Both Barclays Global Investors (iShares) and Merrill Lynch (LDRS) introduced European exchange traded funds (ETFs)
in April of this year. They
hope to repeat the success enjoyed by ETFs in the US, which have been the focus of much investor attention over the last
ETFs were introduced in the US in 1993 in the form of SPDR, an ETF based on the Standard & Poor’s 500 Index. ETFs were initially designed as a means of efficient index tracking, offering a security with a low tracking error (to the underlying index), a low bid/offer spread and low annual
Unlike many fund structures, ETFs do not place a front-loaded charge on the investor and are intra-day tradeable at current fund NAV. ETFs therefore appeal to both
institutional and retail investors. Both classes of investor can benefit from the inherent efficiencies of what is a true hybrid instrument, offering the benefits of both a fund structure and a listed security.
The fund component holds the
constituents of the underlying index and
the listing ensures the shares of the fund can be traded as a single security. The ETF
benefits greatly from the in specie delivery
mechanism, which demands the exchange of the physical lines of stock during the
creation or redemption process. This ensures the ETF is always fully invested in the underlying index, eliminating any cash drag and permitting the fund to track closely the underlying index, with a typical tracking error of less than one basis point.
All of these factors have been highly influencial in the US and the US ETF market is currently worth around $45 billion (£52 billion). The liquidity of the product in the US was initially driven by the retail sector, who seized upon the opportunity to track a major US blue-chip index through a single share at the low total expense ratios offered by the ETF structure. It was not until 1997 (four years after its introduction) that
volumes soared in the SPDR. Between 1997 and 2000 the security became one of the most actively traded stocks on the
American Stock Exchange, with a daily turnover of nearly 6% of the total market cap of the SPDR fund.
This large, single pool of liquidity attracted institutional investors who began to use the SPDR in place of the Standard & Poor’s 500 futures contract, alleviating potential rolling costs. Prevailing institutional volumes have courted much
competition and the bid/offer spreads and management fees have fallen dramatically in the US. The ETF is a truly high-volume, low-margin product.
The competitiveness of the ETF
platform has had a direct impact on the
US indexed mutual fund business; investors are no longer willing to pay the fees demanded by indexed mutual funds
as the ETF alternative is so much more attractive.
How ETFs will affect the European market
The newly introduced European ETF platform is designed to capitalise on the success of the ETF in the US. Both iShares and LDRS have made very promising starts. LDRS’s daily volumes have reached peaks of ?50 million after only six months of trading, representing a daily turnover of nearly 10% of the fund. The two LDRS products are based on the DJ EURO STOXX 50 and the DJ STOXX 50 indexes and were initially listed on XTF, an ETF trading platform provided by Deutsche Börse.
As the two ETFs are targeted at retail and institutional investors they would seem to be in competition with other instruments listed in Europe such as mutual funds and certificates. As already discussed, the impact of the ETF platform in the US has caused many index-tracking mutual funds to reassess their pricing structure and the
evidence in Europe suggests that European indexed mutual funds will do the same.
Currently, the European ETF platform supports only two index ETF products because of the long authorisation process. In addition, the UCITS concentration requirements currently prevent the structuring of more advanced products, such as sector-based ETFs, and disclosure regulations dissuade many issuers from structuring ETFs based on actively managed indexes or baskets.
These areas, at least for the short term, will remain the domain of certificates programs and traditional mutual funds, which also have a much shorter development lead time. Certificates will continue to offer more advanced index strategies that provide access to regional and sector exposure or theme investing. They provide ‘unsophisticated’ investors access to ‘sophisticated’ strategies.
ETFs provide a platform on which products can be issued that offer efficient
exposure to a passively managed underlying fund. They provide investors with a low cost conduit to passively managed strategies. To this end they can be used as part of a core strategy to provide a seed fund for institutions or as a diversified ‘core’ share in a retail portfolio. They need not necessarily be buy and hold strategies, as the ability to trade intra day admits a broader universe of
LDRS performance since their introduction
On 18 September 2000, both the DJ STOXX 50 LDRS and the DJ EURO STOXX 50 LDRS were listed on the Swiss Exchange (SWX). This provided for the first listing of the euro-denominated shares outside the European Union. Since the listing, the combined volume of the LDRS has nearly doubled. The chart below details the daily average volume of the LDRS over the relevant months. It can be seen that LDRS now has an average daily volume of nearly ?20 million (averaged over the entire month). The total turnover since launch has reached ?1.2 billion, equivalent to three times the portfolio size.
After a period of just over six months, European ETFs are establishing themselves as a hybrid security. They are attracting investors from both the retail and institutional environment (with a split of about 80% retail to 20% institutional) emulating the US market, where retail flow provided the initial liquidity for institutional investment. As the LDRS security boosts the number of European regional listings, it will benefit from a wider European retail audience that should encourage large institutions from a liquidity point of view.
As we have seen in the US, large
institutional flow increases the pressure on the annual management fee, which in turn makes the product a more attractive
investment proposition. If the US model is a proxy for Europe and its development in the ETF market, we have an interesting six months ahead.
Robert E Champney,
Global Equity Derivatives Research and Strategy
Tel: +44 (0) 207 772 2184