So far, three exchange-traded funds (ETFs) have been launched in Europe. Mercury-Merrill has launched the Euro Stoxx 50 and the Stoxx 50 funds, listed on Frankfurt’s Deutsche Börse and Barclays Global Investors has launched an FTSE 100 ETF, listed on the London Stock Exchange.
Bringing ETFs to Europe hasn’t been easy. Both organisations met head-on with regulatory roadblocks and decided to register the products in Dublin. In fact, this is the first time where funds are domiciled outside of the market that the underlying stocks in the ETFs trade and settle.
For the uninitiated, a quick primer on ETFs may be in order. ETFs are index-linked investment funds structured as SICAVs, unit trusts or US registered mutual funds. In the US, the first ETF was launched in 1993. Called the SPDR, it is linked to the Standard & Poor’s 500 Index. Since then, a series of new ETFs have come to market, including Select Sector SPDRs, Nasdaq 100 ‘Qubes’, and Dow ‘Diamonds’.
ETFs differ from their mutual fund and SICAV cousins in several ways. First, they are traded on an exchange like an ordinary security. They are also open-end funds, unlike their listed closed-end counterparts.
Typically, however, the ETF is not open for cash subscriptions or redemptions. The issuance or redemption of shares is limited to those investors able to create or receive a portfolio of securities (referred to as baskets) that mirrors the ETF portfolio. Constructing these baskets is an expensive proposition that in effect precludes individual investors from directly subscribing to these products.
However, this is not to say that individual investors cannot easily invest in ETFs. Via a broker or registered investment adviser, individual investors can trade in or out of the funds at any time the listing stock exchange is open. The basket creation/redemption process in essence becomes the insurance policy for the small investor to ensure that quoted prices on the exchange will not deviate significantly from fair value. If deviations materialise, large institutional investors would arbitrage the price difference between the ETF and the underlying securities.
The success of the SPDRs is due largely to their attractions for institutional investors, traders and other financial market intermediaries in the US and overseas. SPDRs appeal to this market segment because the ETF can be interchanged with either the cash market or derivative products structured against the same index. Full replication of the underlying index; ease of moving in or out of the products and very low expense ratios all make the SPDR another trading instrument that pension funds, hedge funds, traders, and other investors can add to their tool box to create and manage equity risk exposure.
A quick review in the stock tables confirms ETFs popularity. The SPDR, now with assets of over $20bn, has average traded volume of approximately $900m, or roughly 3% of the S&P 500 futures traded volume. A product that encourages trading and participation by institutional investors will create liquidity and fair pricing – two characteristics critical to protecting the interests of the small investor.
European products on the other hand, have met a rocky start. Both asset values and traded volumes have been somewhat disappointing. While it is too early to pass judgment because educational and promotional efforts have only just begun, the products do pose important challenges to investors. First of all, the subscription/redemption process is completely separate from the trading and settlement process of the underlying shares in the European ETFs. Unlike the US, where SPDR investors can leverage the efficiencies of the Depository Trust Company and gain access to settlement guarantees through National Securities Clearing Corporation, European investors face a more complicated process in creating or redeeming baskets.
Building the security baskets is also more complicated in Europe, for several reasons. Automated basket trading facilities are not as fully developed in Europe as they are in the US; cross-border securities trading creates complications as trades clear on multiple platforms with varying settlement cycles and fragmented markets compromise liquidity, particularly with smaller issues.
And lastly, ETF expense ratios in Europe are much higher than their counterparts in the US. The Stoxx and FTSE 100 products were launched with expenses of 0.50%, and 0.35% respectively, compared to the SPDRs with an expense ratio of 0.12%. As with the S&P 500, the underlying indices for these products are core benchmarks followed by both institutional and retail investors and also used extensively by traders and brokers to manage risk and structure derivative products. However, these market segments may be less compelled to participate in the products given the expenses compared to alternative means of achieving index exposure, either through the cash market or synthetically through derivative contracts. In Europe then, the market segment that was critical to ensuring liquidity of the SPDRs in the US, may be marginalised from active participation in the European products.
It appears that the European products may be targeting a retail client base more than an institutional base – thus higher expenses to help defray the higher costs for distribution. However, this may compromise liquidity, and therefore, the key advantage of these products – the ‘E’ for exchange traded.
Compared to other markets, Europe also seems to be going down a different path. The Canadian market, a long-standing participant in the ETF business, has long recognised the need to attract institutions and traders to create liquidity in the products. The original TIPS and HIPs, Canadian ETFs, traded with expense ratios of approximately 4 basis points (0.04%). Their successor, the S&P/TSE 60 ETF trades at an expense ratio of approximately 0.18%. A new fund we will be introducing soon will track the Dow Jones Canada 40 Index and have expenses capped at no more than 0.08%. Looking at traded volumes for ETFs as a measure of success, TIPS regularly accounted for over 20% of the traded volumes in the futures markets. Again, pricing seems to play an important role in the trading of these instruments.
ETFs have also seen success in other markets, most notably Hong Kong. The TRAHK fund, an ETF also introduced by SSgA last November, was launched with over $5bn in assets with over 180,000 participant accounts. While it is true that this product enjoys tremendous retail following, this was the result of an aggressive promotional and incentive campaign financed completely by the Hong Kong government. The strong liquidity and institutional participation in the product is due largely to its benchmark, the Hang Seng Index (the core benchmark for investors and traders), and the low expense ratio (well under 0.20%).
The European model for ETFs appears not to be leveraging the experience of North America and Hong Kong. Europe seeks to bridge the gap between attracting institutional and sophisticated trading interest, while simultaneously deriving the benefits of a retail distribution campaign. Unfortunately the nature of indexed, and particularly ETF products, makes this difficult to accomplish. However, the changing nature of fund distribution, largely driven by the advent of the internet and e-commerce may soon make retail distribution consistent with the aggressive expense structure necessary to ensure product liquidity. More active participation by e-commerce financial service providers in the SPDR and other US ETFs is, hopefully, pointing to a successful marriage of both segments.
Agustin Fleites is principal and director of exchange-traded funds at State Street Global Advisors.