In Europe, as well as globally, retail and institutional investors have been steadily embracing the use of exchange-traded funds. Last year, ETFs in Europe saw net inflows of $22bn (£14bn), according to ETFGI, a research and consultancy firm, while Ucits funds suffered net outflows of $119bn ($76bn), according to the European Fund and Asset Management Association.
The move to indexing is being driven by several factors, including investors’ increasingly embracing the benefits of being diversified within and across asset classes. It is also fuelled by the recognition it is difficult to pick stocks or bonds that perform better than the benchmark.
On top of this, it is hard to find active funds that consistently beat their benchmarks, while the costs associated with stock-picking also play a role.
The use of exchange-traded funds by retail and financial advisers in the UK is expected to increase after the retail distribution review comes in, while more investors are using ETFs to implement tactical exposure to specific markets and asset classes.
Most ETFs in Europe are structured as Ucits funds, and although they account for only 3.5 per cent of all Ucits funds, they have been growing at a faster rate than these non-ETF funds -ib total an asset growth of 47 per cent per year over the past 10 years for ETFs, versus 5 per cent for other Ucits funds).
Investors in products bearing the exchange-traded label almost invariably assume they have invested in funds regulated under European Ucits rules.
In fact, the position is far from clear-cut. Whereas exchange-traded funds are listed funds with regulated exposures, exchange-traded notes and exchange-traded commodities lack either of these characteristics. The most common ETN and ETC exposures are wrapped into a debt security, whose value is linked to the performance of designated investments.
Broadly, one type involves a senior, unsecured, unsubordinated note issued by a bank where an investor is not only exposed to an investment risk but also the ability of the issuing bank to meet its debt obligations
The other is generally created out of special purpose vehicles and possible collateralisation programmes. As the structure is unregulated, it is up to investors to ensure they understand the risks and mitigating factors the promoter introduces – or fails to introduce – to mitigate any future loss and create the protections implicit in a regulated fund structure.
Some significant differences between Ucits ETFs and ETNs and ETCs are: the investor often has 100 per cent counterparty exposure to the issuing entity of the ETN or ETC – so, in the case of bankruptcy of the issuer, the investor may not receive back their full investment; fees for ETNs can be higher and less transparent than ETFs and fee disclosure for ETNs is not standardised (or regulated); and there are often additional fees for transaction costs, hedging and index licence costs on top of the annual investor fee.