10 years of ETFs in the UK and Europe

The arrival of the new millennium saw the birth of ETF markets in the UK and Europe. Emma Dunkley looks at how this ETF landscape has been shaped by certain events over the last 10 years

The first ETF listings

The first ETFs in Europe were listed by Merrill Lynch on 11 April 2000, when the firm unveiled two LDRS ETFs tracking the Eurostoxx 50 and Stoxx 50 indices on the Frankfurt Stock Exchange. Shortly after on 28 April, iShares created and listed the first ETF in the UK, with the launch of its FTSE 100 fund on the London Stock Exchange (LSE). By the end of August that year, the UK’s inaugural ETF had garnered over £110m in net new assets, a substantial amount for a brand new product.

Rory Tobin, head of iShares International, said the fund now stands as the fifth largest ETF in Europe, with over $5bn in assets under management. “The iShares ambition when we started the business was to ‘build a better world of investing’,” said Tobin. “One that was founded on some key principles such as transparency, multi dealer approach to provision of liquidity, choice in relation to availability of investment options and cost effectiveness in relation to the value for money proposition”. Tobin added: “We have continued to fulfil this promise by launching over 400 products in the past 10 years, empowering investors with core building blocks to implement their investment strategies in a flexible and cost efficient way.”

Regulatory developments

Arguably one of the most significant factors influencing the development of the European ETF market has been the Undertakings for Collective Investments in Transferable Securities (Ucits) directives. The arrival of Ucits III guidelines, which were passed as law in 2001 and underwent implementation from 2002, paved the way for issuers in Europe to create ETFs using swaps and other derivatives.

Manooj Mistry, head of db x-trackers UK, said prior to Ucits III, the industry lacked clear rules on whether Ucits funds including ETFs could utilise swaps. Consequently, Mistry said the use of derivatives within these funds was not consistent, varying among issuers across Europe. He explained regulators in the UK and Ireland typically tended to be strict about funds using derivatives, whereas in Luxembourg and France, ETFs were already using swaps through the synthetic replication method.

Indeed, Mistry said the implementation of Ucits III served to create a more level playing field for all issuers across Europe, in terms of how they could establish funds and how they could use derivatives.

The process of passporting funds domiciled in one country to another was also simplified by Ucits III. Mistry said: “Before Ucits III there was some inconsistency in terms of registering your fund in jurisdictions.” He explained the process of passporting the first ETFs into Italy took the LDRS team at Merrill Lynch around 18 months in order to register them, although this process was reduced to two months following Ucits III. He added: “Ucits IV, coming in 2011, will simplify the process even further and should bring the time to register down to 10 days.”

Synthetic replication

Under the clarification of Ucits guidelines, Lyxor Asset Management developed the synthetic replication method in 2001 by using a swap to deliver the performance of the respective benchmark. Since then, numerous issuers have followed suit by launching swap-based ETFs, and this has evolved to produce multi-swap provider models, as exemplified by ETF Exchange and Source.

BlackRock global head of ETF research and implementation strategy Deborah Fuhr said: “In the early days, managers of ETFs were all asset managers and they bought underlying securities; that was the way it worked. With regulatory changes through Ucits, ETFs and funds were launched using listed and over-the-counter derivatives, so we saw the emergence of swap-based ETFs come into being, from banks and brokers primarily.”
Claus Hein, head of Lyxor ETFs UK, Nordics and Latam, said Ucits presented the opportunity for ETF providers to consider different index replication methods. He explained the use of swaps within an ETF enables investors to efficiently access a number of markets that are otherwise difficult or impossible to replicate using traditional index management techniques. Hein said: “We pioneered this method with the launch of our CAC 40 and DJ Euro Stoxx 50 ETFs in 2001 and currently follow this process across more than 164 products.”

Index licensing and innovation

The licensing of indices has influenced the nature of the European ETF market to a large extent. Fuhr at BlackRock said the European industry got off to a different start compared with the US, after index provider Stoxx decided to grant five licences at the beginning, as opposed to having one ETF tracking the Eurostoxx 50 or Stoxx indices. She said: “The implications of this for the ETF industry were multiple products on multiple exchanges, therefore fragmenting liquidity.”
In comparison, Standard & Poor’s (S&P) licensed its S&P 500 index to the SPDR ETF in the US as the sole product tracking this benchmark for many years. Fuhr said: “If we had the same arrangement in Europe, there would have been a large Euro Stoxx 50 ETF with a lot of on exchange liquidity, with higher assets and higher trading volumes.”

Innovation in the index space has complemented the creation of new types of ETFs. Mistry at db x-trackers said Ucits III enabled funds to link to the performance of financial indices, although the definition of eligible benchmarks was quite vague. The Committee of European Securities Regulators (Cesr) subsequently clarified this definition, allowing for the creation of commodity indices and the first commodity ETF in 2005.

The development of ETFs based on fixed income indices also represented a landmark in the industry. Morningstar European ETF research director Bradley Kay said there were some fixed income based tracker funds in the past, although these tended to be relatively limited and did not cover specific sectors, tracking aggregate indices as opposed to credit indices. He explained these fixed income indices were initially created for benchmarking the bond desks at various firms, rather than for the intention of launching products off the back of them.

Kay said: “There is now a proliferation of vehicles which cover entire swathes of the bond market, repacking it into a vehicle that is far more liquid than any of the underlyings. To a great extent, fixed income ETFs are somewhat transformational.”

Another area of innovation follows Cesr permitting Ucits funds to track hedge fund indices in October 2007, consequently allowing the launch of the first hedge fund index ETF by db x-trackers in March 2009.

Stamp duty

The abolition of stamp duty for ETFs enabled foreign issuers to list in the UK without investors incurring stamp tax. Consequently, providers such as Lyxor and Deutsche Bank were able to list their products on the LSE. Tobin from iShares said: “The UK authorities are to be applauded for the measures they have taken to facilitate the growth of ETFs in the UK. This decision gave investors even more of a choice when investing in ETFs and also represented a strong validation of ETFs as a distinct investment tool.”

ETCs and commodities

The launch of ETCs added another dimension to the growing exchange-traded product landscape. Hector McNeil, managing partner at ETFS, said the firm released its gold bullion securities ETC on the LSE in 2003. He said: “This was the first ETC in the UK, 100% backed by gold bullion in a vault. We now have over $4.5bn in that product.” In 2005, McNeil said ETFS created the first oil ETP, formed in a joint venture with Shell.

Although the ETC vehicle is revolutionary in providing investors with liquid and low-cost exposure to this asset class without requiring the need to directly hold futures or be involved with physical commodity delivery, the note-based structure of ETCs must be distinguished from the fund structure of ETFs. Fuhr at BlackRock said the challenge now is not to muddy the water in terms of defining ETFs; it must be clear that ETCs are different to ETFs.

Indeed, concerns with certain ETCs amounted with the financial crisis in 2008. McNeil said: “The ETCs were backed by AIG and had a collateral mechanism which only tripped if the firm’s credit rating fell below A.” However, even towards the end of AIG’s bail out the firm was still A-rated. As the mechanism had not been triggered, ETFS decided to invoke it, meaning the products became 105% collateralised. McNeil said this meant the platform became one of the most robust structures globally. He added: “Although assets in our ETCs fell to around $1.5bn, they have since ballooned to over $6bn. The incident highlighted the need for collateral and the different types of ETP structures out there.”

The fall of Lehman and counterparty risk

The demise of Lehman Brothers in 2008 pushed counterparty risk to the fore of concerns, with many investors seeking to mitigate this through a fund wrapper. Fuhr at BlackRock said: “The impact of concerns about counterparty and issuer risk drove people to prefer ETFs over other products.” ETFs found favour, with counterparty exposure through a swap limited to a maximum of 10% of a fund’s total value in accordance with Ucits, and with many providers managing their swap exposure below this limit.

Hein at Lyxor said: “An important trend became very clear throughout the crisis – investors really wanted to understand how ETFs are managed and how these are actually able to track index returns.” As a result, he said issuers, brokers and other market participants set out to explain how portfolios are constructed, the type of instruments held and used within a fund, whether managers lent out these holdings, and the overall application of Ucits guidelines. He added: “All in all, the events of 2008 and everything else that followed helped strengthen the level of communication we have with our clients.”

Retail Distribution Review

The Financial Services Authority’s Retail Distribution Review (RDR) has been dubbed one of the biggest driving forces in manoeuvring retail investors and independent financial advisers (IFAs) into the ETF space. Tobin at iShares said: “Traditionally, ETFs have not been sold to the retail investor in any great volume because of a lack of education within the adviser community.” However, the RDR requires IFAs to offer ETFs as part of the new ‘across the market’ advice they provide to retail investors. He added: “These funds are highly suitable for retail clients, as exemplified by the uptake in the US retail market.”