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Home > Investments > ETFs & Trackers

From Special Report: Passive Investing – June 2013

ETPs and ETFs ready to break the $1 trillion barrier

Experts predict that the European exchange-traded product sector will exceed $900bn (£598bn) in size by the end of 2017. A large part of that is regulatory change, not just in the UK but in other European countries, which are moving customers to a fee-based model that emphasises the importance of low-cost products. What are the advantages and disadvantages of ETPs?

By Deborah Fuhr | Published Jun 05, 2013 | comments

Assets invested in exchange-traded funds and ETPs listed in Europe are forecast to exceed $1 trillion (£664bn) by the end of 2017, according to some analysts. ETFs in Europe are a relatively recent innovation, having been launched just 13 years ago. Globally, ETFs have existed for 23 years. The first was launched in Canada in 1990, while the first ETF in the US was introduced three years later in 1993.

It is important to remember that ETFs in Europe are open ended, index Ucits funds, index funds (active ETFs account for less than 1 per cent of assets) which are listed on exchanges and can be bought and sold like ordinary shares on a stock exchange. They offer broad exposure across developed, emerging and frontier markets, sectors, equities, fixed income and commodities.

ETFs are a very democratic product offering the same tool box of exposures to all investors at the same annual cost with a minimum investment size that is typically one share with a price that is generally less than $100 (£66), which is very unusual in the financial service industry.

ETFs are used by investors to:

- Equitise cash

- Implement diversified exposure to a market.

- Comprise a core or satellite investment.

- Be a long term strategic investment.

- Implement tactical adjustments to portfolios.

- Use as building blocks to create entire portfolios.

- Allow investors to hedge the market.

- Use as an alternative to futures and other derivative products.

ETPs are products that have similarities to ETFs in the way they trade and settle but do not use an open-ended fund structure. The use of other structures including unsecured debt, grantor trusts, partnerships, and commodity pools by ETPs can, in addition to a significantly different risk profile, create different tax and regulatory implications for investors when compared to ETFs, which are funds.

Record net inflows of $83bn (£55bn) up to the end of April helped to push assets invested globally in ETFs and ETPs to a new all-time high of $2.13 trillion (£1.41 trillion). There are now 4827 ETFs and ETPs, with 9897 listings, from 209 providers listed on 56 exchanges.

In the US there were 1459 ETFs and ETPs, assets at a new record of $1.49 trillion (£990bn), from 52 providers listed on three exchanges. In Europe the ETF and ETP industry had 1965 ETFs and ETPs, with 6222 listings, assets of $385bn (£256bn), from 49 providers listed on 23 exchanges across Europe.

In Europe ETFs and ETPs have been one of the fastest-growing products, enjoying a 42.5 per cent compounded annual growth rate in the past 10 years. The growth rate in Europe has been higher than the 29.6 per cent global 10-year compounded annual growth rate and higher than the 28.9 per cent 10 year compounded annual growth rate in the US.

ETFs in Europe are Ucits funds, and although these ETFs account for only 3.5 per cent of the Ucits fund universe, they have been growing at a much faster rate than other Ucits funds with asset growth of 42.5 per cent in the past 10 years for ETFs, as opposed to 5 per cent a year for other Ucits funds.

In the US the use of ETFs and ETPs is embraced by institutional investors as well as a significant percentage of fee-based financial advisers, online brokers that increasingly offer to trade ETFs and ETPs at zero commission to attract new customers on to their brokerage platforms and retail investors. Historically in Europe ETFs and ETPs have largely been used by institutional investors as financial advisers have typically embraced using investment products that paid them which is not a model embraced by ETFs.

Some of the key drivers for the continued growth in the use of ETFs in Europe:

- Regulatory changes.

- Move to indexing.

- Move to multi-asset class investing.

- Access to markets and asset classes that would otherwise be difficult to implement.

- Significant expansion of the breadth and depth of the product offering.

Regulatory changes such as the retail distribution review in the UK and Dutch RDR which ban the payment of commission for distribution for all or some advisers will stimulate the use of ETFs by financial advisers and end-retail investors outside the US. There is an expectation of similar changes in other European countries as well as for platforms.

The move to indexing is being driven by several factors, including investors increasingly embracing the benefits of being diversified within and across asset classes and the recognition that it is difficult to pick stocks or bonds that perform better than the benchmark. Furthermore it is hard to find active funds that consistently beat their benchmarks. The cost associated with picking securities also plays a role.

In his often-referenced article, The Loser’s Game, published in the Financial Analysts Journal, Charles Ellis highlighted the shortfall of active managers. He noted that in the prior decade, 85 per cent of all institutional investors who tried to beat the stock market underperformed the S&P 500 Index.

The challenge of finding professional managers who consistently beat their benchmark, as measured by the S&P 500 index, and delivered alpha by picking individual stocks has not changed much in the past nearly 40 years.

Numerous studies have shown that it is hard for professional active investors to consistently beat their benchmark. What is more, the annual costs associated with investing in active funds is significantly more than investing in an index fund designed to track the same benchmark.

These higher costs are another important factor accelerating the move to index investing. Since the recent financial crisis, investors have become more aware of the impact these expenses can have on active fund performance. An active fund that delivers returns below the benchmark prior to costs being deducted looks like a faulty choice after deducting the typical annual 1.5 per cent expenses for active funds.

An index fund may not offer the potential to outperform a benchmark, but you do know you will get the benchmark minus fees and any tracking error, which should be very small – typically less than 0.5 percentage points for an S&P 500 index fund. In the past few years we have seen growth in the use of index investing by both retail and institutional investors through futures, structured products, equity-linked notes, index funds and ETFs.

Investors need to be diligent in determining how they might implement index exposure to their selected benchmark. Futures tend to cover less than 80 benchmarks. Also many investors are not allowed to use futures, while others are limited in their use and others prefer not to use them.

Structured products and equity-linked notes are investment vehicles which are created by banks and brokers on a bespoke basis. They typically require an initial investment of $20m to $100m (£13.2m to £66m), depending on the index.

Meanwhile index mutual funds tend to exist only on well-known indices while ETFs cover an ever-expanding array of indices and asset classes. ETFs offer a number of benefits over many of the other alternatives mentioned above: small minimum investment, typically less than $100 (£66), liquidity, diversification, low cost, exchange-traded, and real-time access to a wide range of indices and asset classes around the world.

ETFs and ETPs have made it easy for investors to implement exposure to markets that would be otherwise difficult to access such as India, Korea, mainland China’s A-shares and Taiwan, as well as asset classes such as commodities. Investors are increasingly embracing a multi-asset class strategy.

The array of benchmarks and asset classes being offered is allowing some firms and financial advisers to predominantly use ETFs and ETPs to build and offer strategies and solutions where the majority of the assets are invested in ETFs and ETPs. Some examples are risk-profiled portfolios, target date strategies and tactical asset allocation. For some the goal is to use ETFs and ETPs as low-cost beta building blocks to implement asset allocation with the goal of generating alpha.

EDHEC’s European ETF study in 2012 found that 67 per cent of the institutions planned to increase their use of ETFs and ETPs while only 4 per cent of the respondents expected their use of ETFs and ETPs to decline. Investor satisfaction with their use of ETFs is high and has been high for the past seven years the study has been conducted.

The expectations for future use of ETFs is much more positive than investors’ expectations for their use of other alternative index products. Thirty per cent of the institutions expected to decrease their use of total return swaps while 11 per cent expected to increase their use, 26 per cent expected to increase their use of index funds while 24 per cent expected to decrease, and 28 per cent expected to increase their use of futures while 9 per cent expected to decrease their use.

The above factors will help drive the assets invested in the European ETF and ETP industry to exceed $1 trillion (£664bn) by the end of 2017.

Deborah Fuhr is a partner of ETFGI

Experts predict that the European ETP sector will exceed $900bn (£598bn) in size by the end of 2017.

In Europe ETFs and ETPs have been one of the fastest-growing products, enjoying a 42.5 per cent compounded annual growth rate in the past 10 years.

The array of benchmarks and asset classes being offered as ETFs and ETPs allows some firms and financial advisers to predominantly use ETFs and ETPs.

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