MONDAY MORNING MEMO: The next stage of growth for the European ETF Segment

The latest market study by Ernst & Young (EY Global ETF Survey: A new era of growth and innovation) predicts the global exchange-traded fund (ETF) industry will surpass the global hedge fund industry in terms of assets under management within the next 18 months. In addition, the authors of the study forecast a growth rate of 15%-30% annually for global ETFs and 15%-20% annually for European ETFs over the next five years. Since the global ETF industry already showed a high growth rate over the last ten years, this forecast raises the question: From where will this additional growth come?

REUTERS/Arnd Wiegmann

The European view

Even though it seems everybody in Europe is already using ETFs, there are still a lot of investors that do not use ETFs at all in their portfolios. Surprisingly, these are not only retail investors; there are also a number of institutional investors that do not employ ETFs in their portfolios for various reasons. So, there is room for further growth in the ETF segment, but the industry needs to find a path into the portfolios of these hold-out investors.

Innovation

Innovation has always been a driver for the growth of the ETF industry. The first innovation was the launch of ETFs as an investment vehicle. Since those days, the industry went down a path of product innovations to enable investors to translate their market views in as detailed a fashion as possible to the asset allocation of their portfolios. Since all standard asset classes are now covered by ETFs, fund promoters have started to offer strategy products and “smart-beta” products, which help differentiate fund promoters from their competitors.

Smart-beta ETFs use indices with—compared to the weighting by market capitalization—an alternative weighting methodology to determine their portfolio composition. Smart-beta ETFs seem to be a bit more complex than standard ETFs, since the investor needs to understand the index methodology in detail to evaluate the performance risk of the different smart-beta products. Nevertheless, the smart-beta space has already attracted a number of investors and might become one of the drivers for the future growth of the European ETF industry. Not only are established European players lined up in this segment, U.S. smart-beta specialists such as Invesco PowerShares, which has been active in Europe for a number of years, and Wisdom Tree, which has not started its business in Europe yet, are seeking to expand their footprint in the smart-beta space in Europe. In addition, there is smart-beta activity among nonlisted tracker funds, i.e., index funds, which shows there is also demand for these kinds of products.

As good as innovative new products are for the growth of the industry, they also might become a threat. In this regard, the industry should be careful about the strategies and product features they are introducing to the market. Since ETFs are known as being simply structured, easy-to-access products, any additional layer of complexity might irritate investors. Who will invest in products they do not understand? An additional threat, which was seen also by the EY analysts, would be a possible scandal in the ETF segment, which in any case would massively damage the trust of investors in ETFs.

Pricing

Even though ETFs are widely known as being cheap compared to other funds in terms of their management fees, some institutional investors still see them as too expensive. The reason is quite simple: institutional investors, especially pension funds, are normally long-term investors with a given asset allocation. They use segregated accounts and other mandate-based vehicles in their portfolios, and they do not need the accessibility and liquidity that is provided by the ETF wrapper. In addition, institutional investors are often very cost conscious, and since the features of the ETF wrapper add an additional layer of cost, ETFs are seen by a number of institutional investors as being too expensive.

However, since a number of ETF promoters in Europe have cut the management fees for their products on standard indices such as the EuroStoxx 50 or the S&P 500 to below 10 basis points, the products might become even more interesting for institutional investors. Since these price cuts gathered a lot of media attention all over Europe, there is a good chance ETF promoters will reach their target and attract cost-conscious institutional investors to their products.

Having said this, one needs to bear in mind that the European ETF industry is very competitive, with a high number of products tracking the same indices. In this regard, price is one of the differentiators between fund promoters. Therefore, the competition might lead to generally lower prices for ETFs on standard indices, meaning they can be enjoyed by all kinds of investors.

But, it is not only the fees and expenses that need to be taken into account. Trading costs are also a point of interest for investors. In this regard, market makers in the ETF segment need to ensure competitive pricing, i.e., they need to offer low bid/offer spreads for all kinds of ETFs.

Liquidity

In terms of ETF trading market makers have to look not only at trading costs. The liquidity of an ETF is at least as important as the trading cost. Opposite to the U.S., Europe has a number of exchanges where ETFs are traded. This means the overall liquidity for the majority of ETFs in Europe can’t be measured by looking at the trading activity on a single exchange. In addition, a lot of ETF trading in Europe is done by so-called over-the-counter (OTC) trades, which are not always visible to the market. Therefore, it would be very helpful if the different parties in the ETF segment could find a way to disclose to investors the overall liquidity of their ETFs.

Even though some industry participants say an ETF is as liquid as its underlying index, institutional investors are mainly interested in the liquidity of the ETF itself. They want to build or close their positions fast, i.e., in one trade and in a cost-efficient way—with a low bid/offer spread. In this regard, a consolidated disclosure of the liquidity might help make ETFs even more attractive to these investors.

With regards to the above, there is room for growth, if the European ETF industry is doing their homework.