Explosion of new products
It hasn’t been long since the first exchange-traded funds (ETFs) were launched in Europe but the growth and development that this market has experienced during the last couple of years have been quite significant.
Although the ETFs concept arrived in Europe around seven years after it first appeared in the US, Europeans have quickly absorbed the knowledge of their American counterparts and currently much of the innovation related to these investment vehicles is being developed across the European stock exchanges.
According to a recent report by Merrill Lynch, the European ETFs market has overtaken the US market in terms of products for the first time, with a total of 106 listed ETFs as opposed to 102 in the US. Although the US market for ETFs, with over $90bn assets under management, is much bigger than the European one, with assets of around E8bn, in terms of launches of new products Europe is leading the way.
Since the first ETFs started trading in the Deutsche Börse’s XTF segment in April 2000, the market has seen a constant activity that has attracted more and more sponsors and investors across the continent.
Although the first ETFs launched in Europe were index funds, not long after the first actively managed ETFs were introduced with the aim of creating a vehicle that, while maintaining the same low fees and trading flexibility than traditional ETFs, could also outperform the benchmark. These funds’ portfolio composition is directly monitored by a fund manager who buys and sells securities in response to market conditions.
The first actively managed ETFs were launched by Frankfurt-based fund management company DWS, and soon after DG Panagora, also based in Frankfurt, penetrated this market by introducing the first actively managed ETFs following quantitative methods.
Although there has been some demand for this type of ETF, concerns about disparities between the underlying assets held by the trading fund and the price at what it trades, and other issues related to disclosure and arbitrage, have limited the growth of this particular segment, and investors still prefer the index options. “The issue with actively-managed ETFs is that investors are still finding difficult to see that these products do make sense because it’s still early days,” says Marc Bechtel executive manager at DG Panagora in Frankfurt. Also, the higher fees to be paid on these products compared to the traditional ETFs means that, while investors are considering whether the performance on actively managed ETFs compensates for the additional cost, the index solution is the one attracting more assets. “The interest in index ETFs is increasing rapidly and will grow further as the core-satellite approach becomes more popular among investors. Instead of hiring one of the large indexation providers to manage the core, investors are considering using ETFs.” He adds: “Thinking about the near future, I am very optimistic about the growth of the ETFs market as a whole.”
As well as ETFs being seen as a solution for those following passive management strategies, the launch of sector-based ETFs has also proved to be attractive for investors moving away from the high correlation of country indices into investments based on a sector approach. According to Deborah Fuhr, vice president at Morgan Stanley in London, continued market volatility and the investors reluctance to back just one of two stocks within a sector after Enron and other similar cases, have helped broad sector ETFs to attract significant amount of assets during the first half of the year. Only in July a total of 14 new ETFs on Dow Jones STOXX 600 sector indices started trading in XTF, covering sectors such as energy, financial services, chemicals and construction among others. Together with the previous four ETFs already listed, the new launches mean that all 18 sector indices of the DJ STOXX 600 are now tradable as ETFs on a single platform.
Demand from investors has definitely been the motor behind these developments, and as this demand increases more ‘exotic’ vehicles are breaking into the market. In May the first fixed income ETF started trading in XTF. This fund, the Xavex SICAV Dynamic Bond Portfolio fund, was issued by Luxembourg-based Xavex SICAV and is actively managed against the iBoxx Euro Overall index that comprises more than 1,000 bonds.
Although no further development on the fixed income ETFs in Europe has been registered in the last few months, recent launches of bond products in the US by global providers suggest that similar products could be listed on other European stock exchanges soon.
“Launching a fixed income product in Europe is always more complicated than in the US, because there are many different markets involved,” says Mark Roberts, head of product strategy for iShares at Barclays Global Investors in London. “We launched four fixed-income iShares ETFs in the US in July and they have been very successful.” The success of the funds, that have managed to attract a considerable amount of assets over a very short period of time from both institutional and retail investors, could be seen as a key incentive to try and export similar solutions to the other side of the Atlantic. “We have certainly seen interest from European clients in this type of product and we are now in the process of analysing whether it makes sense to launch similar ETFs in Europe.”
Because investors in Europe follow different benchmarks, ETF solutions on a pan-European basis are complicated. “The ETFs market is a very fragmented one, where local sponsors generally control the core benchmark in each country, but we are always looking for products that can appeal to the European market as a whole.”
He adds: “So I think the next stage on product development we are going to see will be beyond the core benchmark and more focused on pan-European solutions. I think this is what people will be looking at, both on the equity and on the fixed income side.”
With this in mind, last year iShares announced the extension of its relationship with FTSE to offer investors access to the two main FTSE pan-European indices, FTSE Eurotop 100 and FTSE Euro 100.
At the same time as ETFs sponsors are getting more into sectors, bonds and pan-European solutions, investors are also starting to feel more comfortable about these vehicles. Whereas the number of ETFs has grown dramatically in Europe, assets still remain low, far behind the figures registered in the US and some believe fees are playing a major role in keeping investors, especially institutions, away from ETFs. “The ETFs market in Europe tends to be a little more expensive on average than in the US,” says Roberts. But as the market develops some believe European investors will start paying less for ETFs in the near future. “I would expect to see prices coming down on ETFs now these products have been around for more than two years. The skills you need when launching a new product make it very difficult to justify low fees, but now I think they will start going down,” Roberts says.
While waiting for fees on ETFs to go down, European investors will continue witnessing further innovation and development in the market, with new pioneer products expected to be launched in the months to come. In November, Eurex, the international derivatives market exchange, is planning to initiate trading in future and options on ETFs. Eurex will then become the first exchange worldwide to offer futures on ETFs, and the only European exchange with this product segment.
The new futures and options will be initially offered on leading European ETFs. For Eurex CEO Rudolf Ferscha this solution will offer custom-made hedging opportunities for the underlying ETFs. “With derivatives on exchange-traded funds, we are offering the market innovative instruments to fine-tune the risk in this new growth market,” Ferscha says. “Derivatives products on ETFs have a high benefit for the customer and they are an ideal complement to our existing index derivatives segment.” According to Eurex, international trading firms will conduct active market-making operations in the new products from the time they are launched in order to provide for orderbook liquidity from the very beginning.
Other strategies currently being discussed in the ETFs market are the introduction of enhanced fixed income solutions and multiple sector approaches, however we might have to wait for some time before we see more products being launched. It is only logical to forecast that the extraordinary growth that in terms of new products that this market has had in the last couple of years will have to start slowing down at some point soon. However, the growth in terms of assets have only just began and the ETFs already listed will see important inflows of cash, as long as investors’ interest stays high.