Issuers of European exchange-traded funds can more than double their funds’ stated management fees through ancillary activities such as securities lending, other enhancements and trading activities, says a new research report from Deutsche Bank.
According to the authors of “In the ETF Labyrinth, Where Does The Thread Begin?”, the bank’s European head of ETF research and strategy, Christos Costandinides, and its European head of index research, Daniel Arnold, synthetic ETFs are the most profitable type of fund, generating an average gross profit margin of 69 percent for their issuers. Physically replicated ETFs generate an average gross profit margin of 64 percent, say Costandinides and Arnold.
Deutsche Bank’s estimate of the European ETF industry’s profitability is based on revenue and cost figures which, apart from fund management fees, are not independently verifiable. The report’s authors do not disclose details of their calculations.
For synthetic ETFs, say Costandinides and Arnold, issuers’ average total revenues are over 1 percent a year, more than double the average fund management fee of 43 basis points (0.43 percent). Securities lending revenues contribute 20 basis points a year towards issuers’ earnings, estimates Deutsche Bank, while trading by the ETF issuer’s associated bank can add a further 35 basis points a year. Other “enhancements” can add 5 basis points more to the revenues of a synthetic ETF, according to the report.
The main cost for a synthetic ETF is an estimated 20 basis points a year for the provision of collateral to the fund, says Deutsche Bank, while management costs—at 5 basis points a year—are only a quarter of those for physically backed funds. Administrative and other expenses total 7 basis points a year.
For physically backed ETFs, the main revenue stream adding to management fees that average 45 basis points a year comes from securities lending, which generates a further 26 basis points a year, Costandinides and Arnold estimate. They say other enhancements add 5 basis points, while, unlike issuers of synthetic funds, physical ETF providers are unable to generate any additional revenues from trading.
Physical ETFs operate with management costs that are four times higher than those of synthetic ETFs, 20 basis points a year, according to Costandinides and Arnold, but since these ETFs do not need to provide additional collateral, they suffer no related charges. A further 7 basis points a year for administrative and other expenses bring physical ETFs’ total costs to an estimated 27 basis points a year, just over a third of these funds’ total revenues.
On this basis, says the report, BlackRock, Europe’s largest of issuer of exchange-traded funds, and whose fund range is almost entirely based on physical replication, earns an estimated €378 million a year in profit from its ETF-related activities.
Lyxor and Deutsche Bank, the region’s leading providers of synthetic ETFs, earn more than €250 million each from their ETF operations, estimate Costandinides and Arnold, while the industry as a whole in Europe generates €1.2 billion in annual profits.
The scale of the revenues that accrue over and above ETFs’ management fees calls into question the traditional fund management model, suggest Costandinides and Arnold.
“The historical premise is that asset managers are independent middlemen who, for a fee, manage assets and look out for their clients’ best interests,” say the authors. “In truth, today money management is performed both by asset managers, which are often part of banks, or by banks directly. The model of an independent fund manager providing services in exchange for a nominal fee, while still relevant, is in most cases obsolete. Money managers are not middlemen anymore, the information revolution is forcing them to transform. Money managers are now routinely involved in activities ancillary to fund management, which result in significant additional revenues.”