

Triple leverage is forbidden under Ucits but other short and leveraged products are permitted, like the ETFS FTSE 100 Super Short Strategy GO Ucits ETF (SUK2). Issuers warn that short and leveraged products may not be suitable to hold for longer than 24 hours – few can trade like this successfully.

Conversely, a non-Ucits exchange traded product is not necessarily more complex, risky or illiquid. Many exchange traded commodities are collateralised notes – a structure ineligible for Ucits. 

In my view an ETC backed by physical gold is reasonable as a small satellite holding in many portfolios. This structure is becoming more common for other areas too.

No substitute for hard work

Ucits has been ubiquitous for as long as ETFs have been available in the UK; indeed, the London Stock Exchange has only just launched a segment for non-Ucits ETFs. 

But the value and relevance in these standards grows as more innovative products are launched with different structures. 

As ETFs must now wear Ucits as a badge of honour in their title, the profile of the rules will grow.

For individual portfolios the message has not changed. Investors should take some comfort that Ucits ETFs meet certain quality standards but there are other important questions to consider when assessing a product: its index, its charges, its liquidity and its structure are all vital. 

No European regulation can replace a solid analysis of an investment.

Disclosure: The author holds no positions in any investment mentioned in this article

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