Spectacular
While a number of commentators were initially disappointed with the
asset growth of ETFs in Europe, we believe that the growth has been –
and still is – quite spectacular. Despite prolonged stock market
declines between 2000 and 2002, ETF assets doubled in each of these
years. This almost exactly mirrors the development of ETFs in the US,
where between 1994 and 2000 assets under management doubled every year.
The growth in the US only slowed down with the onset of the equity bear
market in early 2000, but this has picked up again, with assets growing
by an impressive 50 per cent in 2003. In Europe, ETFs continued their
growth trajectory during 2003, increasing by more than 90 per cent.
The ETF market is on track to again double in size during 2004, reflecting continued interest from European investors.
US mirror
While the early stage growth pattern of European ETFs mirrors the
development of their US counterparts in asset terms, this has been
achieved via a significantly different product offering. The relatively
large number of different funds available in Europe (more than 100) is
the direct result of a fragmented European market place. The ETF market
is similar in many ways to the traditional European mutual fund market,
where large numbers of products are needed to provide locally tailored
solutions, as funds cannot always be distributed on a pan-European
basis.
The average size of a European ETF is currently around US$220m,
compared to US$1.2bn for US ETFs. However, this size differential looks
less pronounced when compared to the average size of US$350m for US
ETFs in 1997, at a similar stage of this market’s development.
Sector ETFs remain the big disappointment of the launching spree that
took place during the three-year period ending in Q3, 2003. These
products were expected to grow dramatically, the only uncertainty being
whether global or regional sectors were the game to play. It is now
clear that neither of the two have, to date, proved a success. It is
therefore no surprise that more than 30 sector products have already
gone to the wall. Their failure is largely a result of the aftermath of
the 2000-2002 equity bear market that saw investors return to a focus
on fundamentals, avoiding ‘theme’ and ‘idea’ based investments.
Workings
Exchange-traded funds are, as the name implies, funds traded on a stock
exchange. ETFs consist of two different markets: a primary market for
subscription and redemption of shares, and a secondary market at the
exchange, where they are traded. (See Chart 2.)
In the primary market, market specialists create and redeem shares in
the ETF at its net asset value (NAV) on a daily basis. This is done in
large blocks of shares, typically in excess of E1m, which represents a
creation or redemption basket. These new shares, once created, can then
be traded in the secondary market.
In the secondary market, ETFs are bought and sold in exactly the same
way as equities. This is a key difference between ETFs and mutual funds
as investors do not subscribe/redeem units with the fund management
company, rather they execute buy/sell orders through a stockbroker
dealing directly with stock exchange market makers.
Due to the fact that an ETF is linked to an index, market makers can
easily provide continuous pricing because its intra-day NAV moves in
line with the respective index. This unique feature allows market
makers, arbitrageurs and other market participants to trade the ETF
close to its intra-day NAV, as any discount/premium is likely to be
rapidly closed by investors for a risk-free profit.
Some observers have also expressed concerns about the liquidity of
these new vehicles. However, this subject is very often misunderstood,
as an ETF’s actual liquidity is a function of the marketability of the
underlying securities held in the fund (and therefore of the index).
Investors can easily go to a market maker and fix the price of an ETF
off-exchange (ie intra-day NAV plus spread and commission).
Users
There are a number of different investors that currently trade ETFs.
These include private client stockbrokers managing discretionary
portfolios, fund of fund providers, as well as professional investors
for specific strategies such as structured products and cash
equitisation.
Future trends
The development of the industry in Europe over the near term will be
characterised by further new product launches, together with
consolidation amongst existing ETFs that have not achieved critical
mass. We see established providers such as XMTCH and iShares continuing
to grow and enhance their market share in Europe.
While we also expect more equity ETFs to be launched, the number of new
vehicles is anticipated to be much smaller compared to previous years.
This is due to the fact that most of the blockbuster products (Eurozone
and local indices) have already been launched, with few product gaps
remaining.
New product development will continue to focus on fixed income ETFs,
which are expected to prove attractive to investors for the following
reasons:
- Government bond ETFs with a specified term structure allow the investor to remain within a maturity window without constant portfolio re-balancing, and
- Corporate bond ETFs enable investors to obtain exposure to a diversified, investment grade credit portfolio.
One of the key developments over the medium to longer term will be the increased cross-border listing of ETF products.
Some progress has been made in this area, but more is necessary as this remains a cumbersome process in many European jurisdictions, largely due to a fragmented market place characterised by different regulatory regimes and stock exchanges.
Cross-listing is important in Europe, because securities bought in the domestic market are usually cheaper (through lower commission) than securities purchased abroad. Once this process starts to gather pace, a consolidation amongst ETF providers is anticipated as a more homogeneous market structure takes shape across Europe.
In summary, the European market has expanded rapidly over the past three years. Whilst development in certain areas went too far, ETFs remain one of the most interesting financial innovations of recent years and, going forward, they are expected to continue to grow significantly.
The best of ETFs
Here are three key benefits of exchange-traded funds:
- They combine the flexibility of equities (intra-day trading and pricing on a regulated exchange) with the diversification and efficiency of a fund.
- They are a simple, cost effective way to gain exposure to an asset class in a single trade.
- They provide a core building block for an investment portfolio as part of an asset allocation strategy.
Markus Hübscher, managing director, head of quantitative portfolios,
Credit Suisse Asset Management
