Assets under management in Europe rose by 8.5 per cent, while in the US the increase was a measly 0.3 per cent and Japan fell by 5 per cent.
According to Deborah Fuhr, executive director of investment strategies with Morgan Stanley, that blip should not be viewed as the US reaching saturation point in ETF investment. “While the US market is more mature than Europe, it was simply a period of slower investment in North America than in Europe.”
With 154 listed ETFs valued at $228.4bn (€174bn) at the beginning of March, US dominance of the sector is undisputed. But Europe is catching up with 119 listed ETFs worth $36.9bn, while Japan has 15 ETFs with $28.8bn of assets.
“In general the European ETF market trails the US by three to five years in terms of innovation and use,” says John Davies, director of market developments at Standard & Poor’s (S&P). About 40 per cent of ETFs around the world are based on an S&P index.
John Davies, Standard & Poor’s
Essentially an ETF replicates the performance of a chosen index and while the portfolio manager tries to minimise the deviation from true tracking of the index, there must be some due fees, expenses and dividend reinvestment.
“There are a few reasons why Europe was so busy, a main one being growing interest from the pension fund market which views ETFs as another investment product that can reduce risk, while offering a good geographic exposure,” explains Mr Davies.
Best of three worlds
The general market assessment is that institutions, and European pension funds in particular, are realising that trying to access all parts of the world for investment is not always cost effective or offers a favourable risk outlook. The beauty of ETFs, so the argument goes, is that they can provide that geographic diversification for both a low cost and lower risk.
“This also allows the funds to concentrate their expertise in the markets they understand and add value to the portfolio,” says Ms Fuhr. She points out that Morgan Stanley research noted that over the past year ETFs identified as offering a broad geographic exposure saw assets under management increase by 142 per cent, while ETFs without that exposure only saw assets grow by an average of 70 per cent. “So the interest is certainly there,” she adds. Even China is due to launch an ETF later this year.
Chris Sutton, chief executive of iShares for Europe and Asia (ex-Japan) notes a few other trends in the European pension fund market: “I don't think its imminent that Europe will use ETFs as a sectoral investment tool as is happening in the US; there are other issues higher in the investment pecking order.”
Chris Sutton, iShares
ETFs are opening new investment doors for institutional investors such as hard-pressed pension funds seeking to allocate assets in a manner which matches their liabilities.
Mr Sutton explains: “ETFs offer that broader asset mix, but they are also highly transparent in terms of regulatory disclosure. While trading volumes are growing, I wouldn’t describe it as a surge yet.”
He also highlights the ability of ETFs to provide an income stream, a factor that can assist pension funds in meeting their liabilities. “Those [pension funds] we talk to are increasingly conscious of cash flow and dividends,” he says. Some ETF products pay a dividend up to four times a year on the underlying assets. In a low return environment, with bond yields falling, such products take on a great attraction.
According to Morgan Stanley’s Ms Fuhr, ETFs are being increasingly used in the US pension fund market for transitioning portfolios and overlay work, on account of their transparency, liquidity and low cost base. “These styles are used in the US market far more than in Europe but that's purely a reflection of market maturity,” explains Ms Fuhr.
This maturity of use has taken some time to come about, however, says Mr Sutton. The process of education in the US has been directed at both increasing the awareness of ETFs and informing investors about the more sophisticated uses of ETFs.
“It’s much more common in the US to see institutional investors use ETFs to represent large or small cap, value or growth sectors but we’ll see that in Europe as more products come on stream,” observes Mr Davies.
Mr Sutton agrees, although he points out that the equity universe of nearly 9000 liquid shares in the US makes creating sector ETFs easier. “Managers there can use ETFs to balance banks against pharmaceutical companies, in Europe we're still seeing them as a way of accessing national indices rather than sectors,” observes Mr Sutton.
But interestingly the US and Europe seem to be following more recent trends in ETF development.
“The single most noticeable development of the year was the scale of success in the US market of the first ETF gold product,” says Ms Fuhr. iShares Comex Gold Trust was launched in January on Amex following the successful launch of the Streettracks Gold Trust on the New York Stock Exchange in November.
“As gold seems to be back in fashion as an investment, we’re likely to see more commodity products based on either underlying commodity price derivatives or mining and energy company share prices,” agrees S&P’s Mr Davies. “If I looked further into my crystal ball, I'd say we'll see property ETFs expand too.”
Mr Sutton suggests that property ETFs based on real estate investment trusts would be a natural product development: “Assets that are likely to produce higher yields in this economic climate will be more attractive ETF propositions and that includes property.” Axa Investment Managers is planning to launch its second property-focused ETF during 2005 – EPRA UK. The firm launched a eurozone product last December.
Declining expense ratios
One significant theme away from investment strategies and noted by Morgan Stanley has been a trend of falling fees. In the US, Vanguard is reducing the annual expense ratios on all its 23 Vipers ETFs. Others have also done the same. In Europe, the iShares EuroStoxx 50 ETF has capped its annual fee at 15 basis points. State Street and Lyxor have also announced reductions.
“The assets in the funds have grown substantially and the companies can afford to take lower basis point fees,” explains Ms Fuhr. The competitiveness of a market where Lyxor, the largest ETF issuer in Europe, enjoys a 24 per cent share of the European ETF market, IndEXchange 22.5 per cent and BGI (iShares) 22 per cent, has been another reason for falling charges.
“The expense ratios are coming down and a[part from more entrants to the market, ETFs are competing against other investment tools,” says Mr Davies.
