A version of this article appeared in Global Investor magazine in May 2007
In the seven years since their introduction into Europe, exchange-traded funds have become an important part of the investment landscape. With an estimated $600 billion assets in ETFs globally in early 2007 being forecast to reach $2 trillion by 2011, ETFs are reaching a critical phase in their development. Brian Bollen assembled half a dozen of investment industry experts at the Zurich headquarters of SWX Swiss Exchange and virt-x, to discuss the future of ETFs in Europe.
Brian Bollen: an international financial journalist for 22 years, a Fellow of the ifs School of Finance (FIFS), and chairman of the Global Investor ETF Round Table in Zurich on April 24 2007.
Peter Thompson, executive director, equities, at Goldman Sachs International in London, looks after GSI’s European ETF and synthetic business.
Alexander Hoffmann, head of banks and financial institutions at the Zurich branch of Pioneer Global Investments, Dublin, responsible for sales of active investments.
Thorsten Michalik, director, db x-trackers, based in Frankfurt, has run Deutsche Bank’s ETF business for the past 12 months; previously responsible for listed warrants and certificates in Asia.
Alain Picard, assistant vice president, product & services management/equity, at SWX in Zurich, ETF product manager for SWX Virt-x.
Roger Bootz, vice president, exchange-traded funds and derivatives, Switzerland, for Société Générale corporate and investment banking, Zurich.
David J Saaty, managing partner, GI GlobalInvest, Zurich, formerly of Merrill Lynch and Schroders; set up own multi-manager boutique in 1996 running pension fund money.
Brian Bollen: Where do ETFs stand in the European retail market?
Alain Picard: In the first quarter of 2007 around 25% of all ETF trades on SWX/virt-x were below CHF 10.000 and therefore real retail trades. The rest is private banking and institutional money. The average trade size for the first quarter was CHF 180,000 with a median of CHF 27,000. Turnover was up 73%.
Thorsten Michalik: Before we address that you have to consider where they stand in the ETF motherland, the USA, where 60% of the new money that flows into ETFs comes from retail investors. The question we must ask is whether these investors are self-directed, or being guided by fee-based financial advisers? ETFs have moved from being an institutional business in the USA to a retail business. Will we also see this trend in Europe? I don’t believe we will, at least not in the next few years.
Brian Bollen: Why not?
Thorsten Michalik: There are two reasons why. First of all, there is already a huge self-directed market in Europe, the certificate market. In Germany, for instance, we have certificates with no maturity date; it will be very difficult to persuade retail investors out of them and into ETFs. In markets where such products haven’t been accessible in recent years, such as Italy, where certificates typically have a three- to four-year maturity, it is much easier. Italy as an example is seeing about 25% of turnover coming from retail investors, compared with 10-15% in Germany. The second reason is fee-based advisers. Generally speaking, they don’t yet exist in Europe for retail investors; the existence of a fee-based advisory market is one of the driving forces behind retail investment in ETFs in the US.
Peter Thompson: We’re a bit more optimistic, Thorsten. What we have seen in the USA is that retail customers have demanded information on ETFs from their financial advisers, who have then had to come up with creative ways to sell them, and find non-standard ways to be compensated. But then it is easier to sell and market ETFs in the States than in Europe, because it’s a single market with a single regulator, and there is a lot of information about them.
Thorsten Michalik: ETFs were a way for retail investors in the USA to have passive exposure. Do retail investors in Europe want to be passive investors? Yes, but what people have to accept is that it’s not that investors don’t understand ETFs, it’s that they already have the passive exposure they want through certificates. That’s the reason why the retail market in Europe will not grow as much. We know from statistics that there are already $300bn invested in passive products here by retail investors. That’s huge compared with the overall ETF market worldwide.
Peter Thompson: I would say to that, Thorsten, compare it with what happened in the USA. We had the mutual fund industry which served the goals of passive retail investment perfectly well. But we have seen a shift of some of the assets that were traditionally in mutual funds. We have also seen some of the very traditional mutual fund companies move to follow the market and bring out their own ETFs, as Vanguard eventually did. But some people are still prepared to pay for the alpha that an actively managed index fund can deliver as opposed to just beta exposure from an indexed fund.
Roger Bootz: The other question you have is when you compare the certificates market in Europe with the ETF market in Europe, is whether it makes sense to go for blue chip indices and standard indices because you don’t have issuer risk as you would have with a bank certificate. It will be interesting to see whether the certificates industry can become much more specific in terms of theme and strategy indices. Will we see some trends emerge over the next few years? What do you think, Thorsten?
Thorsten Michalik: Because of the positive PR that ETFs have enjoyed in Europe you will see a shift of money that is currently in some certificates, and some new retail money will go into ETFs. But it will take five to 10 years. We will see some very liquid ETFs which will attract strong interest.
Alexander Hoffmann: ETFs are one possible way to implement a specific market view and strategy in a retail portfolio. The success of total return products has shown clearly that there is a strong demand for those solutions where the client basically outsources this decision making process to the experts of an asset manager. ETFs can’t offer such solutions to retail investors.
David Saaty: Although I am from the institutional side of the fence, I would like to ask a question and make an observation. Isn’t it the case that a lot of banks and external portfolio managers use mutual funds because they get the retrocession (payments to a financial adviser by the seller of the investment product, also known as trailer fees) while with an ETF they don’t receive anything?
Roger Bootz: You’ve answered your own question, David. The problem that ETFs face in Europe is that active managers charge higher management fees and so can pay for distribution over local networks, through banks or independent advisers. This is not the case with ETFs. To distribute ETFs in Europe you have to find ways to communicate the advantages of the product to final investors and financial intermediaries. A lack of transparency has in the past not been to the benefit of the retail investor. In Switzerland there was a court decision in March 2006 on ‘retrocessions’ that means the independent financial adviser needs to show investors what payments he has received for putting a product into a client’s portfolio. This will help the investor by improving transparency for the investor, and will also help ETFs, because they do not pay retrocessions.
Alexander Hoffmann: Banks want to be paid for their efforts, and that is a fact. In the past, they have been paid by the mutual funds via the retrocession, and charged clients nothing. This will change. Competition between the pure long-only mutual funds and ETFs is already there. In terms of retail, the market is becoming more transparent; in the future financial advisers will have to tell clients how much they are receiving from the mutual fund. If the adviser advises investment in an ETF, he will have to charge a fee to make a living.
Brian Bollen: How important is education to the future development of ETFs, and whose responsibility is that education?
Alain Picard: I personally believe education is very important, and that it should come from all parties involved, the issuers, the index providers, the market-makers and the exchanges. We see more and more issuers hiring local people to approach and explain to local investors.
Roger Bootz: A number of players in the industry have already done a fantastic job on the education side in Europe. In Switzerland, as more and more ETF providers come into the market, there is much more education done, also by the press, with a greater number of articles and new publications springing up. The SWX does a great job with its ETF events, which enable ETF providers and counterparties to come together. However, many pension fund managers don’t know much about ETFs yet.
David Saaty: I agree. What I see is that many of the larger pension funds know the likes of BGI and State Street and other big providers. They know they can ring them up, and they’ll be round the next day, and they’ll give them an index mandate of $100m-plus. But the smaller pension funds are not as well educated about the product; while they are aware of them they are not using them as they could. We started using ETFs last year, and the mechanics of buying and selling are not that easy if you don’t do it on a daily basis, so I think also there is a need to educate institutions. If you’re calling a pension fund outside a large city where they are not accustomed to doing business in English, the mechanics are not that easy, and need to be explained.
Brian Bollen: Might there be a suggestion for some investors that a brand name is more important than the type of product?
Peter Thompson: Institutional clients are looking only at the exposure they get and what it costs them to access that exposure. As long as it is listed, and listed in the right place for tax purposes, and is transparent and liquid, I don’t see many of our client base showing loyalty to a brand.
Brian Bollen: So if you had a choice between an ETF issued by BGI, and an ETF issued by a lesser name, you wouldn’t plump for BGI? You would look only at listing and transparency?
Peter Thompson: You would look at whether they were UCIITs funds, have they been approved by the proper regulatory authorities, are they trading on the exchange with that stamp of approval? Is there liquidity in the primary market? Is there liquidity in the secondary market? The other thing people will look at as they get more adept around this market is the size of the fund. All else being equal, it is probably better to invest in a large fund. Some institutions have a threshold they cannot go over: i.e., they cannot hold more than 10% of the assets of an outstanding fund, so they have to go to a bigger fund.
Brian Bollen: Do the regulators have the necessary awareness of the underlying products and practices? Can they be relied on to get it right?
Peter Thompson: The European ETF market is now around seven years old. Regulators in most countries here have become familiar with the product, and the structure is becoming quite standardised.
Alain Picard: I don’t know a more transparent and regulated product. For instance, the Swiss Federal Banking Commission (the Swiss regulator) gives the right for distribution to thousands of mutual funds in Switzerland. So the regulator has experts in the fund business and they understand more and more how ETFs work. After receiving regulatory approval the fund is also scrutinised and approved by the exchange’s listing department. During the trading day, every trade in ETFs is monitored with regards to fair trading conditions. I believe investors can feel safe with these products.
Brian Bollen: Where do ETFs fit into the overall investment landscape?
Peter Thompson: Iinstitutions are going through some pretty fundamental changes, such as allowing a long-only manager to go short, or creating a more alpha-generative component. Many don’t want to go all the way to using an OTC derivative such as options or swaps that are completely customised. It’s a bridge too far for a first step. They want to create a new alpha-generative structure but they want a product that won’t break them downstream; the ETF fits very well because from an operational perspective it looks and clears and settles and is borrowed like a share. It won’t break the back office, whereas a swap or derivative might. They’re available at a slightly higher cost and they are less customised, but it’s an interim step in the important direction of gaining the exposure they want.
Brian Bollen: Where do ETFs fit in with asset allocation? Do they form part of the mainstream percentage, or the alternative asset percentage?
Peter Thompson: I would put them in the mainstream but I would say that they are more applicable to a situation where a mid-level conservative fund with a global mandate is looking to increase asset allocation to Asia or Asia ex-Japan, where it might not have the resources or the stock-picking investment expertise. They are developed markets, liquid, relatively easily traded, but what are they going to use to get into those markets? ETFs are listed, and easy to use.
Brian Bollen: So they enable you to access a touch of the exotic but not too much?
Peter Thompson: Yes. We have seen great growth on the institutional side as they become more active in playing markets or sectors where there are not as many listed alternatives and futures.
Brian Bollen: How important is size in deciding whether to buy an ETF?
Roger Bootz: First of all it depends on the size the instituition wants to buy. If it is the same as is quoted on the exchange, or less, it makes much more sense to buy directly on the exchange. If it is bigger, or in an exotic market, it makes more sense to contact the ETF provider or the broker. If you’re buying into a commodity ETF, it might make sense to buy the quota when the local markets are open, so you can benefit from the market-makers having tightened spreads. These are all factors that will affect your decision.
Peter Thompson: You’re absolutely right, Roger. If you went into an ETF without knowing fully what you’re doing, you probably wouldn’t achieve what you set out to do. If you tried to buy a €10m European-listed ETF on an Asian country and just lifted the offers off the exchange, depending on how many market-makers there are, and depending on the time of day, you could be paying more and more and more relative to fair value. But if you talk to a broker or a provider who will put you in touch with a trading firm, there are better ways to execute that trade. Could you give an order where I would execute in the local Asian market and give you a fill in the ETF the following morning? Yes, absolutely, but you have to be walked through that, in terms of what your fill will look like, and what benchmarks you will use to look at it relative to fair value of the fund. It’s a standardised product but there are aspects and issues that have to be explained in detail.
Brian Bollen: Are ETFs maturing along the lines you would like to see?
David Saaty: I would say the product is maturing, but there is one limitation to ETF growth: how knowledgeable are institutions to make asset allocation decisions? Are they willing to make these bets themselves or would they prefer to delegate?
Peter Thompson: One thing that has taken me by surprise is that Europe once looked as if ETFs here would be a big regional market, but the market is now looking very much like the USA did two or three years ago. In the USA, new ETF issuers such as Power Shares and Wisdom Tree are creating their own issues. It will be interesting to see if, how and when that will come to Europe. Already you have a broad product offering; you have a large international ETF market, with emerging markets, Asia, south America, and you have the most active commodity ETF market in Europe. It’s a relatively full product offering, and that is a sign that it is maturing.
Alain Picard: I personally have a two sided view. I like the developments that Peter mentioned in the USA, which enable investors to go deeper into a sector and other innovations. On the other hand, in the past ETFs were very transparent, but at the moment I am a bit scared that they are going in the direction of structured products. Many issuers are jumping on the ETF train, offering ETFs that aren’t really ETFs or creating black-box structures.
Peter Thompson: There is definitely a challenge for the issuing side here. As issuers become more and more creative with the exposure they put inside a traditional ETF wrapper, they need to make sure that transparency keeps up with the creativity. Extreme transparency has been one of the primary drivers of the success of this market. If investors find tracking error difficult to measure, or they can’t see where it’s coming from as structures become more complicated, that could be problematic.
Brian Bollen: How active are ETFs becoming? Are the lines between passive and active blurring?
Thorsten Michalik: Let me play devil’s advocate here. Having looked at the latest e-fundresearch.com performance analysis for active funds in Europe, it is clear that some active managers have become very, very passive. The average tracking error of five years ago was at least 8%. Today it is 3%. The question is: do you want to pay active management fees for potential average tracking error of 3%? I don’t want to play passive against active, but both roles have moved closer together and it has become a question of how much you are prepared to pay for outperformance and do you need that outperformance. There are passive strategies, like investing in dividend indices, that outperformed their normal benchmarks in recent years.
Brian Bollen: Alexander, it is part of your job at Pioneer to persuade people to invest in products other than ETFs. How do you do that? Do you highlight their deficiencies?
Alexander Hoffmann: No, it’s not a question of saying ETFs are bad, and that active management is good. It’s a question of where they fit into an individual tool box, alongside actively run mutual funds, hedge funds and derivatives. ETFs could be a perfectly good way of meeting some of their needs. It pretty much depends on the skill-set and investment strategy of an investor which of these tools he uses. For example, if he doesn`t have the capabilities to analyse all active mutual fund managers to find the ones which consistently deliver outperformance and alpha, he has two possibilities. Either he buys this know-how from independent advisers like David at GI GlobalInvest. Or he simply uses ETFs to be invested in the index of the market he is interested in. Sometimes it might also happen that they decide for their tactical allocation to increase the share of a specific market short-term.
Peter Thompson: That’s a great point. We spend a lot of time on situations where an institution has decided to change its investment policy and take a more alpha-generative approach. They know the exposure they want, but they need to be told how to get that exposure. If you want to execute a sector strategy, you can buy a sector future, a sector ETF, a sector swap, a sector CFD, a sector certficate, a programme trade, and there are probably still two or three other possibilities. Everything will give you something slightly different, and have different technical and risk characteristics; it’s a question of working out which is the most appropriate wrapper for each individual requirement.
Brian Bollen: What is the next big thing for ETFs?
Thorsten Michalik: In the future, European ETFs will begin to provide solutions to investors, rather than just provide access to another market. That will be a driving force for the next couple of years. Under UCIITs 3 you can use innovative financial instruments within a fund to replicate an index. You can now offer ETFs on structured or dynamic indices, that was not possible previously. Investors who could not previously access those structured payouts, can now do so. Last year there more ETFs launched that offered access tostyle, structured and dynamic indices than on market access only. Fund structures will become more innovative. Take, for example, sharia-compliant investment. It is good if you can offer an ETF on a sharia-compliant index, but it is even better if you can offer it in a fund wrapper that is also sharia-compliant.
Roger Bootz: I agree. There will be more ETFs on emerging markets, perhaps there will be sharia ETFs, and alternative asset class ETFs.
Peter Thompson: Exchanges are publicising transactions more, and as ETFs proliferate the professional market-makers have come in, volumes have grown, spreads have tightened and transparency has improved. In the States we are seeing the second generation of issuers, the likes of Wisdom Tree and Power Shares, who create the product from start to finish. It’s more a question not of if they will come to Europe with a similar product offering, but when, and how will they do that? Will they need to team up with a European entity, or will see home-grown smaller innovative European issuers develop?
Thorsten Michalik: I’m not so sure. In the US, a single market, it makes sense for smaller boutiques to set up shop , but if you don’t have distribution in Europe and target 10 different jurisdictions, it could be very hard to succeed. I don’t think you’ll see a second generation of issuers on the same scale here.
Peter Thompson: Will that force would-be providers to form joint ventures or partnerships? Or is it already too late to get into the ETF game as an issuer? Vanguard got in late in the US, but they are now in in a big way. Could you see that happen in Europe, with big firms teaming up with smaller specialists from the US? There are around $600bn of ETFs globally, but it is forecast to be $2 trillion by 2011, which is only four years away. If there is that much growth left, surely it’s not too late to enter the market with new indices and products?