European exchange traded funds are catching up with the US in terms of size and efficiency, but there are fundamental psychological and structural barriers to break down
In their fifth year of existence, Europe's exchanged traded funds (ETF) continue their success story. Launched in April 2000 by Deutsche Börse and the London Stock Exchange, Europe's ETF market has enjoyed substantial growth and with 2005 off to a strong start, Europe has emerged as a serious player in the market.
In the opening months of 2005, European ETF assets under management surged more than 17%. At the same time, the US market saw a 2% decline. Similarly, turnover jumped 97%, compared to the US's 31.7% increase. Structural and cultural barriers, however, make long-term ETF growth on the continent more challenging than in the US.
first the good news
The new EU member states represent some of the fastest growing markets in the world. ETFs have been celebrated as easy-to-use tools to get a piece of the emerging market region without having to understand the intricacies of each country. ETFs have also encouraged investors to buy into new markets where purchasing individual equities can be hampered by wide bid/offer spreads and liquidity issues.
Standardisation has also helped. Indeed, six investment companies in Europe offer ETFs based on the Dow Jones EURO STOXX 50 Index alone. Harmonised ETF products enable investors to enjoy the best products on the market at the institution of their choice. Finally, growth has been enhanced by the emergence of institutional investors trading options and futures on ETFs.
Though the first part of the year signals the entry of ETFs into the European mainstream, the region has a long way to go before approaching US levels. The continent's 122 ETFs are not far behind the US's 164 products, but by assets under management, the US's $223bn dwarfs Europe's $30bn. Looking ahead, the US and Europe are set to launch another 20 to 30 ETFs this year.
The US's seven-year headstart explains much of the disparity. Well known products such as the SPDR S&P 500, the Nasdaq 100 Index Tracking Stock and DIAMONDS based on the Dow Jones Industrial Average have had time to grow and mature. Institutional and retail investors alike have come to first understand, then recognize and finally demand these products. Combined, those three ETFs represent approximately 33% of US ETF assets under management. Significantly, these products have provided an easy-to-understand introduction to ETF investing, encouraging traders to expand into additional offerings. These products, primarily sector and style ETFs, account for another 25% of US ETF assets under management.
US pension fund managers have also done much to drive ETF adoption. Eager to reduce costs, boost transparency and simplify trading procedures, US pension funds have widely embraced ETFs and highlighted their use to their investors. And although US investors are more focused on their home market - less than 20% of ETF assets under management are invested in international markets - there is growing recognition of the utility of ETFs in diversifying abroad.
Last, the size and diversity of the US market has also helped build new products. The American equity universe of 9,000 liquid shares has made it easier to create specialised, broad-based ETFs which are wildly popular among the retail and institutional sectors. Hedge funds, which drive tremendous amounts of volume on US exchanges, also enjoy using for example sector and style ETFs for their low costs and highly targeted nature. Indeed, AUM for those ETFs grew by more than 120% over the last 18 months.
The European story
No doubt Europe has a long way to go to catch up with the US. Lack of harmonisation between multiple clearing and settlement systems, product listings and languages all stand as barriers to growth. Another difficulty lies in listing products across the region. Companies wishing to list in multiple markets face arduous registration and administrative costs.
Despite these challenges, market commentators are bullish on ETF growth across the region. Recent regulatory changes are expected to encourage pension funds to increase trading in ETFs. Pension assets in countries such as France and Germany hold only about 5% of assets under management in passive funds, leaving much room for improvement.
Education and awareness are playing a critical role in the growth and success of ETFs in Europe. Themed products, such as those that measure value and growth, have long been popular in the US but are now catching on in Europe as retail investors learn their value. Style investing for long-term planning is also expected to be popular as the region's median age moves higher. Investors increasingly see the benefits of using ETFs to diversify among large, mid and small companies and specified business segments. Worldwide, the high yield approach is also picking up steam. Investors recently funneled $6bn into a Select Dividend ETF launched on the New York Stock Exchange. Major investment companies are expected to launch similar products for Europe and the eurozone in coming weeks.
Lastly, blue chips from other regions like the Dow Jones Industrial Average for the US or an Asia-based product will also see big gains in Europe this year. Product expansion will lead to an even more buoyant ETF business throughout Europe, to the benefit of national and regional blue chip indices. Currently, ETFs are listed in Belgium, Finland, France, Germany, Iceland, Italy, the Netherlands, Norway, Sweden, Switzerland, Turkey and the UK. Other countries are expected to follow suit shortly.
Looking further into the future, investment managers will be following two guiding principals in the creation of new ETFs: transparency and distinctiveness. ETFs have benefited widely from their perception as an inexpensive tool to accurately capture slices of a market. Trust that the index on which the ETF has been built accurately reflects that market has only been earned through transparency. This element is critical for any ETF, but especially in ones where investors are accessing markets which are new to them, or new to all, as they are with emerging regions. Though much has been made about an overabundance of financial information, there will be no slowdown when it comes to ETFs and the data on which they are built. Constant access to underlying index data and trading moves will remain crucial to maintaining investor trust and faith in ETFs.
The second element, index distinctiveness, is only visible in a wider context. To that end, investment product builders will be turning to index providers which offer a global family of indexes, featuring a common methodology and long-term track record of consistency.
With these elements in place, and ongoing market reforms and investor education initiatives, the future for ETF growth is bright not only for investors in Europe, but for those in the US and worldwide.
In the opening months of 2005, European ETF assets under management surged more than 17%.
Looking ahead, the US and Europe are set to launch another 20 to 30 ETFs this year.
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