According to Morgan Stanley figures, Deutsche Börse has 63.3 per cent of the European ETF market share, while London has 7.4 per cent, also beaten by Euronext trading through the Brussels, Paris and Amsterdam exchanges which has captured 14.3 per cent of the European ETF market.
And while many of Deutsche Börse’s competitors might not be in the mood, its fifth birthday is something to celebrate. That market share of ETF business in Europe has risen 10 per cent since only last September and February figures show yet another record in turnover of ETF trading of €4.89bn, beating the last record set in March 2002 by €200m.
Deutsche Börse had witnessed the strong growth of exchange-traded funds in the US market and considered alternative ways of providing European investors with similar opportunities. First it developed a segment exclusively for ETFs on Xetra – XTF – which currently has an index of 63 funds.
Deutsche Börse is also optimistic for the future with one eye firmly on the full introduction of Ucits III which will allow fund managers greater latitude in using third-party funds in their own investment portfolio.
FT Mandate talked to Rainer Riess, Managing Director of Stock Market Business Development at Deutsche Börse, about the direction and issues surrounding this sector.
FT Mandate: Being the first into ETF business in Europe has provided the company with a healthy revenue stream but it must also have thrown up some problems. What have been the greatest obstacles to creating and developing the ETF market?
Rainer Riess: One of the biggest advantages of ETFs was also one of the greatest obstacles to master – the combination of two traditionally independent and completely segregated segments, in other words putting funds and stock exchange trading, into a single product. Prior to the creation of the segment intensive discussions with regulatory authorities, index providers, ETF sponsors and market participants took place to arrive at the best possible ETF setup for the European market.
Over the past five years the regulatory framework has definitively been further developed and improved, particularly through the implementation of Ucits III into national investment acts across Europe. There still remains the major hurdle not yet fully overcome – the education of new and existing investors in the broad range of investment applications this product has to offer.
FT Mandate: Are there likely to be other future developments in the regulatory landscape that will benefit ETFs as a product?
Rainer Riess: A recent development which is likely to benefit ETFs in the future is the requirement for European exchange-listed companies to publish IAS corporate accounts as of the beginning of 2005. All of these 7000 companies will now have to consider the consequences of IAS 39 on their investment policy regarding special funds.
IAS 39 requires companies to treat special funds as subsidiary companies because a controlling relationship is assumed. In other words, there is no longer any difference between fund investments and direct investments in stocks held by the fund. In the future, each stock held in special funds will need to be accounted individually. Investors wishing to avoid this full consolidation can however recourse to ETFs because here the investor only seldom exercises control. Although special funds will not be completely replaced by ETFs, significant changes in the investment structure of existing special funds are highly likely.
FT Mandate: Apart from the regulatory issues how did institutional investors view the development of an ETF market – were they sceptical or did they support its expansion?
Rainer Riess: Five years ago, European institutional investors were probably a little sceptical about the benefits of ETF investments and whether the product was here to stay. At that point in time knowledge about ETFs was limited in Europe and only a small number of products were available.
The lack of experience regarding legal structure and taxation of ETFs also did not help to increase confidence. In addition, most ETF sponsors had only recently been founded and therefore had no track record to prove their index replication skills. It took some time until investors felt confident in purchasing ETFs, but eventually the uncertainty surrounding ETFs declined, helped by the ongoing education activities by both issuers and exchanges. The outstanding growth rates of assets under management are testimony to this development.
FT Mandate: Having overcome a level of industry scepticism, one would imagine the institutional investor is an important player in the market. What sort of investor makes up the greatest customer base for the ETF products?
Rainer Riess: Exchange-traded funds are certainly a major investment vehicle for institutional investors. They generally welcome ETFs as an effective and cost-efficient way to equitise their cash inflows.
In addition, ETFs represent an attractive alternative to futures for pension funds or other institutions restricted from investing in derivatives. We would estimate that among institutional investors, insurance companies and asset managers account for the major stake of assets under management.
Small proprietary trading firms and hedge funds have also discovered ETFs as a complementary trading tool for the efficient implementation of trading and arbitrage strategies, thus providing liquidity to the market and helping to increase market efficiency.
ETFs have also been well established as products for retail investors. Accompanied by a very positive media sentiment for ETFs in Germany and the ongoing educational efforts of ETF issuers and Deutsche Börse, transactions from retail investors (as measured by an order size below €25,000) have grown to approximately 40 per cent of the total number of transactions on Xetra. Considering the lack of incentives available to traditional distribution channels such as banks and independent financial advisors, the success of ETFs among retail investors is quite remarkable and something to be positive about for the future.
FT Mandate: One of the fears many investors once had with ETFs was their liquidity. Have fears of product liquidity been overcome? Why?
Rainer Riess: The accessibility of the order book is fundamental to the market’s overall success. Liquidity is the central quality feature for the assessment of the securities market, whether trading ETFs or other products, as it has a major influence on implicit transaction costs for investors. Liquidity in Deutsche Börse’s XTF segment is also assured by the presence of Designated Sponsors, who act as liquidity providers by fulfiling strict quoting obligations in a hybrid market model. While each ETF in the XTF segment is required to have at least one Designated Sponsor, most ETFs are supported by two or more to further enhance liquidity.
With a total on exchange turnover of approximately €60bn in 2004, ETFs in Europe enjoy liquidity levels equal to the most liquid blue chips. For example, in the XTF segment, the ETF based on the German domestic blue chip index DAX is among the most liquid equities in Xetra trading, in many cases more liquid than individual DAX equities.
FT Mandate: Bearing that in mind what sort of benefits can an ETF bring to an investor or help in a certain style of investment?
Rainer Riess: Both groups of investors – retail and institutional - when trading ETFs on Deutsche Börse benefit from fast order execution, high price quality and low trading costs. The absence of front-load fees and the high transparency of the XTF segment, resulting from a detailed rule book and comprehensive information available on the internet, is in particular welcomed by private investors.
Another major advantage of ETFs is the broad range of investment applications they offer to their users. Besides being an efficient tool for managing cash flows, an increasing number of investors in Europe has started to look into using ETFs as a cost-effective core investment for their portfolios, thus gaining diversified exposure to a target market or sector through a single transaction. Short-term tactical investments in ETFs can also be used as satellites to overweight promising sectors and countries within the portfolio. The overall result is a full core satellite investment strategy based on index-linked ETFs.
FT Mandate: What sort of ETF products have proved to be the most popular to investors?
Rainer Riess: Owing to their high liquidity and strong investor demand, equity ETFs tracking blue chip indices were able to maintain their leading position in terms of trading volume and assets under management among European investors. Within the group of non blue chip ETFs, particularly fixed-income ETFs continued to see growing demand in 2004: by the end of December, total assets under management of the six then listed fixed-income ETFs on XTF had grown by 77 per cent year-on-year to €1.23bn.
FT Mandate: While the story of the ETF in Europe sounds a rosy one, it is generally regarded as being some way behind the US marketplace – how far behind in product sophistication is Europe?
Rainer Riess: Although ETFs have been very successful in Europe to date, a glance at the US market reveals an even larger potential. At the end of 2004, European ETFs accounted for assets under management of approximately €25bn. This compares to a significantly higher €167bn invested in US ETFs at the end of December 2004.
These figures lead to the conclusion that the US market certainly is a step ahead of Europe in terms of product use and sophistication. The broader range of institutions investing in ETFs in the States can also be traced back to a higher degree of education concerning ETFs and their investment applications. For example, investors holding ETFs can significantly reduce their investment fees by short selling. The additional lending revenues generated from the short sale do, in some cases, even surpass the annual management fee of the ETF.
An average short interest level of 25 per cent for US ETFs demonstrates that US investors frequently take advantage of this opportunity, while European investors still seem to be reluctant to lend out their shares.
FT Mandate: How long will it be until Europe catches up with the US?
Rainer Riess: Both markets continue to grow fast in terms of invested assets under management with the European market even outpacing the US market in 2004 on a year-on-year basis. Still, for the European market to reach assets under management levels similar to those in the US, two major challenges will have to be overcome.
Firstly, European investors need to be continuously educated on the advantages and numerous investment applications of ETFs in order to better understand how to fully exploit their potential.
Secondly, development is often hampered because of the high fragmentation of the European market. Over the past five years, due to country specific regulatory requirements, ETF segments have been created in several European countries, each having its own market model and clearing and settlement system.
While the US market represents a capital market with a single legal framework, tax environment, currency and settlement infrastructure, the European capital market is by far more heterogeneous. It consists of several European countries, each with its own ETF segment and corresponding rule book.
The future evolution of these differing markets into one homogeneous and efficient European market for ETFs is a key goal in the years to come.
FT Mandate: It has been good news for the first five years of the sector. What sort of growth is the ETF market likely to see over the next five years?
Rainer Riess: When considering the incredible growth that has been witnessed over the last five years and the fact that there are still many untapped markets and investors, we would expect this success story continue into the future. The US market certainly shows the full potential this investment product has, therefore we see the fifth anniversary as just one of many milestones.
Deutsche Börse
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www.deutsche-boerse.com/xtf_e
