ETFs enter adolescence

As ETFs celebrate a decade in Europe, Morningstar associate director Bradley Kay, looks at what the next 10 years will hold.

Exchange-traded funds, or ETFs, celebrated their first decade in Europe this April. Like any other 10-year-old, ETFs are fast-growing, rapidly changing, and full of promise. These funds began humbly, with the simplest of broad stock indices, but have since proliferated to cover nearly every asset class imaginable. Investment structures grew in complexity, costs fell, and assets skyrocketed. Still, these funds only represent a tiny percentage of investible assets across Europe and will continue to see tremendous changes in the coming years. The potential benefits of investing in ETFs have never been greater, but the need for investor education about these increasingly complicated funds remains considerable.

Humble beginnings, unhumble growth

Merrill Lynch listed the very first ETFs in Europe on the Deutsche Börse on April 11 2000. These funds tracked the Stoxx 50 and Euro Stoxx 50 indices by holding the underlying equities, a small step from traditional tracker funds (the first European ETFs have since been folded into the iShares line-up). By the end of that year, there were six ETFs across Europe with combined assets of less than £1bn. As 2010 began, Europe had nearly 1,000 ETFs and related products with around e160bn in assets. For those counting at home, this asset growth works out to a stunning 90% annualised rate for the nine year period.

The first few ETFs covered large European stocks. Today, you can buy nearly any slice of the global equity markets in an ETF, from European travel and leisure companies to small companies in emerging markets. There are ETFs concentrating on high-yielding stocks, infrastructure-related companies, and real estate. Some funds even weight their stocks differently from the market, resulting in new portfolio concentrations heavy on low-priced stocks and industries. In 2003, the first bond ETF launched in Europe, tracking the Eurex Bonds index of German government issues. Again, today, fixed-income ETFs offer bond indices that focus on nearly every possible quality of issuer, portfolio maturity, and major currency. 2003 also saw the launch of the first commodity ETF in Europe, with the physical gold fund from ETF Securities listing in London. Today, the array of exchange-traded commodities (or ETCs) is absolutely dizzying.

The structures of exchange-traded products grew and morphed almost as quickly as their underlying investments. Early funds held stocks and bonds matching their intended benchmark index in a trust owned by shareholders, and met all the diversification and liquidity rules in that day’s UCITS regulations. Single-holding funds such as physical gold funds required a new structure, and the ETC was born. These funds use special-purpose vehicles instead of traditional trusts, and issue debt instead of shares, in order to make themselves broadly available for sale under the EU’s Prospectus Directive. Still, the first ETCs offered many of the same protections for investors as traditional index trackers, by directly holding the underlying securities in a separate legal entity.

Exchange-traded products really became complicated with the first exchange-traded notes, or ETNs. These notes presented a radical change, as they no longer had the backing of a fund holding the index’s underlying securities. Instead, ETNs are unsecured debt issued by a backing bank, with a promise to redeem the notes for the value of a benchmark index (minus expenses) at the end of any business day. ETNs are cheaper and easier to create than traditional ETFs or ETCs, and allowed backing banks to offer new and esoteric asset classes in a widely-accessible wrapper. But, for the first time, exchange-traded products contained serious counterparty risk.

The next major evolution came with the passage of UCITS III regulation in 2005. Funds across Europe could now hold over-the-counter derivatives to gain their investment exposure, and exchange-traded funds embraced this new ability with astonishing zeal. The swap-based, or synthetic replication, ETF stems from this regulatory change, and offers unbeatably low tracking errors with the chance for higher returns through avoiding dividend withholdings and investing collateral to produce greater income. However, synthetic ETFs also provide much less transparency than their physical replication counterparts, as collateral baskets are rarely disclosed. These funds also often carry greater risk of disruption in the case of a provider defaulting, since the provider is typically the main swap counterparty. Still, these potential drawbacks have not prevented synthetic replication from taking over nearly half the European ETF market by assets.

The next 10 years

ETF industry observers thrill to the idea of an exploding retail market for European ETFs, as they see figures suggesting individuals and advisers account for only 10%-20% of European ETF assets versus nearly 50% in the US market. However, there are large impediments to this potential growth. Compared to the US, there are simply fewer assets in accounts managed by individuals or advisers, due to the more robust pension and private wealth manager systems in Europe. The majority of European advisers still rely on commissions to generate fees, which makes them unlikely to select low-cost ETFs that generally offer no rebates to advisers. The UK’s Retail Distribution Review may change this compensation system and its perverse incentives more rapidly in this country, but that will not generate tremendous retail demand for ETFs across Europe until other regulatory bodies follow in the FSA’s wake. Continued asset growth may come from the inchoate retail market, but larger inflows from institutions seem more likely in the first few years.

Looking to the future

What else does the future hold for European ETFs? Providers will keep packaging new investment strategies, with the most exciting products coming from the alternative investments space. A few actual hedge funds have found success in ETF wrappers, showing the demand for these uncorrelated assets after the crash of 2008-2009. Simple rules-based strategies exploiting returns momentum or other known hedge fund investments could produce cheap and transparent substitutes for the hedge-fund wrappers while staying compliant with UCITS III regulations. In the next several years, I expect to see merger arbitrage, convertible arbitrage, and managed futures (at the least) available in European ETFs for expense ratios of less than a percentage point, opening these previously inaccessible sources of uncorrelated returns to all investors.

Finally, liquidity will continue to improve, as the “exchange” gets put back into “exchange-traded funds”. Until now, a base of large, low-turnover institutional investors has mostly relied on market makers to fill their massive buy and sell orders, explaining the huge amount of off-exchange trading in the European market. That looks set to change with the entry of hedge funds, which use ETFs to invest in macroeconomic or valuation calls, or hedge their portfolio to remain market neutral. These nimble institutions demand greater on-exchange volumes, to reduce transaction costs and use their own proprietary trading algorithms, which in turn makes the market more liquid for individual investors. This virtuous cycle of greater volumes begetting lower costs begetting greater volumes is nigh inevitable over the next decade.

The European ETF industry may have reached adolescence this spring, but adulthood is still a long way off.