Contrasting the development of ETF markets

Deborah Fuhr and Shane Kelly chart the rise in ETFs over the past 16 years and look at how the US and European markets have developed

The global ETF industry has grown from nothing into a multi-billion sector in 16 years, and there are no signs that investor interest in ETFs is fading, despite the current market.

Global ETF assets have hit an all time high of $862bn at the end of July 2009 – 7% above the previous all time high of $805bn set in April 2008. The global ETF industry had 1,768 ETFs with 3,129 listings, from 94 providers on 42 exchanges around the world at the end of July 2009. Year to date, assets have risen by 21.2%, which is more than the 13.5% rise in the MSCI World Index in US dollar terms.

US development

In 1993, State Street Global Advisors (SSgA) launched the first ETF in the US, the Standard and Poor’s Depository Receipt (SPDR), working with a team at the American Stock Exchange. It has since become not only the largest ETF with $69.4bn assets under management at the end of July 2009, but the most actively traded equity security anywhere in the world, with average daily trading volumes of $19.3bn per day. 

The SPDR was launched as a united investment trust (UIT), which is different from a registered investment company (RIC) in many ways, but notably because a UIT does not allow for dividend reinvestment or securities lending which can help enhance the performance of the fund. 

Barclays Global Investors launched World Equity Benchmark Shares, or WEBS, their first ETFs in 1996. These ETFs were subsequently renamed iShares MSCI Index Fund Shares. WEBS were launched as RICs and were particularly innovative because they gave retail and institutional investors easy access to 17 foreign markets.

In 1998, Merrill Lynch developed the sector SPDRs, which are designed to unbundle the S&P 500 index into nine tradable sector funds. SSgA also collaborated on the development of the sector products, as well as continuing to advise the funds.

Globally, ETFs were initially embraced by institutional investors, including hedge funds, as they were used as trading tools to equitise cash and to implement both long and short strategies. ETFs had the exemption to the uptick rule, allowing investors to ‘go short’ even when the last price of the ETF was ticking down. But registered investment advisers (RIAs) also embraced ETFs, when they moved from a commission-based advisory model to fee-based. Today, the retail market in the US accounts for approximately 40% of all assets invested in US-listed ETFs.

US ETF assets have hit an all time high of $582bn at the end of July 2009, which tops the previous all time high of $581bn set in December 2007. The US ETF industry had 706 ETFs from 22 providers on three exchanges at the end of July 2009. Year to date, assets have risen by 17.2%, which is more than the 10% rise in the MSCI US Index in US dollar terms.

Route into Europe

In the late 1990s, many European investors began asking why there were not ETFs listed and domiciled locally in Europe, as they became aware of the fact that ETFs and mutual funds which are structured as RICs are required to distribute their income at least once a year and also any short-term capital gains they realise. The resulting distributions to non-US investors are paid out subject to withholding tax. 

The first ETFs in Europe were the STOXX 50 LDRS and Euro STOXX 50 LDRS, introduced to the Deutsche Boerse in April 2000 by Merrill Lynch. At the end of April 2000, BGI entered the ETF business by listing their first ETF on the London Stock Exchange – the iShares FTSE 100. The original LDRS ETFs were subsequently acquired by iShares in September 2003 and rebranded to join the iShares family, which then became the largest ETF provider in Europe.

Transaction reporting is required for all ETF trades in the US and account for over 30% of the average daily volume in the US equity markets. However in Europe, ETF trade reporting is not required under the Markets in Financial Instruments Directive (MiFID) as they do not fall under its definition of ‘shares’ and are thus not subject to the MiFID transparency regime. As a result, less than one third of ETF trades in Europe are reported on exchange.

The majority of investors using ETFs in Europe are using them as trading vehicles as well as part of longer-term strategies such as core-satellite or tactical asset allocation. The use by retail investors has been somewhat limited over the past nine years, however recent proposed reforms such as the Retail Distribution Review (RDR) by the Financial Services Authority (FSA) in the UK is expected to influence the way financial advisers across Europe use ETFs going forward. Firms that describe their advice as independent will have to broaden the range of investments they advise on to include ETFs and structured products.  

ETFs take centre stage

Following Lehman Brothers’s bankruptcy, many investors have shown an increased preference for ETFs, which are transparent, liquid, tradable, use a mutual fund structure and invest in-specie in physical securities over derivative and ‘issuer-guaranteed’ products such as swaps, certificates and structured products.

Many investment banks and brokers have seen this preference for ETFs and decided to become managers themselves by listing their own set of swap-based ETFs, utilising their existing derivatives capabilities and the flexible nature of the Ucits III guidelines, which allow for the use of derivatives within a mutual fund structure. 

This evolving landscape of products and structures has provided investors with greater choice and flexibility to select products which are the most efficient for their specific requirements, but it also makes it more challenging to understand the differences and risks inherent in each. Europe is a much more fragmented financial marketplace, in terms of tax, regulations and language.

The future looks positive for ETFs, with several factors driving this growth, including:

• Growth in the number of institutional and retail investors who use ETFs and view them as useful tools. 

• Regulatory changes in the US, Europe and many emerging markets that allow funds to make larger allocations to ETFs. 

• The number and types of equity, fixed income, commodity and other indices covered. 

• Development and growth of investment styles that employ products like ETFs that deliver low-cost beta. 

• The growing number of exchanges which plan to launch new ETF trading segments. 

• The expectation that there will be a number of new issuers/managers of ETFs.