Exchange-traded products benefit from new focus on liquidity
While the market turbulence of the past three years temporarily slowed the seemingly irresistible rise of exchange-traded funds, industry professionals say that ultimately the crisis has benefited the ETFs sector by spotlighting the importance of two of their most important characteristics, transparency and liquidity.
The growing use of exchange-traded index-based products, especially by institutional investors, is likely to be boosted, they say, by dissatisfaction with the broad swathe of the actively-managed investment industry that is seen as offering little more than ‘me-too’ products that hug indices anyway and struggle to deliver a return justifying their often sizeable fees.
That’s not to say the ETF industry does not face its own challenges, particularly in Europe, where levels of exchange turnover have generally lagged substantially behind those in the US. Allied with this is the slowness in ETF investment uptake by retail investors – although looming changes to distribution rules in various areas of the continent may well remove some of the hurdles.
However, as etfexpress celebrates the sector’s ongoing dynamism with its first set of industry awards, presented at a ceremony in London last month, there’s no doubt about either its continuing appeal to the investment community or the eagerness of asset managers to explore new and innovative product ideas.
The launch of new products may have slowed to a trickle during the dark days of 2008 and the early part of last year, but the taps have been turned on again in earnest. Just the first week of April saw a flood of new exchange-trade product launches or listings, including one from HSBC on the London Stock Exchange, four from Source on Deutsche Börse, 20 from Amundi on Deutsche Börse and 13 on Borsa Italiana, three from ComStage on Deutsche Börse, one from Van Eck Global on NYSE Arca, 10 from db x-trackers on Nasdaq OMX, one from UBS on NYSE Arca, and nine from Invesco PowerShares on Nasdaq.
ETF assets could grow by up to 30 per cent this year, according to BlackRock’s Global ETF research and implementation strategy team headed by the industry’s long-time premier analyst, Deborah Fuhr. In its latest survey of the industry, BlackRock argued: “The landscape will continue to evolve in 2010 and beyond as we see more products from traditional active asset managers and alternative asset class exposures becoming available to ‘mainstream’ retail and institutional investors through standardised and regulated fund structures such as Ucits in Europe.”
According to the firm’s research, at the end of February the global ETF industry comprised 2,090 funds with just a fraction over USD1trn (USD1,001.9bn) in assets, together with a further 629 other exchange-traded products (largely exchange-traded notes and exchange-traded commodities) accounting for a further USD150.3bn. In total, BlackRock says, there were 139 providers of exchange-traded products, which accounted for 4,918 listings on 43 exchanges around the world.
But there are striking differences in the number of funds and volume of assets of ETFs in the US and those in Europe, where the industry is celebrating the 10th anniversary of the first product launch (on April 11, 2000). A decade later, the continent’s ETF industry consisted 901 funds from 35 providers with assets of USD220.1bn and 2,490 listings on 18 exchanges. Across the Atlantic, the US industry comprised slightly fewer ETFs – 807 from 28 providers – but just over three times the volume of assets at USD678.6bn, and the funds were listed on just two exchanges.
The fragmentation of the industry in Europe, industry members acknowledge, is a major factor in costs being higher – the average total expense ratio for equity ETFs is 40 basis points in Europe compared with 34 bps in the US – and in lower trading volumes on European exchanges, which can impair one of the most fundamental sales arguments for ETFs, that investors can buy and sell them throughout the day on a recognised exchange in the same way as other securities.
It was these issues that prompted a group of banks and other financial market players to launch Source as a new provider in the European market in April 2009. “The question that we asked ourselves before we went into the business was whether the market really needed another provider of ETFs,” says chief executive Ted Hood. “When we looked at the European market we saw two fundamental shortcomings, particularly when we contrasted it with what was going on in the US, and those two things really struck us as opportunities.
“First, the depth of investor penetration of the market, and the degree of turnover in products – the actual trading of ETFs – was very low in Europe compared with the US. It was clear to the banks that came together to create Source that there were structural issues to the market which, if addressed, could allow products to become much more liquid and traded much more frequently, which would really enhance the value the products provided.”
In response, Source has taken a number of steps to improve liquidity. “The first was concentration of exchange listings,” Hood says. “It’s very attractive for a provider to list their products on a number of different exchanges, because it potentially enables them to attract investors who are only willing to invest in products listed on their home market. But the downside is that you’re fragmenting the liquidity – trades on one exchange draw liquidity away from the others. We took the fundamental strategic view that we would have focus liquidity on single exchanges based on what was the best exchange for a particular product.
“The other thing we’ve done was to structure our products in a way that facilitated a liquid borrowing market for the products. If someone wants to short one of our products, they are designed in such a way as to enable the lending of our ETFs in a very liquid and cost-efficient way. As a consequence, we see an enormous amount of trading by investors using our products to express short views on particular benchmarks.”
Hood adds: “A lot of investors used to ask where the exchange-traded component was in European ETFs. We believe we have succeeded in tackling some of the technical issues surrounding products in order to facilitate liquidity in the market.” But he recognises that extending the appeal of ETFs beyond institutions to the European retail market will be a long-term effort.
“Clearly there is broad institutional acceptance of the products, with insurance companies, pension funds and more and more private banks using the products,” he says. “Where we don’t see any material penetration at the moment is on the retail side. Part of that has to do with the way distribution of investment products is structured in Europe, where typically products are sold to investors, and the people selling those products are paid by the manufacturers to sell them.
“ETFs are generally inexpensive products and there’s not an enormous amount of margin, certainly not enough to pay for that kind of distribution channel. But we believe investors in Europe as elsewhere in the world have recognised that ETFs are an excellent way of getting exposure to benchmarks, particularly investors that recognise the value of asset allocation as opposed to individual stock-picking. They find defined benchmarks and products like ETFs are a sensible way to go, and we think this will soon trickle down to the retail investor.”
Hood’s optimism is shared by Simon Klein, head of db x-trackers sales for continental Europe at Deutsche Bank, who notes that in the US, for example, around half of all new ETF investment is coming from the retail market. He says: “We will see further development in Europe as well, through fee-based advisory and discretionary wealth management units. These kinds of business will increasingly use ETFs as building blocks in tactical and strategic asset allocation, so I believe the share of retail investment in ETFs will increase in the future.”
Fuhr and her team at BlackRock also believe that retail investment growth will come to match that by institutions. “ETFs have fundamentally changed the way both institutional and retail investors construct investment portfolios,” she says. “We expect ETFs to continue to be one of the preferred investment vehicles for low-cost beta exposure across both retail and institutional markets. Regulatory change such as the Retail Distribution Review seeking to ban commission in the UK retail market will have a significant impact on ETF usage in the next 18 months, and globally we are seeing growth in institutional usage of European Ucits ETFs.”
Fuhr says the coming year may see growth in the sector boosted by hedge fund firms. Already extensive users of ETFs because of the ease of access to market benchmarks they offer, whether for long or short investment, hedge fund managers are already exploring the use of Ucits vehicles to access a broader spread of investors, a trend that could be extended to ETF vehicles in jurisdictions where regulators are comfortable with the idea.
“Hedge fund [managers] are noticing the growth and appeal of ETFs, which are simple and easy to access, but have powerful distribution networks,” says the BlackRock report. “We expect to see more [managers] looking to create ETFs, with their own funds as the underlying exposure, in an effort to broaden their distribution capabilities.”
Such a trend would present a challenge to the industry, the report argues: “This will, on one hand, give more investors access to the asset class and the ability to do so in small sizes, with daily liquidity, but also make it challenging for them to understand what they are investing in compared with the historical daily transparency of the underlying portfolio in low-cost index based exposures which ETFs have become known for.
“It will be important in the coming years that new generations of ETF [managers] educate investors on their structures and mechanics when they deviate from the traditional definition of ETFs as exchange-listed, open-ended, liquid with secondary and primary in-kind creation and redemption (with support from market-makers and other liquidity providers), with real time indicative NAV, and transparent where the underlying portfolio is disclosed on a daily basis.”
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