ETF themes in governance

Governance and ETFs overview

The subject continues to create debate amongst investment fund Boards, investment managers, institutional investors and regulators alike. This is particularly true for the Exchange Traded Funds (‘ETF’ market) as they have grown in both complexity and popularity as an investment option. Alongside this, developments such as globalisation, digitisation, innovation and regulation are contributing to a changing market and are shifting risk profiles, bringing heighted attention on the area of governance.

As this landscape evolves, so too should the robustness of governance models and the Board’s approach to discharging both its fiduciary and stewardship responsibilities. We set out below the key themes in governance we expect ETF Boards to focus on in 2017.

1. New waves of regulation

The level of local and European regulatory pressure is set to remain intense. As a result, regulation should continue to remain high on Board agendas, with focus on a number of new regulatory developments:

• European Union Fourth Anti-Money Laundering Directive is the European Union’s most recent response to the threat of the financial system being used for money laundering and terrorist financing purposes. It sets out a risk based approach and detailed framework which ETFs must comply with to effectively manage their money laundering and terrorist financing risks. It is increasingly common for Boards to undertake training on AML/CTF to ensure that they are aware of the requirements and responsibilities under this regulation. ETF Boards will not be able to rely on third parties to conduct elements of customer due diligence, and will need to ensure and evidence effective on-going monitoring of investor transactions. Member states must implement the directive into domestic legislation by June 2017.
• General Data Protection Regulation (“GDPR”) is directly applicable in EU member states and is due to come into force in May 2018. It will both update and overhaul data protection law. The new regulation aims to remove red tape for businesses but also tighten privacy protections for online users. Practically speaking, this means that boards of ETF fund companies and asset managers will have to proactively plan their strategies to deal with the new requirements and obligations under the GDPR. Fines of up to 4% of global turnover (or €20 million – whichever is higher) will be imposed for breaches. Boards and Audit Committees will need to understand their new roles and the responsibilities created, in addition to compliance requirements and privacy risks. ETF Boards must ensure effective oversight of these areas is fully embedded into their governance structure. 

Aside from Boards getting to grips with specific new regulations, they will also need to ensure that they fully understand the global and local regulatory landscape, the associated risks and how they will impact the ETF market. Alongside this, managing regulatory cost and dealing with regulatory constraints are expected to be part of long journey ahead in 2017 and should be a key consideration for Boards.

2. Effectively understanding and overseeing risk

As we see the complexity of ETF products increase and different areas of the market open, the risk profile of ETFs are undoubtedly increasing. This is at a time when there is continued focus on the protection of investors. As a result, we expect to see effectively understanding and overseeing risk in the context of the ETF market a key theme for ETF Boards.

It could be argued that market risk is the biggest risk to ETFs however, there are other risks that need to be considered and given equal attention. For example, exposure to complex strategies and competition as the market expands, as well as the risk profile of the underlying securities. Outsource risk relating to service providers is another risk that often gets limited attention and one we expect to see more focus on, with many Boards not clear on the key risks associated with each of its service providers. The key to effective oversight of risk is the implementation of an effective governance framework which enables the Board to make intelligent risk decisions while protecting the interests of investment fund investors.

3. Evolving Board responsibilities

While a critical role of EFT Boards relates to its role as monitor of legal and fiduciary duties, this role is changing. Boards are not only expected to focus on their traditional fiduciary responsibilities such as monitoring performance, risk and compliance, they must also effectively provide effective stewardship through helping shape and advise on areas such as culture, innovation and cyber security.

• Culture - regulators are interested in Board oversight of culture. For an ETF Board, this will include the culture within the ETF and its service providers, particularly the investment manager, and how this culture is promoting and protecting investors’ interests.
• Innovation - ETF Boards are tasked with overseeing the operation and suitability of new and innovative ETFs. This should include shaping and supporting the development of more active ETFs products in response to investor appetite and in line with the pace of technologic change. For example, FinTech, which provides data analytics to produce product comparisons and online distribution platforms.
• Cyber security – new technology and innovation bring market opportunities. They also present new risks, such as cyber security risk, which continues to be an area of focus for regulators throughout the EU. While the applicability of some of the measures to mitigate these risks will depend on the structure and set up of the ETF, ETF Boards should ensure that they understand the cyber security risks and controls in place, both at an internal and external third party level, are effectively overseeing them.

Demonstrating execution of these responsibilities should be a key priority for Boards going forward.

4. Enhanced accountability

Board accountability features as a corporate governance trend across the broader investment arena and will continue for ETFs in 2017. Investors are reiterating the premise that Boards should be accountable to their shareholders, and are actively seeking engagement on a number of topics such as Board composition. Investor engagement is equally important for passively managed funds, which accounts the majority of ETFs, as well as actively managed funds.

We are also seeing legislation and regulation being used as a tool to enhance accountability. For example, in Ireland the introduction of a Directors’ Compliance Statement under the Companies Act 2014 requires Directors to acknowledge responsibility for ensuring compliance with relevant obligations under the Act to include: tax, serious market abuse offences and serious prospectus offences. This requirement is of direct relevance to ETFs which are established as PLC’s under the Irish UCITS Regulations.

Increased transparency
One theme we have seen throughout 2016 is a shift in the ETF industry becoming more transparent. Transparency is a key principle of good governance and ensures that all stakeholders are well informed about the fund’s activities, future strategies and any associated risks. The tide shows no sign of turning and both investors and regulators continue to seek more transparency.

Disclosure is a key mechanism for promoting the sharing of relevant and timely information to investors. The Disclosure Guidance and Transparency Rules require ETFs listed on the main market of the London Stock Exchange (‘LSE’) to include certain corporate governance disclosures, such as description of the main features of the internal control and risk management systems in relation to the financial reporting process. In addition, the Financial Reporting Council’s (‘FRCs’) 2014 Code of Corporate Governance (the ‘Code’) introduced changes to disclosure in three principal areas: going concern and longer term viability; risk management and internal control; and remuneration and shareholder engagement. There have been limited updates to the 2016 Code as the FRC expressed views that there is still further work to do regarding enhancing the disclosures relating to the 2014 Code. EFT Boards listed on the LSE, or Main Securities Market in the Irish Stock Exchange, will need to review their disclosure across these areas to understand any aspects that can be improved.

Conclusion

Good governance can add value as it enables stakeholders to have confidence in the decision-making processes and management of ETF. To foster market confidence it is important that ETF Boards ensure that investors are protected while encouraging innovation and investment in an increasingly complex, uncertain and ever-changing market.