Fast track growth ahead
The growth of Exchange Traded Funds (ETFs) in Europe has been nothing short of explosive. This growth rate has been particularly impressive when compared with the US, where it took over eight years to launch the same number of ETFs and over four years for assets invested in ETFs to reach $8.1bn (E8.3bn).
The first ETF in the US was the SPDR (pronounced spider). Launched in 1993, it tracks the S&P 500. Today, the SPDR is the most widely held ETF, with an open interest of $30.4bn. Currently, there are 106 ETFs and 17 HOLDRS listed in the US, most of them trading on the American Stock Exchange with some $91.5bn in assets.
The first three ETFs in Europe – LDRS (Listed Diversified Return Securities) – were launched in April 2000. ETFs tracking the Dow Jones Stoxx 50 and Dow Jones Euro Stoxx 50 indices were launched on the XTF platform of the Deutsche Borse, and one iShares FTSE 100 ETF tracking the FTSE 100 was launched on the extraMARK segment of the London Stock Exchange.
Six ETFs were launched in Europe during 2000, 65 in 2001 and 35 so far this year. The top 20 ETFs in Europe ranked by assets under management are shown in Figure 8.
Since the beginning of the year, 55 new ETFs have been launched worldwide and 41 ETFs have been cross-listed. Europe has accounted for all of the cross-listings so far this year and most of the new product launches. There have been 35 product launches in Europe, 10 in Japan and five in the US.
Assets under management in ETFs have increased by $19.5bn so far this year. The Japanese listed ETFs have had the largest inflows at $9.9bn, followed by the US listed at $6.9bn and European listed at $3.1bn.
Europe has the largest number of managers of ETFs, with 12, followed by the US and Japan, which each have four. Globally there are 21 firms managing ETFs. Indexchange, with 31 ETFs and assets of $1.98bn, is the largest manager of ETFs in Europe in terms of both the number of products and assets under management.
State Street Global Advisors (SSga) is the largest manager based on assets of $35.72bn and Barclays Global Investors (BGI) is the largest based on the number of ETFs, currently 81.
Over the past year in Europe, the number of sector ETFs has grown significantly. Today there are six ‘families’ of sector ETFs listed in Europe. The total annual expense ratios have been reduced on some ETFs, which has brought the average down to approximately 50 basis points.
The Italian Stock Exchange has recently launched a platform to trade ETFs and expects to start trading ETFs in the next few weeks. By the end of August 2002, after just over two years, approximately $8.7bn has been invested in 106 ETFs with 168 listings on eight exchange platforms in Europe.
The number of ETFs and assets under management grew during August. At the end of August there were 257 ETFs globally with 326 listings, with $124.2bn in assets under management.
ETFs enable investors to gain broad exposure to a particular market, industry sectors or regions with relative ease, on a real-time basis and at a lower cost than many other forms of investing. They can be used to sell short – subject to appropriate borrowing arrangements. They can be bought on margin, are lendable and are bought on a commission basis, like any other share.
ETFs can be bought and sold at market, limit or as stop orders. They do not typically have sales loads, although they do – like funds – have annual expenses. These typically range from 0.9% to 0.99%. ETFs have some of the lowest expense ratios among registered investment products: the annual expenses are typically deducted from dividend payments, which are typically paid on an annual basis.
ETFs offer numerous applications, which can appeal to institutional investors. These include:
o equitising cash flows’
o implementing a European sector allocation or sector rotation model’
o building an international portfolio (MSCI Pan Euro, Dow Jones Industrial Average, Dow Jones Stoxx 50);
o adjusting a sector, broad market or international exposure;
o hedging a sector, broad market or international exposure.
ETFs can be used to equitise cash flows in relatively small increments. The price for a share in an ETF ranges from €3 for both the EasyETF Euro STOXX 50 and EasyETF STOXX 50 to €344 for the EasyETF EuroStoxx Healthcare ETF; all of these ETFs are trading on Euronext Paris.
In most cases investors can buy and sell single shares of ETFs. ETFs can be a good alternative to using futures to manage cash flows. ETFs can be bought in smaller sizes than futures; they do not require any special documentation or accounts as long as a securities/cash account is open; and investors do not have to worry about roll costs and margin requirements. ETFs may not be marketed or sold in certain jurisdictions – given their structure.
ETFs are a useful tool for asset allocation. Investors can use them to target a variety of broad markets indices, sectors and regional indices. For settlement and administrative purposes, ETFs are a more efficient way of investing than purchasing a basket of individual stocks to track a given benchmark.
They can also be a core holding in a multi-asset portfolio, providing a level of diversification that would otherwise be time-consuming and expensive to attain by purchasing the underlying shares.
Major players in the ETF market traditionally have been large institutional investors seeking to index core holdings or pursuing more aggressive market timing and sector rotation strategies. However, since smaller institutions and retail investors can trade in small lots, they can invest with essentially the same terms as larger investors.
ETFs settle just like any other shares on the exchange. They are transparent, as the fund manager discloses the underlying basket of shares to the market every day. ETFs afford investors two forms of liquidity: first, through the trading of shares on a secondary basis on the exchange, and second the ‘creation’ process where an ‘authorised participant’ or ‘market maker’ buys the underlying basket of shares in the local market and deposits the basket ‘in kind’ with the ETF manager in exchange for more shares in that ETF.
The redemption process works in a similar fashion: the ‘authorised participant’ or ‘market maker’ delivers ETF units to the ETF manager and takes delivery of the underlying basket of shares. This unique creation /redemption process means that the liquidity in the ETF is driven by the liquidity in the underlying shares.
Unlike closed end funds, ETFs tend to trade at or close to the net asset value (NAV) of the underlying basket of shares. There are arbitrageurs waiting to take advantage of significant premium or discount relative to the underlying index. An arbitrageur would typically buy/sell the ETF and place an offsetting buy/sell transaction in the underlying basket of component stocks or futures.
Small performance differences between an ETF and the index it tracks can be due a number of factors: fund fees and expenses; a slight premium or discount; tracking error because of optimised replication of the tracked index; rebalancing due to index changes; dividend reinvestment policy of the fund; and non-concurrent trading (for example, the Japanese market is closed while an ETF listed on the Swiss exchange tracking a Japanese benchmark is trading).
Over the next two years in Europe, ETF assets are expected to more than double from their current level of $8.7bn. The number of ETFs are expected to exceed 150 products, and the number of managers launching ETFs are expected to increase. The numbers of exchanges listing ETFs are likely to grow, and total expense ratios will fall further. ETFs will be created on fixed income indices, and listed options on ETFs will be developed. The future of ETFs looks assured.
Deborah Fuhr is vice president at Morgan Stanley & Co International, in London