Exchange traded funds have been in existence for more than a decade but have only recently become significantly popular products. Natasha de Teran charts their progress and new developments.
Although exchange traded funds (ETFs) were first introduced in the US in 1993, they have really taken off in the past three or four years. In 2000 there were fewer than 100 ETFs listed globally, with less than $100bn in assets between them, according to research from Morgan Stanley’s ETF guru, Deborah Fuhr.
By March 31 this year, there were 362 ETFs with 461 listings and assets of $314.9bn between them. That month they were listed across 32 exchanges and there were at least 44 managers competing for assets.
The European ETF market was relatively slow to develop; the products did not even debut there until early 2000. Even so, by the end of the first quarter this year, European exchanges had listed 122 ETFs between them, with $36.9bn in assets. The market has some way to go before it catches up with that of the US, however, where ETFs attract more than 5% of equity fund inflows. But, according to market practitioners, it is well on the way to doing so. They claim that much of the market’s future success is likely to depend on ongoing innovation, which is already doing much to attract new entrants.
Product innovation
Although it is not an issuer, Goldman Sachs is the largest ETF market maker globally. Peter Thompson, executive director at Goldman Sachs in London, says product creation has become a lot more focused in Europe over the past year or so.
“[This] is gratifying to see; two years ago there was something of a land-grab mentality among issuers but now they are seeking to define areas where they can differentiate themselves, or fill particular market gaps,” he says.
“Hence we are seeing – and will see – the emergence of ETFs in areas like real estate and commodities. These give investors a relatively simple and economic vehicle to access areas of the market to which it is otherwise difficult to gain exposure.”
Barclays Global Investors (BGI) launched its first US ETF five-and-a-half years ago and its first UK product five years ago. It is now the largest ETF manager in the world with the highest number of funds and the most assets. Last year, for each dollar that was invested, 80c went into its iShares products. The firm has also been responsible for much of the innovation in the market: in Europe it was responsible for listing the first China, Japan, mid-cap, small-cap and bond ETFs; and in the US it launched the first international, emerging market, value, growth, small-cap and bond ETFs.
Access to portfolios
Chris Sutton, the chief executive of iShares in Europe and Asia (ex-Japan), agrees with Mr Thompson’s verdict on the present day innovation. He says that the most important pieces of recent innovation have been gratifyingly relevant to investors’ needs.
“Our sense is that ETF developments can now be most valuable in giving a form of access to the sort of portfolios or exposures that are most difficult to replicate in the cash or derivatives markets. Recent developments, such as the China, corporate bond and emerging market ETFs, have done just that,” Mr Sutton says.
The SG CIB equity derivatives group’s asset management subsidiary, Lyxor, entered the ETF market in 2001 and now has a 24% share of the European market. It also has a track record for innovation, most notably the first European government bond ETF (which launched in 2004) and the first eurozone style-based ETFs, which included a growth, value and small-cap ETF, all of which were listed in April.
More recently, Lyxor debuted the first-ever inflation-linked ETF in a bid that was designed to capitalise on the growing interest in inflation hedging.
Isabelle Bourcier, ETF global co-ordinator at SG CIB, says the latter will have immediate appeal for insurance and pension funds as well as to other fund managers with inflation-linked liabilities.
She expects the innovation to continue. “While last year saw innovations in the bond area, innovations this year will include further style-based products, commodity-linked ETFs and more emerging market products, such as China and the first emerging Europe ETFs, which we are already developing,” she says.
The most recent European market entrant is BNP Paribas, which recently established a joint venture ETF platform together with Axa Investment Managers and launched the first-ever commodity index-linked ETF. Remi Frank, global head of equity and derivative sales at BNP Paribas, is optimistic about the future for ETFs. He believes that there is still “plenty of room” for more creativity in terms of the underlying assets to which these funds are linked. The next ETF innovations are also likely to be in that area, although it is difficult for the layman to imagine what index spaces the recent surge in innovation have left, he says. Needless to say, he and others are cagey about their future plans.
Competitive action
One less popular move came from Deutsche Bank. The German bank had not issued a single ETF anywhere until January, when it launched into the market with quite considerable noise, undercutting rivals’ ETF management fees by 50%.
Johan Groothaert, global head of the investment products group at Deutsche Bank, explains: “In Europe, ETFs had a very slow start and the market has yet to gain real traction, and that is largely because the management fees have been too high. We recently tried to give the market a boost by launching ETF products with substantially reduced fees.”
Johan Groothaert, global head of the investment products group, Deutsche Bank
The process was not painless for Deutsche, which reportedly had to engage in extended discussions with the index providers before it could offer the low fees it was seeking. But it succeeded and other ETF issuers have since followed suit.
Despite the compressed margins, there is likely to be more competition in the future as more firms seek to capitalise on the growing appetite for the products and more funds are diverted away from traditional equity investments toward ETFs.
Mr Thompson says that the use of ETFs by European institutions is already broadening considerably, not just in terms of the number of accounts using them, but also in the way they use the instruments. “Previously, the majority of users actively used only one or two products – for instance, the major large-cap indices – but, more recently, they have begun to use the instruments to gain exposures to particular areas of the market,” he says. This is a trend he expects to continue and further fuel the market’s growth.
Aside from lower fees, Deutsche’s Mr Groothaert believes that one of the major developments in ETFs will be their use in structured products. “ETFs will link into or merge over time with structured products,” he says. “Most of the active structured product players are also involved in ETFs and vice versa, so it is logical that we will see more cross-over between the two.”
