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The Future of ETFs in the UK and Europe

What does the future hold for ETFs in the UK and Europe given their establishment in the US?

Hortense Bioy, CFA 2 December, 2010 | 9:15AM

It wasn’t long ago, last April to be precise, that exchange-traded funds (ETFs) celebrated their tenth anniversary in Europe. And over the last decade, they have enjoyed incredible growth. There are today 1,352 ETFs listed in 18 European countries, outpacing the 1,075 listed in the United States, according to Morningstar data.

In recent years, the European ETF landscape has also dramatically changed with the emergence of new players--there are currently 32 providers--and the proliferation of a slew of innovative and sometimes rather complex products. However, in terms of assets and trading volume, Europe still has a long way to go to catch up with its American counterpart. The EUR 216 billion European ETF market represents only a third of the size of the US ETF market, and daily on-exchange turnover is 20 times lower. So the question that comes to mind is: What does the future hold for ETFs in the UK and Europe, given their establishment in the US?

Plenty of Room to Grow
Industry participants all agree that the growth potential in Europe remains tremendous given the many advantages that ETFs offer over traditional actively-managed mutual funds, including low costs, intra-day liquidity and access to new asset classes.

As seen in the US, future growth in Europe will come from both institutional and retail investors. At the moment, European institutions invest less than 5% of their portfolios through ETFs. This will soon change as more and more pension funds, insurance companies and private wealth managers are convinced about the merits of ETFs in portfolio construction and as new types of participants such as hedge funds get involved in the market. The number of hedge funds using ETFs to execute their long and short strategies has substantially risen this year in Europe, and this looks set to continue. Hedge funds are particularly interested in what is known in the industry as “create-to-lend”. These programmes make it easy for them to short ETFs when they can’t source any shares to borrow from existing holders.

ETFs are also expected to gain more popularity among retail investors in Europe. This category of investors accounts for only 10%-20% of the ETF market, in contrast to a 50% market share in the US. While retail uptake may be slow to materialise on the continent, it will be prompted by regulatory changes in the UK. The Retail Distribution Review coming into force in 2012 will require financial advisers to expand their range of products in areas such as ETFs.

Future developments in Europe also include sorely-needed trade reporting, which is compulsory in the US but still voluntary here. It is estimated that 50%-80% of ETF trading volume in Europe takes place over the counter (OTC) and most of it goes unreported. This lack of visibility and transparency gives a misrepresented view of ETF trading and possibly discourages certain investors from going on exchanges. Fortunately, regulators are now looking to amend the MiFID directive and introduce a consolidated tape. This will undoubtedly help on-exchange liquidity and potentially stimulate both institutional and retail demand in Europe.

Innovation and Proliferation of ETPs
Europe is also playing catch-up with the US in the race for innovation. In recent years, unusual types of exchange-traded products have come to market to provide exposure to new asset classes and strategies, and more will be created in Europe as investors’ demand evolves and competition intensifies. Today there are plenty of new areas ripe for expansion, especially in actively-managed ETFs, hedge fund ETFs, fundamentally-weighted indices, screened indices and alternative beta.

Actively-managed ETFs are among the most controversial innovative products that have yet to emerge in Europe. In the US, they have failed to gain traction since their launch in 2008. This is partly due to their costs--active ETFs tend to charge annual fees that are comparable to traditional mutual funds--and the difficulty of finding good asset managers excited about the obligation to disclose their holdings on a daily basis.

In contrast, the debuts of hedge fund ETFs have been more promising; at least for those that have managed to mitigate some key issues inherent in this type of investment, including lack of liquidity and limited transparency. Deutsche Bank was the first to test the water in Europe last year with its db x-trackers db Hedge Fund Index ETF. The success of the fund--it has almost EUR 1 billion in assets--has since sparked competition. Marshall Wace and Source have launched their hedge fund ETFs and more are probably on the way.

All in all, it’s fair to say that although the European ETF market has developed at a rapid clip over the last decade, it still has in many respects a lot of catching up to do with the US. As mentioned before, this is the case for assets under management, daily turnover and on-exchange liquidity. But in some other respects, Europe looks far more advanced than its American counterpart, notably in terms of index replication methods. Issuers here enjoy a more flexible creation of products with the possibility of using derivatives, while providers in the US are severely restricted by the SEC. And this may well be an area where the US has to play catch-up with Europe.

This article first appeared in Financial Adviser.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive fund research in Europe.

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