It was hard to miss the tenth anniversary of exchange-traded funds in Europe this past month for anyone who reads the industry news. The incredible growth of assets and products in Europe has far outpaced the United States market through this point in its development, so there was plenty to celebrate. ETF industry insiders and observers have already written numerous quality articles about the changes we have seen over that time, and I do not want to face such stiff competition. Instead, let’s look at what the next ten years have in store.
Not Turning Retail Yet
Nearly everyone agrees that the exchange-traded fund market will continue to grow, but where will the new assets come from? The current European ETF market relies on long-term institutional investors such as pension funds and private wealth managers, investing tens or hundreds of millions at a time. Despite the excitement about the retail market of individuals and advisers coming to ETFs, new assets will still come from the established institutional market for the next two to five years. There’s simply little incentive to chase retail assets yet.
Providers and distributors like large institutional investors because they produce a big asset return on sales efforts; retail assets are very disaggregated and relatively difficult to court. Market makers like these clients because they place large block trades that need to be hedged and trickled into less liquid European ETFs, generating greater profits than the extremely low-margin, on-exchange trading that dominates the US market. Finally, there are plenty of institutional assets still available for ETFs. Even though institutions account for 80%-90% of European ETF assets, they invest much less than 5% of their portfolios through exchange-traded funds. This leaves room for ETF assets to nearly double simply through increasing their share of institutional investment to the same level as in the US.
Regulation’s Role
Retail investment in European ETFs will rise within the next decade, without a doubt. The difference between a marketplace where individuals and advisers own 25%-35% or 45%-60% of ETF assets in ten years’ time mostly depends on one thing: regulation. Much has been made of the Retail Distribution Review in the UK, and how it could push assets into exchange-traded funds by requiring advisers to charge wrap fees rather than commissions while leaning heavily towards low-cost investment funds. What remains to be seen is whether other European regulators will follow the Financial Service Authority’s lead.
Without the push from regulators to drive advisers towards low-cost investments, the retail movement towards ETFs becomes a much slower process of educating individuals on their benefits. That education eventually leads to pressure on advisers to shift toward lower-cost and passive vehicles, but at a generational pace of decades rather than years. Still, whether retail investment over the next ten years arrives in a trickle or a flood, it will drastically affect the rest of the European ETF market by driving greater volume and greater transparency.
New Institutions Come to the Market
The next ten years will see another important new participant in the European ETF market: hedge funds and other rapidly-trading institutions. These funds are natural buyers and sellers of beta products like ETFs, which provide near-instant hedging for equity funds looking to remain neutral across sectors or regions. Many providers are already trying to court hedge funds through consolidating institutional holdings information to make shorting easier and driving greater on-exchange volume to reduce transaction costs. As these institutions start to rely on ETFs more heavily to express macroeconomic views or hedge security-specific views, expect assets to rise and exchange trading volumes to sky-rocket.
By driving substantially greater on-exchange volumes for ETFs, hedge funds and other rapid traders have an interesting symbiotic relationship with retail investors. Individuals and advisers tend not to trade the enormous blocks that allow them to pass execution on to a market maker or major broker. Instead, they rely heavily on short-term liquidity accessible through limit and market orders. As hedge funds drive greater trading on exchange, the effective spreads paid on market orders will likely fall and retail investors will feel safer about taking on the execution risk of ETFs as opposed to traditional funds.
As the ETF market matures, a greater and greater percentage of transactions occur on exchanges between natural sellers and natural buyers who demand no spread versus fair value. This virtuous cycle of greater volumes begetting lower costs begetting greater volumes is inevitable as retail and rapid-trading institutional investors enter European ETFs in the next decade. The ultimate goal is a fund marketplace where the purchase and sale of most ETFs requires as little trading sophistication as traditional funds, because prices so accurately track fair value with such deep liquidity.
Greater Transparency
Broader participation by retail investors and small institutions will also encourage greater transparency for synthetic, or swap-based, ETFs. Providers already show considerable openness in disclosing collateral policies and baskets to institutional investors, but similar disclosures do not exist for the retail market. This is not a matter of discrimination, but stems from the difficulty of producing intelligible disclosure for most investors and the limitations that broad disclosure could impose on synthetic ETF managers.
For retail investors, merely listing a giant pile of securities would do nothing. Without sophisticated IT systems to identify and aggregate the securities, that deluge of information would be disclosure in letter only, not spirit. Instead, providers should give summary statistics for the collateral portfolio: breaking down how much is in each major asset class; how much cash is directly invested in AAA government bills versus money markets versus more esoteric asset-backed or auction-priced securities; how the equities break down by region and liquidity; breakdowns of the durations, sectors, and ratings of bonds; etc. This also addresses ETF managers’ fears of being unable to invest collateral in less liquid instruments that enhance yield but could be traded against if disclosed at a position-by-position level.
This new level of transparency for investors may yet be years off, but will arrive and likely become near universal in the next decade. Even if disclosure results in lower-yielding collateral portfolios and smaller performance advantages for synthetic ETFs, it will be extremely difficult for any competitor to draw retail assets after one synthetic manager combines the lower tracking error of synthetic replication with the transparency of physical replication.
A much larger, more liquid, and more transparent ETF marketplace? Absolutely. I can’t wait for the next ten years.
This article featured on ETFM, IFAOnline's Exhange-Traded Funds Magazine.
