There is no doubt that the market downturn has accentuated and accelerated the growth trend of exchange traded funds (ETFs) in Europe.
Investors, increasingly concerned about counterparty risk, transparency, product structure and liquidity, worries triggered by the credit crisis and Lehman Brothers’ bankruptcy, have found a safe harbour in these passive instruments, which trade on stock exchanges and are designed to deliver performance of the underlying index. In 2008, ETFs domiciled in Europe grew by 11 per cent to reach $142.82 (E113.4bn) in assets under management with net inflows of $76.5bn, while European domiciled mutual funds (excluding ETFs) registered net outflows of $495.1bn, according to Barclays Global Investors (BGI) research.
The key product strengths of ETFs – liquidity, cost efficiency, transparency and their multiple brokers model, which protects investors from the risk deriving from being tied to a single issuer as in the case of a certificate – have drawn significant investors’ interest, says Deborah Fuhr, global head of ETF research and implementation strategy at BGI. Moreover ETFs are attractive in periods of high volatility and correlation to make tactical calls, as investors can trade them in small volumes at any time during the day.
It could be argued that when stock dispersion is limited or correlation between classes is very high, as it is today, active managers find it more difficult to generate alpha and as a consequence ETFs provide a better option to maintain market exposure. But the growth trend is likely to continue, even after the market recovers. In a way, the market turmoil brought these instruments closer to investors.
“The key challenge for ETFs is getting investors to do that first trade and once they do it, and they use ETFs, then they are kind of hooked, because they are a good tool,” says Ms Fuhr at BGI. Regardless of the market cycle, there are always good ways to use ETFs, she says.
According to BGI, in 2009 European ETFs assets will exceed $200bn. Global ETF assets are expected to exceed $1,000bn, a figure which will double by 2011. “The entire fund management industry, and particularly its active community is going to come out of the current downturn with their business models completely reviewed and changed,” believes Dan Draper, global head of Lyxor ETFs, Société Générale Corporate and Investment Banking.
The ability to measure performance attribution and separate how much of an investor’s return is coming from the market (or beta) versus how much is outperformance or alpha, is driving asset managers to focus on their core competency and decide whether to outsource the rest of their portfolios to active managers, or, when active managers are not able to consistently generate alpha, to use instruments like ETFs to gain market exposure in the cheapest way possible.
Sophisticated investors, able to distinguish whether they are paying for alpha or beta returns, are also driving these changes forward.
Increased use in wealth management
The fact that ETFs do not pay a rebate to intermediaries has represented a big hurdle in the uptake of these instruments by private banks, which traditionally operate on a commission-based model and are reluctant to give up the higher margins, often in terms of front end commissions, obtainable by more remunerative products, such as funds or structured products.
However, increasing demand from educated and more knowledgeable high net worth investors has made them more acceptable in the wealth management space.
“On the discretionary management side, wealth managers wanting to reach the efficient portfolio frontier have been adding new asset classes in their asset allocation such as emerging markets, commodities, private equity, real estate, which are now all available on ETFs,” points out Mr Draper.
“But it is in the advisory side where we probably see much more use of ETFs at this time, because high net worth investors have become more aware of ETFs, like to have more of a hands-on approach in managing their own money and want to do it cheaply,” he adds.
Indeed, on the discretionary side there are also interesting developments. In the past six months, wealth managers have started putting together discretionary portfolios of ETFs, where both strategic and tactical asset allocation is implemented using these instruments, explains Eleanor Hope-Bell, head of wealth management sales at iShares, the ETF brand spun out of BGI.
This recent development in the usage of ETFs is largely market driven and due to the fact that investors are not willing to pay fees to active managers who fail to outperform the benchmark, she says.
“We are seeing how a lot of private banks have created either portfolios or funds of ETFs and they charge a flat fee to manage them. Even IFAs, who are so commission-driven can use ETFs, but still make money,” says Ms Hope-Bell.
