Exchange traded funds celebrate 15th birthday in Europe

Providers of exchange traded funds have a spring in their step as they mark the 15th anniversary of the product's launch in Europe.

Inflows are pouring in at a record rate but managers in Europe admit they have significant hurdles to overcome if they are to replicate the success of the more mature ETF market in the US.

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Rachel Lord, the European head of iShares, the ETF arm of BlackRock, says: "We are welcoming new European investors to ETFs every day. There is a clear [growth] trajectory ahead."

BlackRock has an obvious interest in promoting and popularising ETFs, but its forecast suggests growth in Europe will be slower than in the US. Here ETF assets increased from around $620bn on the industry's 15th anniversary to $1.3tn by the time of its 20th birthday.

Much depends on the evolution of asset prices over the next five years.

Other issues prevail. One such problem, according to Arnaud Llinas, the global head of Lyxor's ETF and indexing business, is that there are simply "too many" ETFs in Europe.

A bewildering range of more than 2,100 ETFs is currently on offer, but only 115 have assets of $1bn or more. Around 1,500 have assets of less than $100m - too small to be used by many institutional investors.

ETF trading is also fragmented across a wide range of venues and exchanges, so liquidity is dispersed into small, inefficient pools. Most of the trading still takes place in private, bilateral over the counter transactions rather than on an exchange. Unlike in the US, no comprehensive record of ETF trading exists in Europe, making it difficult to understand the true liquidity of the market.

This often deters institutional investors, who perceive trading as inefficient, complex and labour intensive. Bryon Lake, head of European ETFs for Invesco PowerShares, concedes the European infrastructure for trading ETFs is still "in the building phase".

He believes more needs to be done to improve access to information, boost on-exchange trading and encourage more involvement by authorised participants [large institutional investors].

Improvements are under way. BlackRock, BATS Chi-X Europe, the region's largest share-trading exchange, and Euroclear have developed a new "international" ETF structure that can settle trades across borders, a vital step towards creating a US-style unified market in Europe.

The use of request-for-quote platforms is also becoming more widespread. These allow investors to compare offers to buy and sell ETFs easily, rather than having to phone multiple brokers to ensure a trade can be done at competitive prices.

Tradeweb, a dealing platform, registered European ETF trades of €28.9bn in the first quarter, a 40 per cent increase on the previous three months.

Important differences exist between the ETF investor base in Europe and the US.

Mr Llinas notes that hedge fund managers play a significant role in the US market but are virtually absent in Europe, which influences liquidity conditions. ETFs account for around a quarter to a third of all equity trading in the US but only a small share of European equity trading volumes.

Retail investors represent around half of ETF users in the US but just a fraction of the European market. Mr Llinas sees this as a "route to increasing growth" as regulatory changes, such as the EU's Mifid II and the UK's Retail Distribution Review (RDR), should drive more widespread adoption of ETFs among retail investors.

Mr Lake agrees that new European regulations should support ETF growth. "The US requirement that financial advisers shift to a fee-based model helped ETF adoption spread like a wildfire," he says.

But Reinhard Bellet, head of passive asset management at Deutsche Asset and Wealth Management, is more cautious. He says it remains unclear whether RDR-type reforms will be introduced beyond the UK, Netherlands and Switzerland to the rest of Europe.

Peter Sleep, a senior portfolio manager at 7IM, who uses both ETFs and index trackers, adds that ETFs have penetrated "reasonably well" among institutional investors but have "a long way to go" in attracting retail investor interest.

He points out that some of the large fund platforms servicing financial advisers still do not trade ETFs.

Even so, the pace of investor inflows appears to be accelerating. ETFs listed in Europe attracted inflows of just under $35bn in the first three months of 2015, a first-quarter record. This followed the European industry's best ever year in 2014, when it gathered $61.8bn, according to ETFGI, a consultancy.

Rising inflows have fuelled a price war, with all the major providers jostling to offer the lowest-cost ETFs. In turn this has made ETFs more competitive against derivatives, particularly for non-leveraged investors.

Ms Lord says one of the main drivers of growth will be from investors who previously deployed capital in trading OTC products, particularly bonds and futures. They are turning to ETFs because of their greater liquidity and low costs.

Whether they are turning in great enough numbers will influence how happy the next five birthdays will be for European ETFs.

Almost 15 years ago to the day the first European exchange traded fund was launched on the Deutsche Borse.

It provided investors with a much needed low-cost alternative to conventional mutual funds and fuelled interest in passive investment strategies at a time of growing dissatisfaction with the performance of active managers.

Manooj Mistry, the head of ETPs in Europe for Deutsche Asset & Wealth Management, helped structure the first European ETFs. He recalls the launch as "a leap into the unknown".

"We knew ETFs were good products because of their low costs, transparency and simplicity as index trackers. But passive investing was not as widely understood as it is today," says Mr Mistry, who worked for Merrill Lynch at the time.

Initially it proved difficult to persuade institutional investors to adopt ETFs. They were wedded to stockpicking and did not understand the potential to generate alpha [higher returns] by using ETFs for asset allocation.

But attitudes have changed and ETFs listed in Europe attracted inflows of just under $35bn in the first three months of 2015, a first-quarter record. BlackRock, the world's largest provider of ETFs, predicts that assets in European-listed ETFs will double to just over $1tn by the end of 2019.

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