July 30, 2012 12:39 pm

ETF providers face profitability hit

New rules governing exchange traded funds and other Ucits published last week by European regulators are credit negative for asset managers that manage physical ETFs including BlackRock and State Street Global Advisors, according to Moody’s Investor Service.

Moody’s said profitability would be hurt by higher compliance costs and the curtailment of profitable securities lending activities, a common practice by physical ETF providers.

“Securities lending provides ETF sponsors [with] extra revenue to compensate for slim ETF management fees,” said Vanessa Robert, senior credit officer at Moody’s.

The new guidelines require all securities lending revenues, net of operating costs, to be returned to ETF investors as compensation for assuming the associated counterparty risk.

Securities lending revenue sharing arrangements vary widely among ETF providers in Europe. Some return all of the net income while while others retain up to half for the management company.

As part of the new guidelines, the European Securities Markets Authority also said that investors should be offered a facility to redeem directly with the fund provider in case secondary market liquidity dried up.

“Increasing confidence in ETFs for all these reasons bodes well for the ability of asset managers to attract more assets under management and eventually improve profitability over time,” said Ms Robert.

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