Although the European ETF market has always played asset catch-up with its older US counterpart, it is set to experience a growth spurt on the back of regulatory developments. Helen Fowler reports
Compared to its older American cousin, the European ETF market remains a child, albeit one that is growing up fast. ETFs have not even reached their teenage years in Europe, with April marking their 10th birthday in the region. In comparison, these funds first emerged in the US back in 1993.
But, so far this year, the $231bn European ETF market has grown faster than its much larger American counterpart. In fact, it has grown faster than any other region in the world, according to Deutsche Bank, expanding by more than 13% in the first half.
There are signs that Europe may be playing catch-up with the older $716bn US market. The European market grew in assets by more than a tenth (13.4%) over the first six months of this year, according to Deutsche Bank. An achievement that is all the more remarkable given the main European equity indices on which many ETFs are based fell back over the period.
In contrast, the US ETF landscape showed negative growth, contracting by nearly 1% over the first six months, as equity markets weakened.
Figures for total assets held in ETFs reflect not just investor appetite, but also market performance, over which nobody has any control. Net inflows into products can give a more accurate picture of investor demand. According to BlackRock, inflows reached $2.2bn in Europe in August.
The picture is almost the exact opposite in the US, where investors pulled out nearly $2bn from ETFs in the same month.
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So far this year, net inflows into US-listed products remain firmly in positive territory, with investors putting in $48bn since the beginning of 2010. However, the equivalent European figure is $29bn, almost two thirds the size of net US inflows – despite the European market being only a third of the size of the US.
Source, the open architecture ETF platform backed by Bank of America Merrill Lynch, Credit Suisse, Goldman Sachs, JP Morgan, Morgan Stanley, Nomura and others, has been one of the influential players in driving this trend.
According to Ted Hood, Source chief executive, in July 2009 the volume in sector ETFs settling through the German clearing system was just €1.8bn. By July this year, the figure had risen more than five-fold to reach €10.1bn. More than 90% of the total came from Source products, added Hood.
Deutsche Bank expects the European exchange-traded product (ETP) market to grow by as much as a third this year. “In light of very strong cash flows, we are reiterating our growth forecast of 20% to 25%, with a good chance to come closer to 30% if equity markets rise from current levels,” said the bank.
There is a range of developments afoot that observers expect to cause European growth to accelerate. Many institutions are taking a greater interest in ETFs, according to Source’s Hood. “A positive development is a lot more interest in ETFs than in the past,” he said. “A lot of banks are staffing up in ETFs.”
All eyes are on the retail market, especially in the UK, where legislative changes could lead to greater take-up of ETFs by members of the public. Retail investors account for around half of the US market, according to Chris Sutton, senior consultant at Towers Watson. In contrast, at the moment they are barely visible in Europe, accounting for only about a tenth of the market.
One obstacle in Europe is the higher management fees, according to Hood, although he added this may change. The government’s Retail Distribution Review (RDR) comes into force in the UK in 2012 and when it does, financial advisers will be forbidden from taking commission from product providers, as they currently do.
Source’s Hood said the RDR may result in substantial change. He added: “If advice were offered more objectively, ETFs would be recommended more often.” Under planned changes, advisers will charge clients an hourly rate or set an annual rate based on how much money is invested.
The change is intended to force advisers to recommend the best product for their clients, not simply the one paying them the most commission. Manooj Mistry, head of db x-trackers UK, said: “The retail/institutional split in the US is 50/50. I wouldn’t be surprised if Europe starts to go the same way over the next eight years.”
Another important regulatory change that could encourage greater retail take-up is the next tranche of European fund legislation. Under new Undertakings for Collective Investments in Transferable Securities (Ucits) rules, providers will have to offer a standardised ‘key investor information’ document on two sides of A4 paper. The new format replaces the current simplified prospectus that firms must currently offer clients.
“It will make it much easier for people to compare products,” said Mistry. “The information will be standardised and based on comparable data, rather than just data that suits the provider. It will make it easier for providers like ourselves.”
Changes affecting the retail market could encourage ordinary investors to try out ETFs for the first time, said Sutton at Towers Watson. “There is more untapped potential in Europe than in the US,” he added. “The US has got to a place where most potential investors in ETFs know about them, and have an adviser in place that is comfortable with them. Europe looks set to enjoy growth driven by first-time investors, especially in the UK.”
The arrival of new providers in Europe, such as HSBC Global Asset Management, could also drive growth by pushing down prices. “HSBC has launched funds that are competing on price. They are bringing out copies of existing products with lower fees,” said Sutton. “And more marketing pounds are being spent.”
In September, Credit Suisse launched 45 new funds on the London Stock Exchange tracking a mixture of developed and emerging markets. Investors can now buy a FTSE 100 ETF that charges just 0.33% a year, making it one of the cheapest products available in the market.
Making trade reporting mandatory for ETFs in Europe could also spur market growth. The majority of ETF trading in the region occurs over-the-counter (OTC), and goes unreported. This potentially deters investors from entering the market since reported turnover figures and liquidity look lower than the true level. According to Christos Costandinides, ETF strategist at Deutsche Bank, as much as 80% of trading activity in ETPs in Germany occurs OTC, outside the Deutsche Boerse; in the UK, this figure is around 50%.
The result is a distorted picture of ETF trading that suggests less trading than is the case. Yet even taking off-exchange trading into account, Europe would still lag US trading volumes. Nonetheless initiatives from the Committee of European Securities Regulators to introduce a consolidated tape, which would make off-exchange trading public, could give a more accurate reflection of trading volumes.
Due to more flexible legislation, the European ETF market is in some respects already more advanced than its US peer, according to Costandinides at Deutsche. “Yes, in assets, the US is bigger,” he said. “But in terms of product offering, the European market is a lot more comprehensive.” In April last year the number of ETFs listed in Europe surpassed that in the US for the first time. At the end of August, Europe had 985 funds, compared to 871 in the US, according to BlackRock.
Even allowing for the fact that some of Europe’s funds are replicas of the products listed across the region, produced in a patchwork of different currencies, participants insist Europe enjoys higher product diversity. In Europe providers have the freedom to sell synthetic ETFs, a right borne by Ucits regulation. US providers must jump through hoops if they wish to offer similar products, without any guarantees they will eventually obtain permission from the Securities and Exchange Commission.
“We have more flexible creation of products. So, for example, there has been a lot more growth in commodities in Europe,” said Costandinides. He added in the US, providers wishing to offer commodities-based products must seek special permission from the country’s Commodity Futures Trading Commission. “That can lead to a lot of uncertainty” said Costandinides.
“Europe is more advanced than the US in how funds can use derivatives,” said db x-trackers’ Mistry. “So you see a lot of swap-based ETFs. In the US to do that you would have to go to the regulator to get special permission. In Europe it’s enshrined in law.”
European ETFs will also benefit from a wider shift towards passive products. Sutton at Towers Watson said: “The European market has prospects for growth. We are seeing new products coming to market. There are a lot of opportunities as money starts moving from active to passive funds, especially outside the UK.”
But there are signs that European providers will have their work cut out to catch up with the US. “The US market is three or four times the size of Europe and even bigger in terms of turnover,” said Mistry at db x-trackers. Europe’s $2.7bn average daily trading volume remains a drop in the ocean compared with the $52.9bn notched up in the US, according to BlackRock.
“We have a very long way to go,” said Hood at Source. “I don’t know on what basis people are saying Europe is catching up.” Despite growing by nearly 2% since the start of this year, the European ETF and ETP markets are still only a third (32%) the size of the equivalent US market.
“Europe will always be playing catch-up with the US,” said Mistry. “Europe is a collection of countries, whereas the US is one big market.” The US has the in-built advantage of being one homogeneous market, with a common currency, language, taxation system and regulatory set-up. Even with the single currency, Europe presents a ragbag of markets, where providers will face greater obstacles in acquiring scale, especially across borders.
There are other obstacles in the way of stronger European growth. Hood cites the relative absence of hedge funds in the European market. In contrast, these account for a “huge” percentage of US turnover. Hedge fund trading has driven down spreads in the US, absorbing transaction costs. “Hedge funds are not around (in Europe) because they can’t borrow and short ETFs,” said Hood. However he added that the funds were active in some Source products.
Despite these potential stumbling blocks, there is growing optimism that the European market is set for rapid development. “Whether it can ever catch up in asset size I don’t know, but it has the potential to grow faster over the next five years,” said Towers Watson’s Sutton. With the products looking set for a period of more rapid growth in Europe, let us hope that their adolescence does not prove too stormy.
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