Exchange traded funds (ETFs) are increasingly being used by institutional investors in Europe. This can be gleaned from figures that show that the use of US-listed ETFs and the similar HOLDRS vehicles by European institutional investors has grown 20% faster over the year to end June 2003, compared with the overall rate of 15%.
Most ETFs are structured as open-end investment funds while HOLDRs are structured as grantor trusts. ETFs are designed to track specific equity indices, while HOLDRs are static baskets of shares that provide thematic exposure to selected segments of the US market and do not track specific indices.
The figures are based on data from Thomson Financial’s Carson Geo database of 13F and other fund filings in the US only, as similar data does not exist for European listed ETFs since reporting requirements are not the same.
These show that there has been a significant increase in the use of US ETFs and similar structures by European institutions over the past three years. The number has grown from 32 institutions in June 2000 to 295 in June 2003.
In the past year, significant increases in the number of institutions using US ETFs have occurred in Italy, up 45%, increasing from 20 to 29 institutions; in the UK up 33%, from 43 to 57 investors; and Spain increasing from 45 to 56 institutions, or 24%. The overall number of institutional investors reporting holding one or more US listed ETF or HOLDRS has grown by 15% during the past year, increasing from 1,162 to 1,336.
Nearly 900 institutions have started using US ETFs during the past three years. While this data is not perfect, it does give a sense of the breadth and depth of the use of US ETFs. Europe accounts for nearly half (42%) of all ETFs globally and more than half (54%) of all official ETF exchange listings.
As of the end of June 2003 Europe, which saw the launch of the first ETF just over three years ago in April 2000, has 122 ETFs with 206 exchange listings. This is eight more products than the 114 in the US where ETFs have existed for over 10 years.  
In terms of assets under management European listed ETFs account for only 9.4% of the $15.78bn (E00.00bn) of the ETF total worldwide while the US accounts for 72.2%. Europe has 15 sponsors of ETFs while the US has only seven managers. In Europe there are 11 exchange segments with official listings while the US has only four exchange segments with ETFs with 94% of the ETFs listed on the American Stock Exchange. 
The European ETF market is undergoing some consolidation. Recently three of the ETF managers in Europe announced that the where closing there sector ETFs. Barclays Global Investors closed nine iShares FTSE Europe Sectors in September, Merrill Lynch International also closed 13 FTSE Global Sector LDRS in September and UBS Global Asset Management has closed four Fresco Dow Jones Stoxx Europe Sector ETFs. Earlier this year Unico closed their family of i-tracker MSCI Europe Sector ETFs (5). There have also been some closures of sector ETFs in the US and in Canada. 
Although we are seeing some consolidation in the ETF sector offerings in Europe, there are still globally 95 sector ETFs and 15 HOLDRs. So why are investors showing such interest in ETFs?
ETFs can be effective tools for both active and passive institutional managers and for retail investors. They are a flexible tool that is not a derivative that allows investors to be able quickly to react to short and long term needs or opportunities. As such, they are an alternative to futures, programme trades and the use of traditional active and passive funds.  
The growth in the use of ETFs has been partially fuelled by investors’ attempts to avoid accounting, earnings and other stock specific risk. Also, many investors believe that asset allocation is the primary driver of investment returns as demonstrated in a study conducted by Brinson, Hood and Beebower in 1987 which found that nearly 92% of the variation in pension fund returns were attributable to the asset allocation decision. 
Major players in the ETF market traditionally have been large institutional investors seeking to index core holdings or pursue more aggressive market timing and sector rotation strategies. However, since smaller institutions and retail investors can trade in small lots, they can invest on the same terms as larger investors. ETFs offer numerous applications, which can be appealing to institutional and retail investors, including:  
o The ability to equitise cash flows. This can be done in relatively small increments – ETFs typically trade in round lots with the price of a share ranging from approximately $7 to $400. ETFs can be a good alternative to using futures to manage cash flows: they can be bought in smaller sizes than futures; they do not require any special documentation or accounts and investors do not have to worry about roll costs and margin requirements. In addition, ETFs covers many benchmarks for which there is no futures contract.
o Effective asset allocation. ETFs can be used to target sectors where there are no futures contracts. 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.
o Reducing portfolio risk. ETFs can form the core holding in a portfolio with the aim of reducing portfolio risk. A core holding can help to ensure that a portfolio’s performance does not widely deviate from an established benchmark.
o Switching between sectors. ETF products can be used to implement sector rotation and sector allocation strategies. They can also be used to adjust sector or country exposure.
o Hedge a sector or country. ETFs can be used to hedge sector, country or regional exposure. They can be sold short to hedge a portfolio of stocks, allowing an investor to preserve a portfolio while protecting it from overall market losses.
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 and unlike traditional funds are not subject to style drift. ETFs afford investors two forms of liquidity: first, through the trading of shares on a secondary basis on the exchange and secondly, by the ‘creation’ process where an ‘authorised participant’ or ‘market maker’ purchases 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 NAV of the underlying basket of shares. It is believed that there are arbitrageurs waiting to take advantage of significant premium or discount relative to the underlying index. An arbitrageur would typically buy or sell the ETF and place an offsetting buy or sell transaction in the underlying basket of component stocks or futures.  
The use of ETFs by mutual funds in the US and Europe should increase in both number of users and amount invested in ETFs during this next year based on a recent exemptive relief granted by the SEC in the US and from the implementation of UCITS III in Europe.
In the current uncertain economic climate, we can expect continuing growth in the demand for ETFs worldwide, with products likely to exceed 350 over the next two years. This means more managers launching ETFs, more exchanges listing them and total expense ratios continuing to fall. It also likely to mean we will see more ETFs launched on fixed income indices, with total ETF assets growing to well over $200bn.
Deborah Fuhr is executive director, global exchange traded fund research at Morgan Stanley in London, email: