European fund managers follow ESMA guidelines to develop Key Information Documents (KIDs) for their investors. A central part of this is the performance scenario, which gives a view on how a fund might develop over time. Since every fund manager is required to use the same methodology, it is the industry standard.
At Amsshare, we help fund managers implement these guidelines every day. However, since these regulations have such a big impact, we wanted to look at them from an academic perspective. Regardless of the fact that it is a mandatory requirement, is this actually a reliable way to predict returns?
Summary
This paper investigates and compares the performance of the European Securities and Markets Authority (ESMA) methodology and a sophisticated time-series prediction model (also called: TSP model) in predicting 1-year future returns for European passive ETFs.
The ESMA methodology for predicting future returns solely relies on past return data as an explanatory variable for future returns, which contradicts the weak form of the Efficient Market Hypothesis (EMH). The results show that the ESMA methodology is rigid and does not capture the dynamics of market fluctuation, leading to inaccurate and biased predictions for both European passive stock and bond ETFs.
On the other hand, the TSP model, which uses important explanatory variables from the existing literature, provides more accurate and unbiased predictions for European passive stock ETFs, but does not provide significant accuracy or unbiasedness for European passive bond ETFs.
The paper concludes with a recommendation for the ESMA to consider the TSP model as an alternative model to predict future return, given the importance of accurate performance scenario disclosure in the mandatory Key Information Documents (KIDs) for fund managers.
