Europeans developing an appetite for ETFs

Barclays Global Investors hit the headlines in September 2003 for closing down nine sector exchange-traded funds (ETFs) in a rationalisation of product offerings. Merrill Lynch has withdrawn from the market altogether.

But these apparent indicators of gloom have been contrary to an underlying upward trend in demand from European institutional and retail investors. Assets have grown 37 per cent over nine months to E21bn, and despite the closures, BGI has recently launched corporate bond ETFs and registered its iShares range in Italy.

It is four years since the launch of the iShares brand marked the dawn of ETFs in Europe, with products linked to the EuroStoxx 50 and the DJ Stoxx 50 indices. Over these four years, European demand for ETFs has grown faster than in the US, according to Deborah Fuhr, ETF analyst at Morgan Stanley. Over 100 ETFs have been listed in Europe during this time. It took the Americans 10 years to launch the same number of products and over six to gain the equivalent weight in assets.

Fatter funds

The average fund size also contributes to grow, having broached the E190m mark, after more than doubling during 2003. The most popular European funds are those providing exposure to the eurozone indices, according to Ms Fuhr, whose analysis identifies eight European ETFs with more than $1bn (€830m) in assets and three worth more than $2bn.

Thomas Meyer zu Drewer, chief investment officer of Germany-based IndexChange, Europe’s largest provider with E5.7bn in 35 ETF products and a 27 per cent market share, argues that the European market is growing strongly. IndexChange has enjoyed net inflows of €2.1bn into its ETFs in the past three months alone. BGI’s assets have risen from €2bn in July 2003 to €5.3bn today. This has moved BGI’s iShares franchise from the third to the second largest provider of ETFs in Europe.

Around 85 per cent of IndexChange’s new money has flowed from institutional investors with the rest from retail investors. “You need to attract at least 100 retail investors for every one institution to collect the same volume of assets,” says Mr Meyer zu Drewer.

He believes European sales have increased as a result of the four-year educational campaign by ETF providers.

While the majority of demand for IndexChange’s ETFs is from its home market in Germany, 40 per cent of inflows are from France, Switzerland, the UK, Luxembourg, Austria and the Netherlands.

Motives for using ETFs clearly vary between investors, but low cost compared with other products is a key demand driver. According to Fitzrovia International, the average total expense ratio (TER) for equity ETFs in Europe is 0.47 per cent, significantly below the average of 1.2 per cent for equity index tracking funds and 1.62 per cent for actively managed equity funds. The average TER for fixed income ETFs is 0.16 per cent against 0.99 per cent for fixed income funds in Europe.

Ironically, it is also the low cost of ETFs that has hindered take-up by retail investors. “Most retail investors buy products through banks or financial advisers. The low charges mean ETFs are not a lucrative product to sell,” says Mr Meyer zu Drewer. “They can sell other funds with up to 5 per cent upfront commission.”

He believes there are two main factors that investors differentiating between products should look at. The first is liquidity. Mr Meyer zu Drewer identifies the EuroStoxx 50, the Dax in Germany, Cac in France and FTSE 100 in the UK as the most liquid indices in Europe for ETFs to be linked to. “Liquidity is important because it leads to tight bid offer spreads and enables investors to trade large amounts.

“It is no good if an ETF has a spread of one basis point if an investor can only trade €10,000. Institutional investors are more likely to want to trade €10m.”

Replication

The other differentiating factor is replication of the underlying index. Our chart compares the divergence of ETFs from their indices. Mr Meyer zu Drewer says: “The question for investors is whether an ETF has full replication or optimised replication of the index. German law allows our ETFs to hold more than 10 per cent of the portfolio in a single security.

“This enables us to provide full replication of an index through one share by using the original shares in the original weightings only.

“Under Ucits III, ETFs in other countries can now offer full replication. But other providers are not providing this yet. But if you use derivatives or index certificates, there is counter party additional risk.”

IndexChange is currently developing products likely to cover real estate, commodities and hedge funds. But the company’s strategists believe Europe is not yet ready for style ETFs, such as growth and value.

BGI believes product development will continue in Europe, even though some funds were shut down last year. It recently expanded its ETF range in the UK and Italy through the launch of five ETFs to replicate its strategy in the US.

According to BGI, iBoxx € Liquid Corporates, which is listed on the Borsa Italiana, was the first corporate bond ETF to be made available to Italian investors. The other launches were the iShares FTSE Euro 100 and iShares FTSE Eurotop 100. They complement iShares based on the S&P500, DJ Stoxx 50 and DJ Euro Stoxx 50 already listed on the Borsa Italiana.

In the UK, where all its ETFs sold in Europe are first listed, BGI launched the iBoxx Sterling Corporate Bond and iShares FTSE 250.

Mark Roberts, head of product strategy of iShares Europe, says it offers 90 products in the US to provide investors with a “broader exposure so they can construct portfolios based on benchmarks of their own choosing. In the UK, for example, most investors use the FTSE All-Share or FTSE 350 indices as benchmarks but we only had the FTSE 100 until now. The FTSE 250 will be popular because of the strong performance of mid-cap stocks over the past year.”

Much of the increased demand for ETFs in Europe, says Mr Roberts, is coming from fund managers who use them as portfolio management tools particularly when they need a home for excess cash. This cash may be invested days, weeks or months later.

The advantage of ETFs is that they can be traded as frequently as the investor needs without penalty charges, including every hour. Investors can also use country or sector ETFs to make active bets about certain markets. They can therefore be used as a hedge against the main stock markets held within an investor’s portfolio.

Alan Dubois, head of European ETF distribution at State Street Global Advisors, agrees there will be further product development and that sector funds will not disappear in Europe. “With new products like sector ETFs, providers have to be patient. In the US, it was a while before sector ETFs took off. Investors are open to new products but it can be quite difficult in the early days as they have to understand them.”

An important consideration in selecting ETFs providers, says Mr Dubois, is the underlying index. This obviously largely determines the performance of the ETFs. “Investors should look at the composition of the index they are buying for the return they are likely to make and at what level of risk. The EuroStoxx index, for example, only has 50 stocks, very few of which are mid and small-caps and no pharmaceutical companies.

“In contrast, the MSCI has an average of 600 stocks, including small and mid-caps, as well as a good weighting to pharmaceutical stocks. Investors first have to understand the index and the level of volatility and risk they are taking before choosing an ETF.”

Dr Christian Gast, head of product development and management of Fresco Index Shares at UBS Global Asset Management, argues that product development acts as a differentiator between ETF providers.

Product development

He says Fresco is the only ETF provider in Europe offering a Japan product and covers all the other “major developed markets of the US, UK, eurozone, Switzerland and Germany. This allows many investment applications, such as a global hedge. Fresco has recently implemented a global hedge (MSCI world) for a major Swiss institutional investor.”

In the future, Dr Gast believes the short side of ETFs will develop more strongly. “The lack of understanding of the process of selling ETFs short is disappearing. Securities lending will become more important for the client who lends the ETF as well as for the fund that lends the underlying stock. This income can sometimes be more than offset the expense ratio.

“The pace of new launches will remain slow. Product development will focus on niche products, such as small-cap and emerging markets, and wrapped solutions such as funds of ETFs and managed ETFs portfolios.”