Going gets tough for squeezed middle in European ETF battleground

The rapid expansion of the global exchange traded funds industry shows no sign of abating. In the US, total assets are now just shy of $3tn with growth at a robust 16.7 per cent year to date, according to Cerulli Associates. Meanwhile, in Europe assets under management reached €577.8bn ($677.2bn), up from €514.5bn at the end of 2016, according to Thomson Reuters Lipper.

Europe’s growth is set to continue, with many in the industry expecting it to reach $1tn by 2020, and it is investors who will be the biggest winners, claims Fergus Slinger, co-head of iShares Emea sales. “They will have greater choice in the types of asset classes and markets they can gain access to through an ETF, while growth will spur further product innovation and will enhance the underlying liquidity of the market.”

But for the providers, this growth means a seemingly relentless launch of new products and new entrants into an increasingly competitive market, and not everyone will be successful, he says, explaining how large and boutique firms are likely to emerge as the winners. 

“Large players will have the advantage of offering a product range covering the full breadth of markets and asset classes, while specialist providers will have a strong chance of gathering assets from investors looking for a niche exposure or specialist strategy. This will leave mid-sized players without the necessary scale or those unable to carve out a niche likely to be squeezed out of the market.”

Top heavy

The European market does appear to be ripe for consolidation. A quick look at the league table of European providers shows how dominant the big players are, with iShares, BlackRock’s ETF arm, way out in front, leaving the likes of Deutsche Bank’s Xtrackers, Lyxor, UBS, Amundi and Vanguard battling it out for the other podium places. 

Much of this can be explained by the fact that the vast majority of assets are held in a relatively small number of core, cap-weighted funds. 

“If there are about 2,200 ETFs listed in Europe, the bulk of assets sit in about 100 of those,” says Mark Fitzgerald, head of equity product management at Vanguard. 

“There is a very long tail of very small funds. It is inefficient to run those. In the long-term I think we will see some of those closed or merged, and perhaps see some consolidation between providers too.”

Although the numbers of products and providers continues to rise, new entrants are most likely to try and compete in the more niche areas and leave the traditional cap-weighted ETFs to established players, he says.

“A provider coming in now has to make a decision. Do I try to compete with the big investment houses, who have large pools of assets and big teams of analysts, or do I seek to be a niche provider and try to create products that try to create value and offer clients something a little bit different? The middle ground could well be tough because you are neither one thing nor the other.”

A portent of things to come could well be Invesco’s purchase of Source in April, expected to close later this year, subject to regulatory approval.

“Is there space for more consolidation? Yes,” says Chris Mellor, executive director, equity product management at Source. In areas such as simple beta index products, scale does make a difference, he explains, as having a large product allows a provider to pass on better cost savings to the end client. 

“However that doesn’t mean there isn’t a niche for those providers who have a niche offering. The smart beta space is an obvious area in which they can carve that out.”

Harder than it looks

Although ETF providers highlight how much cheaper these vehicles are than traditional active funds, replicating an index is not easy, and it is not zero cost, warns Jean-René Giraud, CEO and founder of ETF analysis platform TrackInsight. “Replicating the MSCI Global Index, for example, brings with it lots of challenges, be it currencies, custodian banks, time zones and so forth. It costs a lot of money to deliver and is really only for the big players.” 

Although it cannot be a good thing when one player has around 50 per cent of the market, Mr Giraud believes the big boys bring a number of benefits to the industry, for example by bringing costs down and through the adoption of better practices. 

“We see smaller players struggling to offer a quality service because it is expensive and complex,” he says. “So the industry is really splitting in two at the moment, with the handful of major players offering a wide range of core products and all engaging in a price war. Then you have the smaller players who are trying to find niches, be it through smart beta or thematic ETFs.”

But although the biggest providers appear to have the plain vanilla market sewn up, it is not the case that they are therefore ignoring the more specialist areas. 

“We see ourselves as the supermarket for ETFs,” says Simon Klein, head of ETF distribution for Europe and Asia at Xtrackers from Deutsche Asset Management. “The biggest flows go into the market cap ETFs, but we need to offer smart beta to be a credible partner for our clients.”

Indeed, size can also be a benefit in these strategies too, he believes. “The bigger the ETF the better it is for the client: the more efficient the tracking, the higher the liquidly, the lower the trading costs.”

Being big also enables providers to educate their clients, to help them structure their portfolios efficiently, to engage in research, to reinvest and to gather new growth.  

“The winner takes it all, so I think the consolidation will definitely come as flows into ETFs accelerate.”

When Xtrackers launched back in 2007 its ETFs were constructed entirely by synthetic replication, but the firm has since had a change of heart as investor preference now strongly favours physical products. 

“We agreed to a 180 degree change in our business model and switched from synthetic replication to physical replication in many areas. We now have approximately 70 per cent by AuM in physical – we are the largest European-based global ETF provider – although the perception remains that we are a major synthetic provider.”

Fees have also come down, although Mr Klein stresses it is not about being the cheapest out there, but rather being cost efficient across the product range.

Staying ahead

Price is certainly an important consideration for investors when choosing providers, admits Fannie Wurtz, managing director of the ETF, indexing and smart beta business line at Amundi.

“In an environment characterised by high volatility and low yields, offering investment solutions at competitive pricing is crucial to let investors maximise their returns,” she says, but highlights the importance of maintaining quality.

Innovation is another way for ETF providers to capture new assets, and is something that Amundi claims is “part of its DNA”.

A “pragmatic” approach to innovation, with clients’ needs placed firmly at the centre, is essential, says Ms Wurtz. She claims Amundi’s research capabilities and close relationships with index providers help define clear index methodologies and enable it to launch efficient and transparent products. 

“The outcome is that more than a third of our range was unprecedented at launch date, while maintaining a focus on simplicity and liquidity.” 

She points to the success of Amundi’s range of floating rate notes which have seen "impressive inflows" over the past 12 months, and describes plans for innovations in the fixed income and smart beta arenas.

The need for relevant bond allocation tools derives mainly from the challenge posed by low interest rates and search for yield, explains Ms Wurtz, and this is certainly an area of the market witnessing rapid growth. 

The European ETF space has long been dominated by equity products, but bonds are beginning to catch up. 

“Although it is a complex market, we observed in 2016 that 54 per cent of inflows into European ETFs went to fixed income exposures, representing close to €23bn,” she says, and is an area which Amundi is targeting.

In April 2016, the French firm added to its corporate bond offering by launching a new currency-hedged dollar/euro share class to its dollar-denominated floating rate notes ETF.

“The launch of this new currency-hedged share class responds to increasing investor appetite for exposure combining a hedge against both a potential interest rate hike and currency volatility, while offering potentially better performance,” she explains.

iShares is also betting on fixed income, reporting that investors are looking to diversify their allocations and are using ETFs to tilt portfolios to express views across geographies and duration, and to hedge their exposure to currencies and interest rates.

“We believe bond ETF adoption will ramp up as the market infrastructure deepens and investors turn to low cost, scalable ETFs in an increasingly fee-based environment,” says Mr Slinger. As a result, he expects bond ETFs to become more ingrained as the tool investors use to form part, or in many cases the basis, of their bond allocations.

UBS ETFs on the other hand are only active in certain areas of the fixed income market, believing its expertise lies elsewhere. “We do have selected fixed income products, but we were later into this area and are not trying to copy what was already out there,” explains Simone Rosti, head of Passive and ETF Specialist Sales Europe at UBS ETFs. 

“There is a first mover advantage in this industry, so we try to focus on areas which are not covered by other providers, but not niche, still core.”

Core equity is very much the UBS area of expertise, he explains, but also highlights sustainable investing as another area of particular focus. “Clients no longer see this as niche, rather they have realised that SRI does not mean giving up performance. Rather it also has the effect of reducing portfolio risk.” 

This is a major area of growth for UBS, says Mr Rosti, adding that smart beta products are also gaining momentum. He predicts this is the direction that a new group of entrants to the ETF marketplace is likely to go in.

“Right now we are seeing the traditional active players looking to get into the game, for example Goldman Sachs, Templeton and JP Morgan. They have a huge platform in terms of funds, but they are just setting up their ETF businesses.” 

These firms will be able to leverage their strong distribution networks and their brand names, says Mr Rosti, but are likely to focus on some selected strategies rather than the big indices.

Providing an edge

Any new entrants to the market will need to provide something different, believes Nizam Hamid, head of ETF Strategy at WisdomTree Europe, adding that although some of the long-established players have some very dominant products and a good portion of the market sewn up, people also want to have choice. 

“The smaller issuers can only exist because they provide an edge. We feel that we do, simply because we build our own indices.”

Many providers are hampered by having to go to an index provider and having to pick and choose a strategy, he explains, which means that any other issuer can effectively do the same.

“We talk to clients and focus on building the solutions they want,” claims Mr  Hamid. “We can build something that is unique. We can be first to market.”

WisdomTree very much concentrates on the smart beta sphere, an area which is finally beginning to gain real traction among investors, and one in which he believes Europe is ahead of the US.

Part of this is down to clients establishing just how they would like to position smart beta within their portfolios, he says. “The bulk of money is still invested in active funds, but investors are getting used to the fact that in the ETF and smart beta world you can access strategies that pretty much replicate the sort of performance you would previously have gone to an active fund for.”

Investors are realising that the smart beta strategies they are allocating to are not that all that different from what they had been accessing in the active space, says Mr Hamid, rather they just go about things in a more systematic way that should provide more consistent returns and exposure to a particular style. 

All change

In terms of specific factors, he reports outflows in what was previously the “trendiest” set of products, namely the low volatility space, but which have now fallen out of favour, with clients now focusing much more on value. 

He puts this down to some of the low volatility products underperforming during the more volatile market environment experienced towards the end of 2017. “Some of the S&P 500 low vol products had higher volatility than the S&P itself!” 

As market valuations have become stretched, investors are looking to maintain their equity allocation, but are taking a more value-orientated and slightly more defensive approach, says Mr Hamid.

Emerging markets and commodities are the areas in which China Post Global specialises. The international asset management arm of the China Post Group bought RBS’ ETF division in early 2016, believing its Asian expertise would marry nicely with the team’s established strengths.

Its Gold Bugs ETF has seen strong client interest in recent years due to heightened political and macro-economic risk, reports Danny Dolan, managing director at China Post Global, while commodity products are also seen as a hedge against inflation.

The firm recently launched a smart beta product focused on quality Japanese companies, which is also benefiting from investors’ search for perceived safe havens.

Smart beta is certainly an area in which the provider has big plans for the future, including a couple of products focused on China which are in the pipeline. 

There was some scepticism about the number of smart beta products that came on the market, he says, and there were question marks raised by investors as to whether these added value or if it was simply complexity for the sake of it.

“There needs to be a credible connection between the strategy chosen and the market you apply it to – so that it solves problems for investors,” warns Mr Dolan.

Riding the wave of regulation

Although most in the financial world tend to moan about the effects of regulation, most ETF providers tend to see it as something of a boon, with the retail distribution review (RDR) in the UK and the upcoming MiFID directive seeming to have the effect of pushing investors towards these instruments. 

“We do see the secondary effects of regulatory change and that my be one of the reasons ETFs are doing so well,” says Chris Mellor, executive director, equity product management at Source. 

RDR has removed the ability of funds to pay commission for sales, which has shifted the focus onto finding the best possible solutions for end clients. 

“That breaks the grip of the traditional fund management model and makes the ETF a more interesting opportunity, or an area that investors are, due to regulation, almost required to look at,” he explains.

This could help boost the use of ETFs by retail investors in Europe. In the US, retail makes up around half of the total ETF market, but in Europe the market is dominated by institutional investors.

“Pre-RDR there was probably less inclination for an adviser to recommend an ETF because there was no commission. So now we might expect to see greater retail adoption,” says Mark Fitzgerald, head of equity product management at Vanguard. 

As pension markets change from defined benefit to defined contribution schemes, there is a lot more emphasis on the end investor taking ownership, which should also increase the uptake of ETFs among retail investors as they become more aware of the advantages of these products.

View from Morningstar: China the growing index giant

Global emerging markets equity ETFs attracted the highest inflows during the second quarter of 2017. While the asset class has been on the front foot since the beginning of 2016, the recent slide in the US dollar, as well as increased valuations in developed market equities, have only provided further support. 

In Europe, the lion’s share of assets in emerging markets equity ETFs is in products tracking the MSCI Emerging Markets Index. While funds tracking this well-known benchmark are generally cheaper, investors should question whether a standard market-cap weighted approach to emerging markets is the right investment option nowadays.

‘Emerging markets’ is a blanket term. The group is made up of about 20 countries, each with its own distinct policies, currencies, economic orientation, and companies. Apart from the central running theme of a reliance on the Chinese economy, there have been large performance differences among the individual markets.

During the commodity bubble, these differences were not as pronounced, as most emerging markets countries were turbo-charged by China’s manufacturing engine operating at full speed. But now, with China’s economy slowing and looking to transition to a more diversified growth model, these developing economies are decoupling. 

As such, investors seeking exposure to emerging markets equities may be better served with more diversified funds than those tracking the MSCI Emerging Markets Index, which is highly concentrated at the country level. Currently, China represents 29 per cent of the entire portfolio and its allocation is only likely to get bigger.

In June 2017, MSCI announced that it will add 222 China A-Shares (onshore stocks listed in the Shanghai and Shenzhen exchanges) to the MSCI Emerging Markets Index as part of a two-step process beginning in May 2018. Upon full inclusion, China is estimated to represent 40 per cent of the MSCI Emerging Markets Index. 

Investors seeking a more diversified approach may be better served with funds which cap single country weights. The innovative ETF industry already offers many products linked to indices meeting that criteria. And of course, investors may also consider the merits of actively managed emerging market equity funds, particularly those run by portfolio managers who are benchmark-agnostic.

Monika Dutt, analyst, Passive Strategies, Manager Research, Morningstar