ENJOYING THE BENFITS OF SCALE

It is ironic that exchange traded funds (ETFs) are designed to provide investors with diversification across investment markets and greater access to a range of asset classes, when the European ETF market is concentrated in the hands of just a few providers. This concentration was exacerbated in February 2007 when Barclays Global Investors (BGI) completed its acquisition of IndEXchange from Bayerische Hypo-und Vereinsbank (HVB) for ?240m. The combined group had ?32bn in assets under management in European ETFs at the end of 2006 and a market share of 48.4 per cent, according to Morgan Stanley. Before this acquisition, the largest ETF provider in Europe was Lyxor Asset Management with ?16.4bn in assets under management and a 24.9 per cent market share. The next largest providers are Axa/BNP (6.2 per cent), Credit Suisse Asset Management (5.2 per cent) and Credit Agricole Asset Management (3.7 per cent). Tim West, chief operating officer of BGI’s iShares Europe franchise, says the acquisition provides BGI with significantly more scale in European ETFs. “This is a scale game. If you are trying to attract institutional investors, you need sizeable assets under management,” he says. “Investors cannot own more than 25 per cent of a fund. Therefore, if an institutional investor wants to invest £50m, the ETF needs to have at least £200m (?295m) in assets.” Furthermore, in theory, ETFs should benefit from economies of scale. The larger they are, the lower should be their costs and charges. Deborah Fuhr, managing director at Morgan Stanley, says the average total expense ratio (TER) for equity ETFs in Europe is now 0.46 per cent per year, compared with one per cent for equity index funds in Europe and 1.91 per cent for active equity funds, according to Lipper Fitzrovia. Ms Fuhr adds that the average TER for fixed income ETFs is 0.18 per cent per year, which is significantly below the 1.09 per cent for fixed income funds in Europe. This reflects continued growth in the European ETF market. Assets under management in European-listed ETFs grew by 63.3 per cent in 2006 to reach ?66bn by the end of the year, says Ms Fuhr. She adds this is significantly more than the 29.9 per cent increase in the MSCI Europe index in dollar terms. Five European-listed ETFs now have assets under management of more than ?2.2bn and 23 have assets of over ?700m. Reducing costs is important because they affect the performance of ETFs and the tracking error from the underlying index. Ms Fuhr highlights the degree to which tracking error varies by pointing to BGI’s emerging markets iShares. She says iShares’ US listed emerging markets ETF has a tracking error of five per cent whereas the European listed emerging markets ETF has a tracking error of two per cent. Why are there differences in the degree to which ETFs track underlying indices? Two key reasons are the degree to which ETFs replicate the underlying index and charges. Charges include trading costs when stocks enter and leave the index as well as the annual management fee. The indices may be rebalanced every quarter, or more frequently in some cases. It is said ETFs have lower charges than index trackers. But the dealing costs of buying and selling ETFs can push charges into line with index trackers. SIZE LIMITATION It is more straightforward to replicate the FTSE 100 index because there are only 100 stocks to hold. But Ms Fuhr says: “When an ETF is launched, it is usually too small to hold all 1,000 stocks in the MSCI World index, for example.” Daniele Tohme-Adet, co-head of Easy ETFs, says for an index such as MSCI World, ETFs may only hold 600 of the 1,000 stocks. This succeeds in reducing trading costs but means the performance of the ETF does not fully match that of the underlying index. It can be more problematic to fully replicate emerging markets indices. This is because of less liquidity in some cases than in developed markets and a difficulty in holding stocks in every emerging market. Mr West adds: “An index is a hypothetical construction and is not in line with reality. It does not take into account the dividends and cash taken out. This is the cash drag that is caused by the different performance of the cash held until distribution and the stock held as part of the index composition. “Some stocks cannot be bought in the required quantities and may be illiquid. Therefore, optimisation has to be used to alter the portfolio and select similar stocks, which affects the tracking error. Any taxation that applies will also affect the tracking error.” Ms Tohme-Adet says that rather than holding stocks in the index directly, some ETFs use swaps. This enables ETFs to match fully an index but it does add an extra cost in managing the ETF. Lipper has researched the tracking error of ETFs. It studied the daily risk/return profile of 21 ETFs to see how European ETFs track their underlying index. Aureliano Gentilini, head of research in Europe at Lipper, says the underlying indices are a key factor. “In Europe, ETFs tracking a purely domestic index and traded on a domestic exchange display favourable correlation and tracking error when analysed against their index,” he says. “This relationship holds, although to a lesser degree, for products pegged to pan-European indices, domestic indices traded on another European exchange and fixed income products. The additional complications associated with European ETFs pegged to international indices provide the lowest correlation results.” Among the factors contributing to the different levels of correlation between an ETF and its underlying index include “liquidity, bid-ask spreads and inefficiencies in the creation unit mechanism”, says Mr Gentilini. He says additional unfavourable factors for ETFs in tracking international indices include: “time zone bias and trading day differences between exchanges, exchange rate bias and higher adverse selection costs contributing to wider bid-ask spreads. In addition, for some ETFs pegged to international indices, such as the Nasdaq 100, intense short sales activity may lead to temporary discrepancies between the NAV and the price at which the ETF is traded.”

‘Investors can halve the amount of capital they have invested but maintain the same level of exposure because of the leverage’ - François Millet, SGAM Alternative Investments

Mr Gentilini adds that tracking error can also be explained in part by an increase in index volatility. This can result in “inefficiencies” between ETFs and their underlying indices. He says these findings may have less impact on retail investors than institutions, although this depends on their investment time horizon. MINIMISING VARIATION “Variations between daily results are minimised for longer periods as the index and ETF converge,” he says. “Considering the impact of foreign exchange rates, stale prices and operating expenses, the average retail investor may not even notice the divergence whenever excess returns are positive. “Retail long-term investors with longer term investment horizons will gain the desired index exposure, regardless of the factors causing periods of inefficiency. Some ETFs appear not to be an investment vehicle suitable for investors pursuing a short-term passive investment strategy.” Ms Fuhr says that at the end of 2006, there were 272 ETFs in Europe with 588 listings managed by 26 asset managers on 16 exchanges. Last year, 108 ETFs were launched in Europe and one ETF was delisted. Ms Fuhr says there are plans for the launch of another 68 ETFs in Europe in 2007. A GROWING BUSINESS Despite nearly 90 per cent of the ETF market being in the hands of five or six providers, Mr West believes there will be new entrants. “ETFs are a growing and attractive business. The European ETF market has grown faster than the US at the same stage of development,” he says. Indeed, seven ETF providers have entered the European market over the past year. These included Zurcher Kantonalbank, BBVA Gestion and ABN Amro Bank. ETFs investing in European markets continue to prove the most popular with investors, accounting for 28 per cent of total assets under management. ETFs covering regional eurozone indices have 22.4 per cent of assets. Emmanuelle Choukroun, global ETF developer at Lyxor, says the four largest ETFs in Europe are Lyxor DJ Euro Stoxx 50 (?4.59bn), iShares DJ Euro Stoxx 50 (?3.78 bn), Lyxor CAC40 (?3.65 bn) and IndEXchange DJ Euro Stoxx 50 (?3.47 bn). She says that if demand is calculated according to activity on stock markets then it is concentrated in six countries. Germany, France, the UK, Italy, Switzerland and Spain account for 95 per cent of trading activity. XTF comprises 37.10 per cent of activity, which is followed by Next Track (24.60 per cent), the London Stock Exchange (13.10 per cent) and MTF (11.60 per cent). This does not, however, truly represent local demand, as institutions do invest in foreign indices. Ms Tohme-Adet says such mainstream ETFs prove particularly popular after market corrections, as happened in March 2007. This is because investors wanted to gain quick access to the market to benefit from cheaper share prices. Institutional investors account for around 80 per cent of inflows into European ETFs, says Mr West. He believes Europe will follow the pattern set by the US, where retail investors have expanded their proportion of overall assets. This will be through increased awareness of the benefits of ETFs and because of the expansion in the number of fee based advisers. “We believe we are at a turning point in the retail market in Europe.” Ms Choukroun argues that more specialist ETFs are also proving popular with investors, especially emerging markets ETFs. There are, for example, 32 exchange traded commodities (ETCs) with ?1.53bn in assets and 91 listings managed by two asset managers on four exchanges in Europe. Assets under management in ETCs increased by 89.1 per cent in 2006. Ms Tohme-Adet admits there are questions over whether all ETFs in Europe are cost-effective given the small size of many of them. She says some specialist ETFs have to be subsidised by more mainstream ETFs, such as those linked to the DJ Euro Stoxx and S&P 500 indices. Societe Generale Asset Management (SGAM) focuses on specialist ETFs through its Alternative Investments range. François Millet, head of index linked distribution for SGAM Alternative Investments, describes these as second generation ETFs. The asset manager has recently launched SGAM ETF Bear and the SGAM ETF XBear. These two ETFs each offer products linked to the DJ Euro Stoxx 50 and CAC 40 indices. Mr Millet says SGM ETF Bear enables investors to profit if the stock market falls in value. This is a one-for-one fall and the investor can lose a maximum of 100 per cent of their capital. This ETF enables investors to short the market if they are negative about the outlook or to hedge their existing portfolio exposure to stock markets. Mr Millet says they appeal particularly to investors who cannot use derivatives to short stock markets. TRANSATLANTIC DIFFERENCE Under the SGAM ETF XBear, investors can leverage their shorting position to 200 per cent of the underlying index. He says SGAM ETFXBear enables investors to more efficiently manage their capital. “Investors can halve the amount of capital they have invested but maintain the same level of exposure because of the leverage. They can then reallocate half of their capital to other investments,’ he says. The XBear ETF has proved the most popular of the SGAM range, says Mr Millet. “In two days, the ETF had 400 trades,’ he adds. The European ETF market differs from the US, says Ms Tohme-Adet, because of the need for cross-listings for regulatory reasons and to attract inflows from retail investors. She says that at the end of March 2007, there were 428 ETFs in the US with $428bn (?315bn) in assets. In contrast, there were 300 ETFs in Europe with $98.5bn (?72bn) in assets. But when cross-listings are included, there are 672 ETFs in Europe, thus more than doubling the number.

‘This is a scale game. If you are trying to attract institutional investors, you need sizeable assets under management’ - Tim West, BGIiShares Europe