Innovative providers rise to challenge of an expanding market

In the rapidly expanding exchange traded fund (ETF) industry, existing and new market participants are trying to capture new money by broadening their product range. Although the large majority of ETFs track traditional, market cap weighted indices, providers have extended their product development to more specialised areas, by using their existing proprietary benchmarks or building new ones in-house or in collaboration with external index providers.

“There is always innovation in the index space and the earlier adopters of that innovation seem to be the ETF providers,” says Manooj Mistry, head of db X-trackers UK. “We have a lot of dialogue and interaction with all the index providers. What drives innovation is client demand, as investors use ETFs as portfolio building blocks, to access different markets and asset classes. Now that all the main markets and asset classes are covered, we are moving into the more niche product territories.”

Launches of actively managed or quantitative based ETF strategies in the hedge fund space are prime examples of the market’s natural evolution.

“There is nothing in the rule book that says ETFs have just to track standard indices. ETFs are very much an access tool, a wrapper through which you can access different types of markets, provided the right fundamentals are in place in terms of structuring a liquid and tradable product,” explains Mr Mistry.

In January, Deutsche Bank’s ETF platform launched an equity strategies hedge fund index ETF. This is a sub-component of the existing db hedge fund index ETF, which is linked to the performance of six core hedge funds strategies and has so far gathered $1.5bn (€1.1bn) in assets.

The recent launch meets investors’ demand for liquidity, as equity long-short and equity market neutral strategies are the most liquid subset of the six strategies, says Mr Mistry. The index, which is linked to the performance of 17 hedge funds from 13 alternative managers, gives exposure to actual, as opposed to replicated, hedge fund performance.

Last year, hedge fund Marshall Wace entered the ETF space with its market neutral ETF, which tracks the proprietary MW Topps global alpha index. Changes in the underlying portfolio are made through the firm’s rule-based proprietary systematic process. This was a clear indication of the interest of the hedge fund community in these passive instruments to enhance their distribution and product offering.

Recently, Europe’s largest hedge fund firm Man GLG followed suit, launching the Man GLG Europe Plus Source ETF on the Source platform. The product provides exposure to a long-only total return index, developed by Man Systematic Strategies, based on the best trading ideas from approximately 60 brokers. GLG, recently acquired by Man, has used a systematic process to select the best quality broker ideas and run a liquid and diversified portfolio since 2005.

Addressing the common industry-led criticism that active-type ETFs often attract for their lack of daily disclosure of their entire portfolio composition to market makers, which would ensure a tight bid-ask spread, Sandy Rattray, head of Man Systematic Strategies, states the product offers full transparency.

Authorised participants will always know the constituents of the ETF and dealers should find it very straightforward to hedge this portfolio, which holds between 200 and 250 names, weighted by market capitalisation, he says. “The returns of the portfolio show characteristics which are ‘index plus’,” says Mr Rattray. “Our own ‘plus’ – when compared with a broad European equity benchmark – has been historically between 200 and 800 basis points, with a tracking error in the range of 200 to 500 basis points.”

Recently, Source, which describes itself as an open architecture provider with a multi-partner approach, agreed to distribute a range of “well engineered and smarter” ETFs with Pimco. This led to the creation of a GDP-weighted ETF, while the partnership with Merrill Lynch last year brought to launch two ETFs tracking the Merrill Lynch Factor Model strategy. The model uses a portfolio of six liquid and well-known market indices to replicate the global performance of hedge funds. The product would appeal to investors who want hedge fund exposure without incurring potential liquidity problems, says Source’s CEO Ted Wood.

In addition to product innovation, the ETF platform’s multi-partner approach answers to the structural innovation needs of the ETF market in Europe, says Michael John Lytle, founding partner at Source. “Fragmentation is one of the key issues of the European ETF market, which has developed in a way that looks more like a structured product market, with each different institution launching products that make sense to them as an institution, as opposed to meeting industry needs.”

Unlike the US, which is a single ETF market, in Europe, where there are multiple currencies and different tax systems, many products track the same indices and trade on multiple exchanges. Many European ETF products never reach a critical mass, with significant liquidity and the trading volumes necessary to make them attractive for secondary trading.

Liquidity problems have not yet become widespread in Europe, as around 80 per cent of assets are held by institutions, which trade over the counter, ie they go to market makers for all their large block purchases or sales rather than trading on exchanges. Retail investors, holding just 20 per cent of assets, trade in small sizes and must rely on exchange liquidity.

The creation in 2008 of Source itself, which today has seven trading and product partners (Bank of America Merrill Lynch, Morgan Stanley, JP Morgan, Nomura, Goldman Sachs, Pimco and Man GLG) – but more than 20 partners including market makers – has reduced the number of ETFs in existence, says Mr Lytle, as otherwise each of them would have launched ETFs on their own. Equally, Source’s recent partners could have been competitors too. “Going forward I think there is potential for consolidation,” says Mr Lytle. “Smaller ETF providers who cannot reach critical mass have the potential to merge with others, and Source is ideally set up to work in partnership.”

With $7bn in assets under management and $160bn in trading volume, the firm has made good inroads into the European market in the last two years. But new entrants are coming to the market and existing ones are revamping their offerings, trying to loosen iShares’ grip on the continent. The now BlackRock-owned giant still controls 44 per cent of the global market (year end 2010), 15 years on from the launch of its first ETF in the US, but its rivals in the old continent have had some success. Over the past four years, although its assets under management have almost doubled to $101.8bn (€75bn), iShares’ market share has slipped from 48 per cent to 36 per cent in Europe, according to BlackRock figures.

Part of this fall may be due to the fact that iShares has no real exposure to the commodities market, which has grown significantly and has benefited those active in this space, such as ETF Securities and Source. However, the ETF giant seems to be taking action and Axel Lomholt, head of ETF product, iShares Emea, says “we have an interest in commodities and we are seeing how the market plays out.”

Critics have pointed to iShares’ recent deviation from its physical-based replication method, with the launch last September of two single country swap-based equity ETFs for India and China, as an attempt to try and contain competition. But Mr Lomholt explains these were rather the exception to the norm. “In these two markets a swap-based solution was the better one, but iShares philosophy will always be to see if we can bring out physical based ETFs as a primary approach. There are some countries where there are structural barriers where we can’t do it and we might consider doing a swap there.

“Emerging markets and frontier markets are a big part of our plan going forward and we will continue to build up that product story,” he adds. Meanwhile, iShares has been particularly active in developing core ETFs, particularly in the fixed income space, where it controls 48 per cent of the market in Europe.

Although it may be challenging for new entrants to gain market share, as the key beta building blocks already exist, the increasing client demand for passive products is pushing bank-owned firms to accept lower margins, rather than see investors go elsewhere, and point them towards their new and improved ETF units, according to Bradley Kay, associate director of European ETF Research at Morningstar.

The major concern is about keeping their existing assets in house. “ETFs are the low hanging fruit that can be added fairly easily to a fund line-up and help maintain the bank’s existing relation with clients,” says Mr Kay. “It’s just about giving clients the passive exposure they want, while using a vehicle that’s fairly cheap to roll out and could possibly bring in some outside assets via buyers on the exchange.”

Credit Suisse ETFs, the exchange traded fund business of Credit Suisse, rebranded its Xmtch ETF fund range to the current name to more closely align its ETFs with the Credit Suisse brand, and it was the ETF firm that gained the highest market share last year, 1.3 per cent, according to BlackRock data.

HSBC also grandly entered the space, launching 16 ETFs in Europe since August 2009, including the two latest ones on China and South Africa. “We launched ETFs primarily in response to demand from investors, many of whom HSBC already serves. Our focus has been on entering the European market with a range of simple, high quality, good value products,” says Farley Thomas, HSBC’s global head of ETFs. “The logical starting point for us was product that had most demand from our clients and this has not involved innovation but certainly has brought increased choice for customers.”

“ETF assets account for 3 per cent maximum of total fund assets in Europe and people see there is still opportunities for growth,” says Mr Mistry at db X-trackers. “New entrants may not be able to reach the dominant position of the big four or five, but probably there still is room for new players,” he says.

In the US ETF market, which is more mature than in Europe, there are still new entrants and new products being launched. “The private wealth space is obviously an important area for growth potential,” he says.

“The explosive growth in ETFs is an incredible opportunity for investors to really bake a cake in as many different ways as they choose,” says Rupert Robinson, CEO at Schroders Private Bank in the UK. However he stresses the importance of analysing factors such as the level of tracking error or the level of leverage, to really understand the return profile, given different market scenarios. “A lot of people have had their fingers burnt by probably not reading the small print, and that’s where the private investor who is not well advised is vulnerable.”

Investors increasingly ask for ETFs as a cheap and liquid investment vehicle and the introduction of different types of ETFs meets their needs, according to Juan Garrido, managing director for Spain’s BBVA Private Banking Investors. “The use of one ETF product or another will depend on the financial culture, sophistication and risk profile of each individual client. We don’t think innovation creates confusion, in fact it offers a wider range of investment instruments.”