Competition fierce as ETF providers fight for control

It is a tough market for exchange traded fund (ETF) providers, but one which has potential to grow considerably across Europe, where ETFs currently account for just 3 per cent of funds under management, compared for example with 8 per cent of funds under management in the US. If, as many believe, ETFs have the potential to take 10-12 per cent of any one market, the European market for ETFs could triple to $900bn (€692bn).

Not all recent entrants into the marketplace have achieved scale, however, and further consolidation is anticipated. Banking regulation is also putting paid to some operations, such as Credit Suisse, which is selling its $17.2bn (€13.4bn) ETF business to raise funds to strengthen its capital position.

Charges are a major differentiator in this market, with fierce competition driving them down. When Vanguard launched five ETFs in London in May, its strategy was to price each product at or lower than competitor’s prices. A similar entrée into the Canadian market last December resulted in a price war. Tim Huver, ETF product specialist at Vanguard, says investors are learning to focus on the total cost of ownership, including tracking error and bid/offer spread, rather than the simple management fee.

Vanguard’s UK debut consists of major building blocks such as FTSE 100, S&P 500, FTSE All World, FTSE EM and UK Government Bonds rather than niche funds. Although there is an abundance of products for investors to choose from, the major cashflows have been into these core vehicles, says Mr Huver.

Source, co-owned by a group of large investment banks including Goldman Sachs, JPMorgan, Morgan Stanley, Merrill Lynch and Nomura, is also keen to grow market share.

“We think we can capture 15 per cent plus of net new assets,” says Michael John Lytle, managing director. In 2011 Source was ranked third in collecting new assets in Europe and in 2012 is currently second after iShares. The market is highly concentrated, says Mr Lytle, with just 12 providers responsible for 40 funds which have net annual inflows of €100m.

Cost consciousness, market dynamics and regulation are all coming together to boost the ETF market. The difficult economic climate and the UK’s imminent Retail Distribution Review (RDR) are both focusing attention on charges, and it remains a challenging environment for active managers to outperform. The huge educational effort put in by manufacturers in recent years is also bearing fruit, particularly in Switzerland and Germany where providers have long been banging the drum.

The imperative of adding value in a challenging investment market has encouraged the private wealth segment to develop a more sophisticated blending approach. “We see much broader blending now – over a wider number of asset classes, not just a few core asset classes,” says David Gardner, managing director at iShares, which has conducted research into how asset managers are blending ETFs and active funds.

“The world has become more tactical since the crisis and wealth managers can make tactical bets using an index product cheaply and quickly. ETFs allow them to move from a risk-off to a risk-on position easily, and selling is straightforward in comparison with trading an active manager, where there is a tendency to buy into the manager emotionally.”

iShares’ survey found 25 per cent of wealth managers adopting indexing for tactical exposure and moving towards a comprehensive approach to blending.

“Index product flows have increased sharply since the financial crisis and RDR will help accelerate the pace of blending in the future, demonstrated by the massive curiosity private wealth respondents showed about the strategies of their peers,” says Mr Gardner.

“The next stage is a more refined conversation about how active and passive cohabit, moving on from the primarily barbell approach with highly active persistent alpha-generating managers on one side and passive funds on the other,” he adds.

“Traditionally, in portfolios adopting a ‘core/satellite’ model, the investor would perhaps hold bonds and equities in the core and use ETFs to take the satellite exposures,” says Manooj Mistry, head of db x-trackers UK at Deutsche Bank.

“Today, with such a wide range of exposures now available in ETF form, investors are increasingly using ETFs and ETCs (exchange traded commodities) for both the core and satellite parts. Because ETFs are so easy to trade, investors can tailor their portfolios easily, which means they could, for example, use ETFs to increase their exposure to certain sectors or regions.”

Investors are also learning to prefer ETFs over futures as a way to gain access to investment ideas very quickly without the rolling period in futures.

For future innovation, fixed income is the real area to look at, says Mr Gardner at iShares. It is still in its infancy but growing dramatically. For example, three Italian government bond funds launched by db x-trackers in June have taken in more than €200m. This demonstrates a search for yield as the zero coupon fund investing in bonds with a maturity of one year that yields 2.5 per cent has been most popular as an alternative to money market funds, many of which have closed to further subscriptions.

ETFs are also a simple way to take more specific positions in emerging markets. Earlier this year db x-trackers added Pakistani, Bangladeshi and mainland China funds to its large suite of emerging market funds, which already boasts sector funds such as healthcare and consumer discretionary, which are largely used tactically. iShares also plans to grow emerging market offerings significantly in 2013. Broad-based emerging markets funds remain popular, however, for diversification properties.

There is deepening curiosity about smart data and non-cap indices. ETFs based around strong dividend companies and indices that boost diversification using an array of risk factors are attracting interest. The prototype for dividend products, the iShares UK Dividend Plus, was mauled when it overweighted banks ahead of the crash. This year investors have been drawn to State Street UK Dividend Aristocrats ETF. Launched in February, it includes ‘Steady Eddie’ income stocks and a 30 per cent sector cap which should help avoid its predecessors’ trap.

ETFs based on minimum variance, low volatility or value and growth indices are also the flavour of the month but will always work best in certain parts of the cycle.

In 2011 Source launched a product with Man GLG, a smart product based on broker recommendations, which has raised more than €600m, making it one of the largest smart passive funds in Europe. This index has outperformed the MSCI Europe TR by 3.06 per cent in the last 12 months, and its performance over most discrete periods holds up – “its most challenging period has been the last five months of last year when brokers were unsure where markets were going,” says Source’s Mr Lytle.

Some advisers are concerned, however, that not all smart funds will stay the distance. Russell, for example, recently cancelled all but one of their ETFs quoting lack of demand.

VIEW FROM MORNINGSTAR

Financial sector provides boost

Exchange-traded funds (ETFs) tracking the MSCI Europe Index have performed well for the year-to-date through October, generating average returns of 13 per cent. While in absolute terms, this is a marked turnaround in these funds’ prospects versus last year, when they lost 8 per cent of their value on average; their performance relative to their broader Morningstar Category peer group (which includes traditional open end funds) has suffered.

For the calendar year 2011, the performance of this group of ETFs ranked within the top quartile of its wider cohort. Through October of this year, these funds have ranked just inside the sixth decile in terms of relative performance. This turnaround in these funds’ performance can be largely attributed to the fact that they are relatively light on exposure to the healthcare, consumer discretionary, and industrials sectors versus their actively managed peers. These three sectors combined have accounted for 5.3 percentage points of the MSCI Europe Index’s absolute performance through end October.

The key driver of these ETFs’ year-to-date performance has been a buoyant financial sector, which accounts for about one fifth of the MSCI Europe index’s value. Financials have contributed nearly a third (4.1 percentage points) of the MSCI Europe Index’s increase through the first 10 months of the year. In fact, all sectors represented in the index — save telecoms — have increased on a year-to-date basis.

Measuring the relative performance of ETFs tracking the same index can be a game of centimetres, and sometimes millimetres. Index investors have a target alpha of zero. They would ideally like to perfectly mimic their benchmark’s return. Furthermore, ETF investors would like to minimise transaction costs such as commissions, bid-offer spreads, and market impact.

Based on two metrics, Morningstar’s Estimated Holding Cost (which uses an ETF’s past performance data to predict how it will perform relative to its benchmark index in the future) and trailing three month average on-exchange volumes for the funds’ primary listing, two of these ETFs set themselves apart from the pack. The db X-trackers MSCI Europe ETF has an estimated holding cost of nil (ie based on its past performance we expect it to track its index perfectly) and the second greatest trailing three month on exchange trading volumes amongst the group — a good proxy for liquidity and hence trading costs.

Another clear standout is the iShares MSCI Europe (IE) which has an estimated holding cost of -0.03 — indicating that we would expect this fund to outperform its benchmark index by 3 basis points. Furthermore, this fund is the most liquid of the group as measured by trailing 3 month average on-exchange volume for the fund’s primary listing.

Ben Johnson, Director of Global Passive Funds Research at Morningstar