barclays global investment's closure of their sector funds and the takeover of merrills' etfs leaves market experts surprised
The exchange-traded fund (ETF) industry in Europe has been going through a period of rapid consolidation and change. Despite a strong growth curve so far and with the example of the hugely successful US model to follow, 2003 saw the closure of Barclays Global Investors' (BGI) range of sector funds but also saw the company take over the management of two STOXX-linked ETFs from Merrills and launch into the Italian market.
Barclays' decision to close the sector funds is surprising, not only because of the broad success of the iShare range but also because the impetus for the launches came straight from a substantial number of clients who said if they would invest in those products if they were available. On top of that, most investment in ETFs is from institutional investors, who are generally regarded as less fickle than their retail counterparts.
So why did the funds need to be closed? It was a combination of the low margins of ETFs and the general drop in interest for sector-focused products.
Adam Seccombe, business development director for BGI, London, puts it simply. "The reason for the closing funds was because clients stopped using them and they were overly costly for us to maintain," he says.
The collapse of demand of sector funds following the disastrous failure of the TMT sector hit ETFs particularly hard because they are low margin products by design. They need to be large to survive as serious competitors to index-tracking funds and that requires the market demand to be there. Nonetheless, the BGI sector offerings were competitive in global terms.
"The Total Expense Ratio is a key component of analysing the cost of an ETF," says Seccombe. "For instance ETFs now in the US have a spread between around nine basis points up to 99 bps. The sector funds in the US, which are highly capitalised and well traded, averaging something around 60bps whereas the BGI sector funds that closed had up to 40 basis points total expense ratio."
The widespread view that in general US ETFs are less expensive than European ones is wrong, claims Mark Roberts, head of product development for iShares.
"If you just take the funds that are out there and their Total Expense Ratio and you just do a flat average, the US is actually more expensive than Europe. The average ETF in the US is about 47 bps and the average ETF in Europe is about 45 bps. It is actually a complete myth.
"However, there are a few funds which are extremely large and extremely cheap that draw everyone's attention. When you do a dollar-weighted average, yes, the US is cheaper - it is about 25 basis points and Europe is about 35 or 36. That 10 bps gap is not nearly as large as people make it out to be."
Roberts attributes that remaining 10 point gap to the fact that setting up funds, administration and custody are more expensive in Europe, but also because many European ETFs track a broad range of international equities from multiple exchanges.
On the upside is the deal that landed BGI management of Merrill's two EU ETFs: the now rebranded pan-European iShares DJ STOXX 50 and the eurozone iShares DJ Euro- STOXX increased their assets by E2bn.
In this case, the funds are easily large enough to be profitable, but although the deal was a secret, the reasoning behind it was not. It was down to focusing on core activities and avoiding conflicts of interest.
"It is a classic case of two firms looking to develop business in their areas of core expertise," says Roberts.
"We are managers and we are committed to building a pool of ETFs that we manage because that is what we do best. Merrill was trying to be a jack of all trades - doing the management on one side but also trading it and selling it and doing research on it. This makes the whole thing much cleaner," he added.
London-based BGI has traditionally targeted the market it knows best - the UK - but the Merrill move is part of a strategy of European expansion, which also saw the launch of an S&P500 ETF into Italy in the spring of this year.
The European market certainly is big enough to sustain a wide variety of different ETFs. However there are three main barriers holding back widespread adoption of ETFs by European investors.
conditions for market growth
The first is obvious - equity sentiment is poor. Once that picks up, all products giving exposure to equities will profit.
The second is that half of the market - the retail half, has not really picked up on ETFs yet. Getting it to do so is a question of alerting investors to the advantages of using these products as the major source of index exposure in a portfolio. But this is a general problem of investors love affair with actively managed portfolios and star managers.
Seccombe says: "There are endless reports showing that 90% of returns come from asset allocation so it is not a question of teaching people why they should use ETFs it is a question of understanding when they should not. Ultimately they ought to have a very good reason why they are investing in an individual stock as against just buying the index but that attitude is not a very popular one."
Meanwhile, the big ETF players do not want to spend huge amounts marketing low-margin products to retail investors.
the retail investor
Roberts says: "There is a conundrum within the retail market in that if you are going to make a product that is attractive to institutions and price it very cheaply, it does not leave you a lot of room in the budget for mass media marketing to retail. So, the resulting criticism is that we do not care about retail. Retail investors have to figure it out for themselves, which is the key.
"For years in the US the SPIDER sat there with $2bn or $3bn in assets and it was known largely among sophisticated investors as the best kept secret on Wall Street. You could buy it for one tenth of what a traditional company would charge you for an index tracker. It built steam through a grass roots exercise.
"It was such a compelling proposition that once it reaches that critical threshold of awareness, there is no stopping it."
The final problem is the incredibly complex web of protectionist taxation and other legislation that covers the whole of the EU market, making genuine pan-European ETFs a remote dream. BGI's Dublin-listed ETF range requires re-registering in every country in which they are sold, despite them being Ucits funds.
There are also problems of non-domestic funds attracting tax penalties - very much against the spirit of the single market. For the solution to this problem, which affects not just ETFs but the whole of the finance industry, product providers can do little but look to Brussells and wait.
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