ETFS enter uncharted territory

The exchange traded funds (ETF) market in Europe is developing as rapidly as the indices they track. Not only are assets continuing to pour into ETFs, but providers are offering ever-more sophisticated products. From tracking the major indices in developed markets, providers have moved on to individual and emerging markets, sectors, commodities, capital protected, leveraged as well as semi-active and active ETFs. Institutional investors still dominate inflows by value, but retail investors match them for the number of transactions. Furthermore, providers believe the arrival of commodities and other specialist ETFs will attract greater inflows from retail investors. By the end of March 2006, there were 182 European-listed ETFs offered by 21 providers. Since the start of 2006, ETF assets under management have increased by 16 per cent to reach ?53.5bn. There have been 17 new launches of ETFs in Europe alone this year. Equities, bonds and commodities are all represented in the European ETF market. Equities account for 87.5 per cent of assets under management, which is followed by bonds (11 per cent) and commodities (1.5 per cent). The most commonly tracked index is the DJ Euro Stoxx index with six ETFs. Style-based ETFs have ?1.4bn in assets under management, which is only 2.5 per cent of the total European market. But they are enjoying strong growth, having risen 70 per cent since December 2005. These include ETFs that track capitalisation-based indices, those indices of high dividend stocks and growth/value indices as well as ethical ETFs. Of these, small cap ETFs have the most assets under management. Since the start of 2006, assets under management for emerging market and Asian ETFs have risen 33 per cent. Japanese ETFs total ?3.3bn (56 per cent) of this market segment. At the end of March 2006, there were 20 bond ETFs listed in Europe, which had assets of ?6.3bn. This represented 11 per cent of the total market. Bond ETFs’ assets under management have increased by 23 per cent from the start of 2006 to the end of March. Alain Dubois, head of European ETF distribution at State Street Global Advisors, says he anticipates two major trends in the European ETF market. These are the use of broader benchmarks, such as the MSCI World and emerging markets indices, and the launch of ETFs linked to commodities like gold and silver indices to follow the trend seen in the US over the past two to three years. He says that sector ETFs, however, have not proved as popular as some providers expected. “The main buyers of sector ETFs were hedge funds. Some providers believed sector ETFs would have a broader client base. But while technology was popular in the late-1990s, there is not always broad support for investing on a sector basis.” Mr Dubois says demand is rising across most European countries. These include Switzerland, Germany and Italy but ETFs in Europe have mainly attracted demand from institutional investors. Mr Dubois says demand from retail investors has not picked up as much as expected, partly because distributors do not have an incentive to recommend ETFs through commissions. What is required, he says, is more education for investors about the benefits of ETFs. “We believe retail investors will increasingly use ETFs to diversify their portfolios as cost-effectively as possible,” says Mr Dubois. “But this could take five to 10 years to develop.” UBS says that demand for ETFs is moving from standard developed markets to more specialised indices, such as dividends and emerging markets like China. The most popular ETFs at the moment, according to UBS, are commodities, emerging markets, style ETFs and sector ETFs. In Europe, the greatest demand for ETFs comes from Switzerland, Germany, Italy and Austria. What to look for In terms of how to differentiate between ETF providers, UBS says investors should look at management fees, assets under management, the number of listings, liquidity, the number of market makers, outstanding ETF shares and the market share.

‘Retail investors will increasingly use ETFs to diversify their portfolios as cost-effectively as possible. But this could take five to 10 years to develop’- Alain Dubois, SSgA

UBS expects the growth of inflows into ETFs will be similar to the levels of the past six years of between 57 per cent and 74 per cent a year. Véronique Rauturier, head of alternative and structured investments business development at BNP Paribas, says the European ETF market is now a mature one. “It is no longer an emerging market but is well-established. This is shown by the number of ETFs that have been launched and the volumes that are now traded on European stock markets.” BNP Paribas clearly believes the ETF market offers significant potential because it signed a partnership agreement with Axa last year for its EasyETF range. Ms Rauturier says there has been an expansion in the range of ETFs available. She cites the launch of the EasyETF GSCI in May 2005 as an example. This is based on the Goldman Sachs Commodity index and comprises 24 commodities across four sectors – energy, metals, agriculture and livestock. The EasyETF GSNE is based on the same index but excludes energy. She argues that ETFs such as these broaden the investor base by providing access to asset classes like commodities that are not normally available to retail investors. “Our ETFs are Ucits III funds, which makes them widely available to investors. Not all investors are able to use futures, swaps and certificates. These financial instruments may have high minimum investments whereas investors can access an ETF by buying one share.” Ms Rauturier says the intention is to provide investors with the tools for diversification within a portfolio through ETFs. This is achieved by offering commodities and real estate, as well as equities and fixed interest. “ETFs enable investors to gain quick exposure to asset classes. Some use ETFs as the core of their portfolio and then invest in active managers to try to provide some outperformance of indices.” Another trend identified by Ms Rauturier is ETFs being listed on multiple exchanges. “It has become apparent that investors prefer to invest in ETFs listed on their domestic exchanges. Therefore, ETF providers have to go to investors to gain distribution rather than relying on them to come to your exchange.” Ms Rauturier admits that institutional investors still dominate the ETF market in Europe. She adds, however, that the degree of dominance varies between markets. “Statistics from exchanges suggest the number of retail investors in ETFs are increasing. It is not surprising, however, that it is taking time to grow the retail market. Any new product requires education and marketing.” She believes that sector ETFs will bounce back despite the low inflows so far. “Many sector ETFs were launched in Europe in 2001 and 2002. I believe there will be increased demand in the future because investors are showing greater interest in sectors generally.” Charge considerations Ms Rauturier says that in choosing between ETFs, investors should consider charges, although the differences have been reduced, whether ETFs pay dividends and the performance compared to the underlying index. Differences between the performance of the ETF and underlying index can be a result of fees, the way the ETF is managed and whether it fully replicates the underlying index.

‘Some use ETFs as the core of their portfolio and then invest in active managers to provide some outperformance’- Véronique Rauturier, BNP Paribas

Emerging markets ETFs, for example, may have a relatively wide tracking error. This is because the ETFs may not be able to gain full replication since foreign investors are not always allowed to buy all the stocks on an emerging markets index. Cristina Dimopoulos, who is responsible for the ETF product development/life cycle management at Credit Suisse, says that based on data from the Deutsche Borse the number of transactions in Europe seems to be fairly evenly split between retail and institutional investors. In terms of volume traded on the Deutsche Börse, however, it seems to be dominated by institutions with around a 95 per cent share. Ms Dimopoulos believes more institutions, notably pension funds, will be attracted to invest in ETFs in the future, but she also believes retail investors will increasingly use ETFs. She argues that retail investors are being attracted by asset classes that are normally difficult to access. “The commodities theme is attracting retail investors to ETFs,” says Ms Dimopoulos. “ETFs on broad based commodity indices, such as GSCI, DJ-AIG and CRB, and gold ETFs have been launched in Europe. Silver ETFs are under preparation in the US. These are asset classes that retail investors would like to invest in but might not always be able to. This should increase interest in ETFs.” She says commodities ETFs will prove more popular than sector funds. “Investors asset allocate by countries rather than sectors. Therefore, there has not been great demand for sector ETFs.” Ms Dimopoulos believes there will be a number of trends in the European ETF market in the future. “We expect to see the launch of single emerging markets ETFs. We also think there will be increased use of ETFs based on customised indices. An asset manager can ask Morgan Stanley or Dow Jones, for example, to establish a customised index. Indices may be developed based on climate change, water and renewable energy. What is important is that there is liquidity in the underlying index.” Another trend, says Ms Dimopoulos, may be in the development of semi-active or active ETFs. “An example is an ETF tracking the FTSE Rafi index, which is not capitalisation weighted like other indices. Index constituents are weighted using fundamental factors, such as company sales, book value and cash flow.”

Dimopoulos: cross-border ETFs are hard

“Other recent launches include capital protected ETFs that use constant proportion portfolio insurance (CPPI). Providers have also launched ETFs with leverage. This has the attraction of increasing exposure if investors believe the underling index is to generate strong returns.” The ETF market is currently dominated by providers in their home countries, such as Lyxor in France, Credit Suisse in Switzerland and BGI in the UK. “It is very difficult for providers to distribute ETFs cross-border in Europe. This is for tax and regulatory reasons. Providers have to list ETFs on stock exchanges in other countries to attract foreign investors,” says Ms Dimopoulos. The first two ETFs launched by SGAM Alternative Investments have been provide leverage and capital protection. The SGAM ETF CAC 40 Flexible and the SGAM ETF FTSEurofirst 80 Flexible provide 80 per cent capital protection while the SGAM ETF CAC 40 Leveraged and SGAM ETF FTSEurofirst 80 Leveraged use up to 200 per cent leverage to increase exposure to the underlying indices. Francois Millet, head of index linked product sales at SGAM Alternative Investments, says the capital protection and leverage are actively managed. “We use Dynamic Portfolio Insurance to manage the exposure to the index to ensure we can provide 80 per cent capital protection,” says Mr Millet. As the value of the index rises, the higher the exposure the ETF will have to the index. If the value of the index falls, however, the less the exposure the ETF can take to the index.” SGAM uses derivatives to increase and reduce exposure in its leveraged ETFs. The degree of leverage depends, among other factors, on the valuation of the index, the market environment and the trends in share prices. “There is strong demand for structured products in Europe, as shown by the ?15bn inflows last year. The challenge of our products is to make them as transparent as ETFs,” says Mr Millet. “They also allow investors to invest in and redeem at any time. This is an advantage over traditional structured products.”