However, we are now at a tipping point, as new adopters from across the retail spectrum discover the ways in which ETPs can help them achieve their long-term goals.
Within the ETP universe, Ucits-compliant Exchange Traded Funds are the largest fund category and the most common ETP available in Europe. The growth in the ETF market reflects an increased interest in passive solutions, including ETFs and index mutual funds, driven by increased awareness of index-based strategies and also by new regulation such as the retail distribution review last year.
The RDR aimed to level the playing field by banning retrocession payments on specific funds. This has meant that ETFs, which never paid retrocessions, have become more frequently used as advisers seek to blend active and passive strategies in a way that optimises their clients’ fees and active risk budgets.
Furthermore, we have seen advisers adopt a more dynamic approach to enable them to capture opportunities more effectively, and the liquidity and variety of the ETP market enables them to be more nimble in their overall allocation.
Investor appetite has continued to be strong so far this year, with ETP flows into European-domiciled ETPs for the first five months of 2014 reaching $25.8bn (£15.1bn), exceeding all of 2013.
With this pace of asset gathering, and the broad economic recovery across Europe, the European ETP industry looks set for a very positive year, with the potential to reach $50bn (£29bn) inflows by the end of the year and $500bn (£294bn) in total assets under management by early 2015.
Much of this year’s flow has gone into fixed income exposure as clients seek yield through emerging market debt and high yield strategies.
We have also seen a return to emerging market equities as valuations became compelling compared with those of developed market equities. Niche markets, as well as new asset classes, are being accessed through index solutions. The ability of ETPs to provide a more granular exposure enables investors to be selective, choosing, for example, China and Taiwan rather than a broader basket of indices.
The growing use of ETFs is coming from a number of different routes and we are seeing some evidence of it on platforms as advisers – and their clients – recognise the role these funds can play in creating dynamic low-cost portfolios.
This view was supported by the findings of a survey of UK advisers carried out by Platforum in the first three months of 2014. When asked what investment instruments, other than mutual funds, they expected to be included in client portfolios in 2014, 33 per cent of advisers mentioned ETFs.
Advisers who use Diversified Growth Funds or platform-based third-party managers to provide outsourced solutions are also indirectly using ETFs.
This is because the majority of these approaches will use a broad toolkit, notably in core-satellite structures, in which ETFs play a major role.
For advisers considering the use of ETFs, a broad reduction in platform trading costs is to be welcomed, although work remains to be done to level the playing field with mutual funds.
It remains the case that the latter’s dealing costs are typically embedded in a spread, whereas ETFs will attract an explicit charge, which to some represents a hurdle.
However, we encourage advisers to consider the total cost of ownership, that is to say, the cost of buying, holding and selling an ETF, which can, in many instances, be lower than an equivalent mutual fund.
That is because, unlike a mutual fund, ETFs have a secondary market. The resulting competition among market participants means spreads will typically be tighter than the underlying assets.
For evidence of how the market for ETFs in the UK and Europe might evolve, we can take a look at the US, which moved to a fee-based model more than 10 years ago. In the US, ETFs are now very much part of the adviser mainstream and play a key role in personal and workplace savings.
The liberalisation of the UK retirement market, and the introduction of auto-enrolment default fee caps, will no doubt further accelerate appetite for index solutions in the UK.
For this growth to continue, further development is needed in the UK and Europe because the trading infrastructure in these markets has lagged the growth in ETF assets.
Major players in the ETF industry have long been advocates for improved market efficiency. This will make a big difference to uptake. For example, in the US, ETFs now reflect more than 20 per cent of the daily reported volumes traded on US exchanges.
In fact, the US equity market – a common reference point of market efficiency – is extraordinarily fragmented at the exchange level, with multiple participants. However, the exchanges have a common regulatory framework – similar to Europe’s Markets in Financial Instruments Directive – put in place in 2007 to promote competition through connectivity of quotations across market centres. Since this framework was installed, US trading volumes in ETFs have grown considerably.
Trading in ETFs across Europe is still fragmented, and data on a fund’s true liquidity can be difficult to access, since the majority of trades are over-the-counter and therefore not reported to an exchange. Improvements are needed to bring the system up to its maximum efficiency, and work is being done to address this.
A selection of ETF market participants recently came together to give feedback on the second instalment of MiFID II.
They championed a more transparent view of market activity for ETFs through various proposals including harmonising trading regulation, and clarity of reporting rules.
All these initiatives aim to highlight the ETF market’s broad liquidity and provide a truer indication of pricing.
These reforms and developments in the structure of the ETF market in Europe should push us closer towards the US model, where investors benefit from tighter spreads and more visible liquidity.
ETFs have excellent growth prospects in Europe over the next few years, as the marketplace delivers a more efficient, reliable and streamlined investment infrastructure, and the move to fee-based advice spreads across the Continent.
Mark Johnson is head of UK sales at iShares
Key points
* The ETF sector has enjoyed rapid growth, and total assets now exceed $450bn (£265bn).
* The growing use of ETFs is coming from a number of different routes, including platforms.
* ETF units can be lent by custodians in certain circumstances, potentially providing a source of revenue that mitigates the TER.
