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ETF guidelines will see investors reclaim securities lending profits

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EUROPE - The guidelines released by the European Securities and Markets Authority (ESMA) last week will help exchange-traded fund (ETF) providers who have chosen physical replication to adapt their business model and will lead to greater transparency among funds, according to the EDHEC-Risk Institute.

In a statement, the institute said it welcomed the guidelines, which also touched on issues relating to UCITS, released on 25 July by ESMA, which indicated that all profits from securities lending should be returned to the fund.

According to EDHEC, the rule set by ESMA will change the business model of ETF providers who have chosen physical replication because securities lending represented considerable sources of revenue for the asset management firms.

"These revenues did not correspond to disproportionate profits but allowed ETFs to show lower management fees," the institute said. "As a result of receiving all of the lending profits, the ETF can now expect its management fees to increase."

EDHEC nonetheless recognised that the arrangement will have the "merit of clarifying" the real costs of replication and the profits associated with the risk taken in the area of securities lending.

The institute went on to say that the new rules on securities lending by UCITS would have a "strong impact" on the volumes handled on the securities lending market.

"This market is an important factor in ensuring a good level of liquidity and improving the efficiency of equity markets," it said. "It would therefore be important for an impact study to be produced in order to reinforce ESMA's decision."

Additionally, EDHEC welcomed the decision taken by ESMA towards more transparency in the domain of financial indices, which, until now, "was characterised, under the pretext of protecting intellectual property, by the low level of information given to investors on index methodologies and compositions".

"ESMA, through these recommendations, is putting a logical end to these practices, and is allowing all stakeholders to access details on the methodology, which should allow the investor to replicate the index and the composition of the indices without any additional cost," EDHEC added.

According to the institute, any financial index that is marketed on the basis of its track record - which itself is produced on the basis not only of live performance but also of historical simulation - should be able to justify that track record both through systematic ground rules that leave no room for ambiguity or discretionary decisions and through compositions that correspond to those ground rules.

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