Exchange-traded fund use in Europe is likely to broaden from its current focus on equities, according to participants at the inaugural “Inside ETFs Europe Conference”, held in Amsterdam this week.
“ETFs must also increasingly be seen as a real alternative to derivatives such as swaps and futures, particularly for holding periods of more than three months,” Thorsten Michalik, head of Deutsche Bank’s x-trackers ETF platform, told the more than 400 asset-management industry executives and financial advisers gathered at the Moevenpick Hotel on Monday and Tuesday.
Another factor helping ETFs become a biggerpart of Europe’s investment landscape is anxiety about tax and regulatory changes in the U.S., which may inspire some to get their investment exposure using European-listed ETFs, according to Deborah Fuhr, head of ETF research and implementation strategy at BlackRock. One such change is the recently announced end of withholding tax relief on qualified interest income (QII) for investors in U.S.-listed ETFs who are non-residents, Fuhr said.
European regulations are meanwhile moving toward greater transparency, which could deepen participation in ETF markets, leading to better tradability in the form of slimmer bid-ask spreads on European ETFs, said Alain Dubois, chairman of Paris-based Lyxor, the asset-management subsidiary of Société Générale and Europe’s second-largest ETF issuer.
Still, an undercurrent of frustration was coursing through the conference, as some fretted that the fragmentation of European securities markets, both in terms of ‘me-too’ replication of ETFs and their multiple listings, threatens to slow the progress made by the ETF market. The nearly US$250 billion invested in European exchange-traded products is about a third of ETF assets in the U.S. The Asia Pacific region comes in third with US$67 billion as of March 31, according to data compiled by Deutsche Bank.
“Liquidity is increasing, but we have a fundamental liquidity gap in Europe,” said Peter Thompson, director of strategy at London-based Source, an ETF platform jointly operated by Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley. Thompson lamented the relatively low ETF trading volumes in Europe when compared to the U.S.
A Mixed Bag
Dubois at Lyxor expects upcoming regulatory changes in Europe to help deepen European ETF markets. Specifically, he said the next version of Europe’s fund regulations – the so-called UCITS IV – as well as slight changes to MiFID, the European Commission’s directive covering share trading, will bolster the transparency and tradability of ETFs in Europe. UCITS IV is expected to be promulgated in June 2011.
UCITS IV should impose a best execution requirement on providers of swap-based ETFs when shopping around for the derivatives component of their fund structures, and will also standardise rules on collateral and counterparty risk. MiFID may well change to incorporate mandatory post-trade reporting for European ETFs, something that doesn’t exist now, Dubois explained.
It’s not all plain sailing for the European ETF market, however, despite the prospects for further growth. In a report issued to mark the tenth anniversary of Europe’s first ETF launch, BlackRock’s Fuhr points to the potential abuse of the original, successful ETF concept as a real concern.
“Product developers are working hard to find ways to put structured products, hedge funds and active funds into an ETF wrapper without maintaining the basic features of an ETF – transparency on the underlying portfolios, in-kind creation and redemption, and a real-time indicative net asset value,” she said.
What’s more, the proliferation of ETF listings is making it harder for liquidity providers to offer competitive price quotes across the region, given that each listing imposes an obligation on market makers to quote two-way prices, eating up valuable capital, according to Michael Barmettler and Jan de Bolle of Flow Traders, an Amsterdam-based ETF market maker.
“Why do we need 55 separate European listings of ETFs tracking the same Euro Stoxx 50 index?” de Bolle asked.
Also, assets under management are highly concentrated among the top three ETF providers (iShares, Lyxor and db x-trackers), who jointly control around three quarters of the whole European ETF market. That means that more marginal ETF issuers are likely to shut down or merge, said Barmettler.
An ETF Bubble?
“Could there even be an ETF bubble?” some conference attendees asked, reacting to clear indications that the use of exchange-traded products is expanding rapidly in Europe, regulatory and structural impediments notwithstanding. ETP use has increased five-fold in the past five years.
Probably not, Daniel Donovan of Salix Capital argued during a panel discussion on “Sourcing Off-Exchange Liquidity.” ETFs are merely tools to access underlying market exposure, so there will only be a bubble if there’s a bubble in an asset class particular ETFs are designed to access, Donovan said.
However, ETF providers need to keep in mind that their products should be scalable – that is, capable of growing without capacity constraints, said Matthew Holden of Knight Capital, speaking on the same panel.
This applies both to the underlying index being tracked and the replication method used, Holden said. He cited concerns that issuers of some swap-based ETFs had faced difficulties providing efficient index-tracking to their funds during 2008 as a result of balance-sheet constraints at the parent banks. Swap-based ETFs depend on a bank, often the parent bank of the ETF issuer, to guarantee the index return to the fund.
Overall, however, Holden was bullish about the prospects for ETF trading activity.
“We're on the verge of an explosion of volume in ETF trading in Europe," he said.
The presentations used during the conference sessions can be accessed via the following links: