Investor demand continues to drive ETF evolution

When the first European exchange traded funds  (ETFs) were listed on the Deutsche Börse  in April 2000, few people could have anticipated how popular these products would become. Fifteen years later there are more than 2000 ETF/ETP products listed in Europe, by 45 different providers. 

Assets in European ETFs broke through the $500bn (€448bn) barrier to reach a record $511bn at the end of April, according to ETFGI, and the industry continues to grow at a formidable rate. In the 12 months to the end of April 2015, European ETFs/ETPs saw a record level of net inflows of $38.4bn, significantly higher than the $20.4bn accumulated over the same period in 2014. 

BlackRock, the world’s largest provider of ETFs through its iShares brand, predicts assets in European-listed ETFs will double to just over $1tn by the end of 2019. “ETFs are one of the success stories of 21st century investing in Europe,” says Rachel Lord, head of Emea for iShares. “ETFs domiciled in Europe continue to grow rapidly, despite recent economic and geopolitical uncertainties. In fact, the growth in uptake of ETFs here is far higher than the global average.” 

So where is this growth coming from, and has the type of investor using ETFs changed over their 15 year lifespan in Europe?

There has definitely been an evolution in the investor types using ETFs since they were first introduced, believes Nizam Hamid, head of sales at WisdomTree Europe. “While initially their use was almost exclusively in the institutional landscape, we now see a much more balanced and widespread use of ETFs in a number of European markets.”

The split between institutional and retail customers is currently around 85 per cent/15 per cent, although he highlights that within the institutional space a significant proportion is accounted for by large-scale wealth managers. “Their usage of ETFs has been driven increasingly by demand from their end-clients, which are typically high net worth individuals,” adds Mr Hamid.

There has been a general shift towards passive investments gaining momentum over the years, helped by a substantial focus on educating investors as to the benefits of using ETFs within their portfolios. The generally low-cost fee structures, transparency benefits and ease of trading have all been highlighted, and many now predict a huge uptake in the use of ETFs by retail investors, pointing out they now account for half the US market.

“The US has been the trailblazer when it comes to ETFs, and Europe follows behind,” says Howie Li, head of the Canvas platform at ETF Securities. The world’s first ETF was launched in the US in 1993, and he believes the country is probably five years ahead of Europe, although the gap is narrowing.

Europe is quite a fragmented market, says Mr Li. “In the US you have got lots of different states, but they all use a single exchange, focused towards New York. In Europe you have all the different states, but each has its own regulations, exchanges and so on. There are efforts to address this fragmentation, whether it is trying to get to a single settlement system or finding some way to centrally clear everything, which would help to unify the market.”

As the European ETF market has grown, so it has evolved. Many of the early vehicles were market-cap weighted equity products, but the industry now offers a much wider variety to investors, be it in terms of the asset classes available or strategies on offer.

Powershares, founded in 2002 in the western suburbs of Chicago, was bought by Invesco in 2008 and has been in Europe for seven years, focusing on the more innovative side of the ETF landscape. 

“We saw the benefits of ETFs but felt the indexes which providers were putting into the vehicles had limitations,” says Bryon Lake, head of Invesco PowerSharesEmea. “So we tried to become an innovative, value-added ETF provider. That now often gets referred to as smart beta, but it is what we have been doing before anyone called it that.”

Globally, Powershares has capabilities across a range of asset classes and is currently the fourth largest ETF provider, with $100bn in AuM. Although their European offering is predominantly in the equity space, fixed income is certainly an area in which the firm sees expansion potential, says Mr Lake.

While the low fees attached to ETFs have undoubtedly drawn clients in, along with a growing appreciation of the role passive investments can play in a portfolio, he believes the biggest attraction of these products has been their performance, something that will stand out more and more as the marketplace gets more crowded.

“There are new entrants to the market – some of the big banks, some independent asset managers – but even if there are, say, 40 or 50 ETF providers in Europe, there are thousands of mutual fund providers,” notes Mr Lake, predicting firms will become more specialised in what they offer.

“At the end of the day all ETFs are is a wrapper to deliver a strategy. You have to be able to see how investors are going to use your products and how it is going to improve their investment prospects.”

There is currently a shift going on in the asset management industry, believes Mr Li at ETF Securities. “Not long ago it was ETF providers versus mutual fund providers, passive versus active. Now we are seeing ETF providers move into the active space and traditionally active managers looking towards the passive end of the spectrum to provide solutions for existing clients.”

Institutional investors once looked to ETFs for tactical allocations, says Mr Li, trading them much as they would stocks. But the financial crisis was a game-changer. “Since 2008, the emphasis on liquidity has become more important as a risk management tool. You now have ETFs being used much more strategically and over the long-term as building blocks, given liquidity benefits.”

Rather than the smart beta products championed by Invesco, Vanguard chooses to operate in this core building block space, with both equity and fixed income strategies among its 13 European-listed ETFs.

“There has been a misconception that ETFs have been for very active traders,” says Tim Huver, ETF product manager at Vanguard. “In fact what we find is that, although they can be used for very tactical purposes, they are moving towards strategic usage, and so we do find investors seeking ETFs as a long-term buy and hold, core holding.”

This is certainly the way multi-family office B-Capital utilises them, says founder Lorne Baring. “We use ETFs for the majority of our portfolios, both cap-weighted and smart beta. The ETFs make up the core and we use active managers for the satellite.”

The rise in ETFs, and other passive vehicles, has led some to claim the time is up for active managers and the high fees they tend to charge. Mr Baring disagrees. “It is not a question of passive being the death of active. The two are both relevant. Passives will continue to grow in terms of active share, and actives continue to shrink, but that is probably just a Darwinian stripping-out of the weaker active managers.”

Selecting and blending different styles within active management is key in creating better risk-adjusted returns for clients, says Andrew Summers, head of collectives at Investec Wealth & Investment, although the firm has been using ETFs for many years. They make for a useful investment tool and provide a catalyst for very important cost competition within the active fund management space, he says. 

“We are unlikely to use them for tactical purposes, rather, for long-term core exposure in liquid, efficient markets where we haven’t found an active manager who we believe can outperform, such as the US and UK large cap markets.  However, even in these situations, there will be many circumstances  – perhaps even the majority – when ETF exposure in these markets are supplemented by specialist active managers in the same sector, who do provide something different to pure beta exposure.”

As the market develops, Mr Summers sees lots of potentially interesting areas to explore in the future, including smart beta products, although these are not currently on the Investec menu.

Gavin Rankin, head of managed investments at Citi Private Bank, is yet to be convinced by the new wave of more innovative ETFs. “Given the nature of our clients and what they are trying to do, we haven’t embraced these. I think the growth in ETFs is set to continue as index replication methods improve and costs come down, but I am not sure it will be in these new strategies.”

As a house, Citi remains a firm believer in active management, but admits there is a time and a place for ETFs, and highlights bonds. “If you look at fixed income markets, you have a number of ETFs tailored to specific duration. Actively managed fixed income is not really going to produce significant outperformance from the market. I would say the growth of fixed income ETFs has been the most attractive aspect from the wealth manager’s perspective.”

The growth of ETFs has not necessarily been at the expense of actively managed funds, says Mr Rankin, although he admits ETFs can be “cleaner instruments” on certain occasions. “If you want exposure to a market, an actively managed fund brings with it manager risk and market risk, which at different points in time might be a hindrance or might be a positive.”

ETFs on the whole are well suited to quite beta-driven equity markets, says Mr Rankin, for example the US, which over the last few years has seen high stock correlations in a rising market. Almost all active managers have underperformed the market because it is very hard to pick winners when everything is going up, he says. 

“Once you move into market conditions that are much more driven by fundamentals and are seeing much more volatility, then active managers become more valuable.”

In inefficient markets, for example in the developing world, the return to stockpicking is much higher and ETFs lose their attraction, he claims, while also highlighting recent examples of very high tracking errors in some well known ETFs.

The growth of ETFs will only be bad news for active managers if they don’t recognise the ETF vehicle is here to stay, says Mr Li at ETF Securities. 

“We are talking about the best delivery vehicle for the underlying investors. If they say ‘I want to have a highly liquid, intra-day investment, but I like your active strategy’, if active managers  are open-minded enough to realise that they can deliver that same solution, but wrap it into an ETF structure where it can provide the client with that intra-day liquidity, then there is nothing to prevent them from entering the ETF space.”