Carving a niche

Total expense ratios are being pushed down as new entrants manoeuvre into the ETF arena. But is there room for more funds tracking the same core indices? Helen Fowler reports

Despite the fact that most leading providers of European ETFs lost market share last year, there was a notable exception to this trend. The firm in question was not a long-established player, but a virtual newcomer that remains unknown to many people outside the industry.

ETFlab Investment launched its first ETF only two years ago. But in that short time the German firm has already succeeded in gathering more than 3% of the European market. 

Its success shows how much potential remains for entrants to the $218bn business in Europe, and it helps illustrate why so many other firms, many of them big asset managers, have either recently entered the ETF market or plan to do so. 

“We expect entrants to be coming in all the time,” said Hector McNeil, managing director at ETF Securities (ETFS). 

Since its launch in 2008, ETFlab has risen to become one of the five largest ETF providers in Europe. It was alone among the top five players in growing its assets last year, by 1.4% according to research by BlackRock. 

In contrast, this data shows market leader iShares suffered a 0.8% fall in assets, second-placed Lyxor Asset Management lost nearly 4% while db x-trackers, in third place, dropped 0.2%.

Source, the ETF platform backed by investment banks initially including Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley, is another example of a successful recent entrant to the market. It has amassed a 1.3% market share since its launch less than a year ago, placing it eleventh in the European ETF market. 

Other firms are either entering the market or beefing up their existing presence. UBS Global Asset Management, ranked tenth, has plans to launch more than 20 ETFs in Europe in coming months. 

HSBC Global Asset Management entered the market last August, when it launched a FTSE 100 ETF product. The firm says it plans to have a suite of 30 ETFs by the end of this year and wants a 10% market share by 2012. Last year Pacific Investment Management Company (Pimco) and Charles Schwab launched 15 ETF products, which have since accrued $820m in assets. 

“Several firms made a splash with ETF launches in 2009,” said State Street Global Advisors (SSgA) in a report on the ETF industry. 

Goldman Sachs Asset Management, John Hancock, T. Rowe Price, Putnam and Russell Investments are among those firms planning to launch ETFs in coming months. 

Credit Suisse Asset Management is also expanding into the area. Dan Draper, former head of ETFs at Lyxor Asset Management, has joined the firm. “Dan’s extensive experience will be invaluable as we continue to grow the business,” said Oliver Schupp, head of beta strategies at Credit Suisse Asset Management. 

London-based hedge fund manager Marshall Wace is planning to enter the arena in the next couple of months, with an equity market-neutral ETF based on one of its proprietary indices. 

Pushing down costs

As new entrants arrive in the ETF market, expense ratios have fallen. “Most categories of ETFs have seen a decline in average cost over time as new entrants came to market with lower costs,” said Bradley Kay, associate director of European ETF research at Morningstar in Chicago. 

“This is especially clear with the sector equity products,” said Kay. Expenses on sector products have typically halved since 2005, according to Morningstar, dropping from just over 50 basis points (bps) to around 25bps. “Total expense ratios may come down further with more market entrants,” said Kay. 

However, questions remain over how new players can carve out market share. There are already 33 ETFs based on the Euro Stoxx 50 index, with collective assets of $32.4bn, according to BlackRock. The FTSE 100 index is almost equally crowded, with 13 ETFs and $7.3bn in products tracking the benchmark. 

“A very real concern is whether there is enough room for another CAC 40 based ETF,” said Kay at Morningstar. “The answer is, quite possibly not.”

Deborah Fuhr, global head of ETF research at BlackRock, said: “I don’t think we need any more ETFs on the core benchmarks, but we will see more of them. It’s a mistake for the index providers to keep licensing more and more products. We don’t need any more. It’s confusing and it fragments liquidity.” 

Nizam Hamid, head of sales strategy Europe at iShares, said it made sense for new entrants to focus on niche products. “There is limited value to be had in launching a new set of ETFs on existing indices,” he said. “People are all trying to do different things.” 

When Osmosis Investment Management set up 18 months ago to invest in climate change, it decided to offer an ETF to tap this sector. June Aitken, partner at Osmosis, said: “We thought the best way of offering exposure was through a cost-effective and accessible ETF.” 

The Osmosis Climate Solutions ETF launched on the London Stock Exchange on February 8. It tracks an index of a hundred global companies that earn money from the “efficient use of natural resources and the mitigation of climate change.” Aitken said: “We believe there is room in the market for innovative thematic products.”

Defining ETFs

As new players enter, the definition of an ETF is changing. Fuhr said: “The definition of an ETF continues to be used inconsistently to describe products that are very different.”

The ‘traditional’ ETF trades intra-day, is open-ended, transparent, and has in-kind creation and redemption. “What’s happening as you get new entrants come in is that they will not have the same transparency on underlying portfolios, real-time net asset valuations or in-kind creation and redemptions,” said Fuhr. “It can be confusing.”

The arrival of new products may force the ETF industry to agree on its definitions, said Fuhr. “One of the key challenges is that the Securities and Exchange Commission (SEC) has a definition of an ETF but most banks and brokerages do not follow that definition when writing reports about ETFs and exchange-traded products (ETPs). There are likely to be a lot of new products called ETFs that don’t follow the SEC definition of what an ETF is.”

Another increasing trend is for banks to enter the ETF market by becoming market makers on existing platforms, such as Source and ETFS’s ETF Exchange (ETFX). In February, JP Morgan and Nomura joined Source as shareholders.  

Kay at Morningstar said: “We are seeing new entrants coming in by partnering up and serving as another market maker on existing products rather than coming out with new products. We are likely to see more of that.” 

He explained many of the banks are eager to move into synthetic ETFs. Kay said. “It gives their equity desks the opportunity for extra income generation and arbitrage. So it’s profitable for market makers.” He added: “The hope is that as banks get lower and lower prices on the swap they will pass that on to investors.”

ETFS has set up ETFX, a platform that spreads index replication across a range of financial institutions. “Entry costs are significant for a bank. We went to the banks and said, ‘Rather than you fight against us why don’t we work together?’” said McNeil at ETFS. In February, Barclays Capital joined ETFX as a swap provider and authorised participant, joining forces with Bank of America Merrill Lynch, Citibank and Rabobank. 

McNeil said: “We created a platform that everyone co-owns. If a bank creates shares in an ETF they get to write the swap, which is the profitable part of the deal.” 

Active management on the rise

New entrants are also leading to increased numbers of actively managed ETFs. “The emergence of well-renowned mutual fund managers in the ETF space leads to speculation that actively managed ETFs will gain greater prominence in years to come,” said SSgA. “Active products have arisen from reputable and proven active managers.” T. Rowe Price is among those firms looking to roll out actively managed funds.

With the ETF market so crowded, newer entrants are looking for other niche areas where they can add value. “Investors are searching for new, effective tactical uses for ETFs in arenas apart from traditional large-cap equities,” said SSgA.

Being a new entrant can mean disadvantages. “It’s a volume game,” said one industry participant. “And that can be a challenge for a small, new player. There are concerns about economies of scale and getting to a sufficient size quickly enough.” 

But the European ETF market remains immature, with just $218bn in assets, making it less than a third of the size of the $705bn US market. As assets for global ETFs continue to grow, reaching a new high of $1trn at the end of last year, there is incentive for further new entrants to join the market. Not that more incentive is needed, judging by the level of existing interest.