The growth of ETFs
ETFs are growing rapidly as investors are attracted by lower costs and simpler trading. At Fund Forum 2017 I was fortunate to join a panel of ETF experts - Howie Li, co-Head of CANVAS, ETF Securities; Sascha Cronemeyer, ETF Sales Trading, Corporates & Markets, Commerzbank and Mark Harris, ETF Capital Markets, SSGA - discussing the next steps in the evolution of the market, and how industry participants can overcome the challenges to further growth.
A tale of two markets
The US and Europe offer similar exchange-traded products, but that is where the comparisons end. Whereas ETFs were introduced in the US in 1993, they only arrived in Europe in 2000.
And, whereas (as of 30 April 2017) around €650 billion was managed in European ETFs, in the US, ETFs account for more than $3 trillion. This reflects the relative maturity of each market.
Europe is making headway: after 16 years of existence, the US ETF market was worth $80 billion, compared with the €650 billion under management in. Nevertheless, the gap is large and there are considerable obstacles to overcome before European can close it.
Obstacles to growth in European ETF market
The two major differences between the markets relate to exchange versus OTC trading and to the development of retail business in each.
In the US, 70% of ETF trades are made on exchange, and 30% via over-the-counter (OTC). However, the reverse is true in Europe, where about 70% of trades are done OTC.
Why? Because institutional investors have large ticket sizes – on average about €3.5 million - and are more familiar with the OTC method. The average on-exchange trade is less than €500,000.
Meanwhile, in the US, the retail market accounts for 40% of ETF trading, while in Europe retail investors are just 10% of the market. One of the main drivers of retail activity in the US is that people invest their own pension funds.
More on-exchange trading in Europe and more retail engagement would increase ETF volumes. Centralised infrastructure would also help to do so.
In the US, ETFs are traded on just three exchanges and are all settled in one place – the DTCC. In Europe, there are 25 exchanges and trades are settled on the local central securities depository (CSD)
Although alignment between CSDs appears simple, it is actually complex, costly and risky.
At Euroclear we want to replicate the US model and create one place for settlement. We started the journey four years ago and now have €230 billion in this environment.
Another obstacle to growth is liquidity. Because much of the European market is OTC, investors cannot be sure how liquid a product actually is, panellists argued. Since an ETF is a wrapper and not an investment in itself, fund buyers are advised to refer to the actual manager to understand the underlying and how it is traded.
The structure of the market presents another obstacle. Market-makers observed they would like to be able to lend and borrow shares.
But, the lending market for ETFs is not mature in Europe compared with the US, leading to higher costs for European market-makers and, consequently, wider spreads on exchanges.
Opportunities for future growth
Expanding both the institutional and retail investor bases is critical if penetration in Europe is to reach US levels. Capital markets firms noted there had been ’real growth’ in the number of ETFs available to lend, with institutional clients and some big investment banks now using ETFs as collateral.
Lending is important because it adds liquidity to the market. For market-makers in particular, it is important to know that if a trade fails, there is readily-available inventory. That has a positive impact on spreads.
Lending will also attract new clients which have short-selling strategies. In addition, by lending ETFs, asset managers and owners are offsetting their total costs of ownership.
The emergence of innovative ETF strategies is likely to draw new investors into the market and help it retain existing ones.
ETF products have moved away from tracking the main indices and there is demand, for instance, for a greater variety of fixed income products and thematic investments based on megatrends. Thematic investing tends to be uncorrelated with the views expressed in core portfolios, so can be added to the portfolio without significant friction.
The panel also foresaw increasing demand for ETFs based on alternative strategies. Wealth managers and asset allocators in particular seek sources of uncorrelated returns for their clients.
Regulatory drivers are also creating opportunity. Structured products are no longer being provided by investment banks, who are now working with ETF providers to launch structured products based on a number of underlyings.
In the retail market, regulation such as MiFID II and the Retail Distribution Review (RDR) is helping to bring more individual investors into the ETF market. MiFID II is bringing liquidity to exchanges: under the Directive, whether the trade is onscreen or done via OTC, it will be printed, so the market will see the whole spectrum of liquidity.
So, despite the long wait for its implementation, the advent of MiFID II will provide the visibility that will encourage more investors into the ETF space.