Smaller fees point to greater consolidation

Demand for exchange traded funds (ETFs) from European investors continued to increase in the first three months of 2005. But five years after the first ETFs were launched in Europe, the continent is experiencing a change in providers. While Deutsche Bank has entered the fray over the past year, asset managers believe the market will see a fall in the number of providers and ETFs, particularly because of the reduction in annual management fees cutting margins.

In the first two months of 2005, assets under management in ETFs in Europe increased by 8.5 per cent, according to Deborah Fuhr of Morgan Stanley. This compares with a growth of just 3.6 per cent by the MSCI Europe index. This means Europe continues to attract assets into its ETFs at a faster rate than products in the US. In the first two months of the year, assets in US ETFs increased by just 0.3 per cent while Japan decreased by 5 per cent. Assets under management in ETFs around the world increased by 1.7 per cent in January and February. This exceeded the growth of 1.4 per cent by the MSCI World index.

Three ETFs in Europe now have assets under management of more than $3bn (?2.34bn) and nine have assets of more than $1bn. Three of these ETFs track the Dow Jones EuroStoxx 50 index. The most popular ETFs are those providing exposure to the eurozone with 33.4 per cent of total assets followed by ETFs covering European country indices with 32.5 per cent of the assets.

European roll

The number of ETFs in Europe continues to increase. Two ETFs were launched in February and none were delisted. Five ETFs have been launched in Europe during 2005 and another 17 are planned during the rest of the year.

There has been change among providers. Crédit Agricole has acquired Credit Lyonnais, Axa Investment Managers and BNP Paribas Asset Management have formed a partnership for the management and marketing of the former’s 15 EasyETFs and Deutsche Bank has entered the ETF market through the DVG-Deutsche Vermoegensbildung brand.

Another development has been the lowering of annual management fees for ETFs. The average total expense ratio for equity ETFs in Europe now stands at 0.44 per cent a year. This is significantly below the average TER of 1.20 per cent for equity index funds in Europe and the average TER of 1.62 per cent for active equity funds in Europe, according to Fitzrovia. The average TER for fixed income ETFs is 0.17 per cent, which is below the average 0.99 per cent charged by fixed income funds in Europe, adds Fitzrovia.

As the size of ETFs in Europe grow, so their TERs should fall. This has a beneficial effect on the performance of the ETFs. Another influence on the performance of ETFs, says Ms Fuhr, is whether they replicate an index. “Performance can vary a lot between ETFs. Some will have optimised portfolios for certain indices such as MSCI by having a basket of stocks that reflect the overall index. This means performance may not as truly reflect the returns of the index as when ETFs replicate the benchmark.”

Frederic Jamet, deputy general manager of State Street Global Advisors France and head of the equity management unit, says the lowering of annual management fees, however, is likely to lead to further consolidation among ETF providers. “ETFs fees came down from 1 to 0.5 per cent and now some are as low as 0.15 per cent. But it is hard to see how some ETF providers can be making money by levying such low charges.

“The assets under management show that some ETFs cannot be profitable. If fees are halved then assets under management have to double. Therefore, you have to expect there will be consolidation among ETFs and providers.”

Mr Jamet believes Europe has now entered a new stage of development in the ETF market. After the arrival of ETFs in 2000, “everyone wanted to launch funds. We have now seen some consolidation, which started with Merrill Lynch exiting the market and was followed by the closure of sector ETFs. Now we are seeing fees come down as providers become more aggressive to win market share.”

Fund bunching

This last phase has led to differentiation in demand for ETFs and too many funds on certain indices, says Mr Jamet. “There should be no more than one or two ETFs on each index because there is insufficient liquidity to support more. If the number of ETFs on an index doubles from one to two then liquidity halves.” He points to the fact that the number of ETFs in Europe tracking the EuroStoxx 50 index has reached six.

Mr Jamet adds that retail investors tend to buy ETFs linked to smaller indices such as the EuroStoxx 50, CAC40 and DAX 30. But, says Mr Jamet, institutional investors tend to choose indices like the MSCI Europe and SPDR Europe 350. “The larger indices are more expensive but have more liquidity and tend to be more efficient and therefore are chosen by institutional investors. The smaller indices are better known and cheaper and thus attract retail investors.”

Veronique Rauturier, head of business development for structured and index products at BNP Paribas Asset Management, says it formed a partnership for the management and marketing of Axa Investment Management’s 15 EasyETFs because it wanted to add this product to its existing range. The two asset managers started discussions when BNP Paribas applied for new licences to run ETFs on the CAC40 index.

“We had been looking at ETFs in Europe because there has been a significant growth in demand and we want to be able to offer all the investment tools to investors,” says Ms Rauturier. “ETFs are an important investment tool because they help with asset allocation and provide a cheap way to gain exposure to markets.

“We felt that the end of last year was the right time for BNP Paribas to enter the market and a partnership with Axa was the most effective way of achieving that. If we had developed a full range of ETFs ourselves, it would have taken more than a year to complete.”

Laurent Trottier, index portfolio manager at Crédit Agricole Asset Management, says demand among European investors used to be generally focused on blue chip indices like the EuroStoxx 50, CAC 40 and DAX 30. This followed the initial pattern set in the US, says Mr Trottier, where investors headed for the main indices, such as the S&P500. “This is because the ETFs on these stock exchanges tend to be cheaper, easier to trade and the indices are well known. However, an advantage of having ETFs on broad and diversified indices like the SPDR Europe 350 is that there are no existing liquid futures and options. Thus broad-based ETFs provide unique tools to catch a broad European exposure that is usually the real benchmark of institutional investors.”

As with other asset managers, Mr Trottier says potential growth areas for ETFs are commodities, property and different cap sizes and styles, such as growth and value. The main buyers of ETFs in Europe, says Mr Trottier, are still institutional investors, notably fund managers and increasingly fund of funds managers. In contrast to the US, adds Mr Trottier, retail investors comprise only a small proportion of the inflows into ETFs in Europe.

Hot cakes

Chris Sutton, chief executive of iShares Europe and Asia (ex Japan) of Barclays Global Investors (BGI), is optimistic about the outlook for the ETF market in Europe not only as a result of the continued growth of assets under management but also because trading volumes are increasing at a faster rate.

He believes this indicates that investors are increasingly using ETFs as asset allocation tools. “We have seen a rapid growth in demand for ETFs tracking international equity indices, notably in Asia. There have been strong inflows, for example, into our China 25 and MSCI Japan ETFs.”

The other area of future growth identified by Mr Sutton is in corporate bond ETFs. But he recognises that not all areas of the ETFs market will be successful, as shown by BGI’s decision to close nine sector ETFs in September 2003.

Even though institutional investors still dominate the European market, Mr Sutton argues this will change. “We’re seeing more demand from private investors and it should follow a similar path to the US. When we launched iShares in the US, 70 per cent of inflows were from institutions and 30 per cent from retail investors. But 2004 was the first year that private investors comprised the majority of new inflows into iShares in the US at around 60 per cent.”

In Europe, says Mr Sutton, retail investors in ETFs are generally in the high net worth category, with a large proportion investing in ETFs through private banks and wealth managers. “It is not always possible to know if investors are institutions or private clients except for the trading size. The one country where retail demand is strong is Italy although many clients from countries such as Germany buy ETFs via private banks in Switzerland and Luxembourg.”

While Mr Sutton is optimistic about prospects for corporate bond ETFs, Markus Huebscher, head of quantitative portfolios at Credit Suisse Asset Management, says fortunes for this part of the market have been mixed so far. “Some of these ETFs have not grown as large as providers had hoped.”

Mr Huebscher adds that it is becoming increasingly hard for new providers to break into the ETF market. This is despite the fact Deutsche Bank and BNP Paribas have done so over the past year. “It is very difficult to enter the ETF market now because new launches tend to be me-too products as the main indices are covered. The experience has been that one ETF provider, which is usually the first to be launched, attracts virtually all the assets for each index.

“There are three ETFs on the Swiss stock market, for example. But while we have ?2bn in our ETFs, the other two have around ?100m and this is after three years. Having first mover advantage counts for a lot and it is hard for those coming on to an index second.” Mr Huebscher says there is still a requirement for the industry to raise awareness and educate private investors about the advantages of ETFs. This is not helped, he says, by the fact that financial advisers are not paid commission for selling ETFs.