Since breaking through the $3 trillion of assets under management mark in early 2015, ETFs have broken more records in the past year. David Stevenson looks at where investors have placed their flows and the drivers for it.
In a year that has seen dramatic moves in monetary policy as well as stock market performance, exchange-traded funds (ETFs) seem to have emerged unscathed. In fact, the industry is set for another record year, with the amount of net new assets in these products outpacing 2014.
The main story has been European equities, which Philip Tychon, European head of ETF capital markets at Vanguard, describes as “the trade of the year”. He adds $25 billion (€23 billion) of net new assets went into the firm’s European equity ETF products in the year to October.
While quantitative easing helped to make European equities an astounding success, other asset classes did not fare so well. Commodities have struggled, partly because of the oil rout, though globally they
have still managed to accumulate $8.9 billion in assets in the year to the end of November, according to BlackRock.
Another ETF category yet to rediscover its mojo is emerging markets. Almost $30 billion has flowed out of this sector since the start of the year as investors, largely retail, lost faith in this once counter-cyclical investment haven.
For their part, ETF providers have had a bumper year. James Waterworth, head of ETF sales in the UK and Ireland at Lyxor, says his firm enjoyed flows of €60 billion from the start of the year to the end of October, compared to €45 billion the previous year. “There has to be something drastic for it not to be another record year,” he says.
Who is buying the products?
Traditionally, Europe’s investment base was largely dominated by institutional investors, compared to a much more even split between retail and institutional in the US. This may be starting to change, though.
When the UK introduced the Retail Distribution Review (RDR), one result was an increase in the number of retail investors entering the market as commissions on selling funds were curtailed.
Tychon says: “Some of the regulatory drivers like MiFID [Markets in Financial Instruments Directive] II and RDR will open the retail end of the market. We have seen retail growing, existing ETFs in a new way and new users valuing the value proposition ETFs have.”
Ursula Marchioni, head of iShares EMEA equity strategy and ETP at BlackRock, agrees up to a point. MiFID II will benefit retail investors, but she does not see ETFs moving from institutional to retail. Moreover, she thinks stricter reporting guidelines regarding over-the-counter transactions will benefit the industry as a whole. This will be beneficial, she believes, as Europe, with its fragmented stock markets, does not have the liquidity of the US.
“MiFID II will give a greater level of transparency to the levels of liquidity,” she says.
The number of firms decamping to Europe to win business has seen an uptick as well. Earlier this year, Market Vectors, the ETF provider for US firm Van Eck, launched two gold mining ETFs in Europe, hoping to capitalise on the funds’ success in the US.
Canada-based BMO Global Asset Management, a recent entrant to Europe’s ETF market, believes its acquisition of the UK’s F&C Asset Management provides it with a European platform.
Marc Knowles, the director hired to push forward the firm’s ETF push in Europe, says: “Europe’s a mature market. Our strategy is to bring products to market that provide solutions to clients; we don’t want to launch ‘me too’ products.”
The market is crowded with basic beta products, he says, so his firm has launched a range of smart beta ETFs. On the equities side, there is a yield product. In this instance, stocks must first go through a quality filter before being filtered for yield.
“We’re looking for quality income-paying companies that can deliver sustainable performance over a period of time,” say Knowles.
Fixed income makes inroads
ETFs started out as an equities product, but fixed income products are starting to expand significantly, as are the assets held by them.
According to data from consultancy ETFGI, of the total new assets of $68.6 billion that went into European ETFs, equity ETFs gathered the largest net inflows year-to-date at the end of October with $39.5 billion, followed by fixed income ETFs with $24 billion.
Waterworth says: “Many ETF investors cut their teeth on equity ETFs, but fixed income lends itself more to an ETF format than equities. The indices are designed in such a way as to provide liquidity.”
For example, he says while a corporate giant like Apple offers only one stock, it could have many bonds of varying duration. He says the bond market is so much bigger from a securities perspective, as well as from a notional perspective.
Part of BMO’s recent range of ETFs includes fixed income with an interesting twist. The firm has allowed investors to position themselves on the yield curve, so, for instance, if an investor has a high conviction interest rates are going to increase, they may want to position themselves on the short end of the curve.
Or, as Knowles explains, they may take a contrarian view and place themselves on the long end of the curve.
One aspect of fixed income ETFs that has caused debate over the year is their apparent liquidity. It all comes down to size, according to Waterworth. As an ETF gets larger, it will see increased trading on the secondary market, which negates the need to access the primary bond market.
“If the underlying bond spread is 50 basis points, if you have a large ETF, that spread would decrease,” he says.
The caveat would be if there were a huge trade, the agent would need to go to the primary market to fill it and the spread would widen. But, as Tychon at Vanguard says: “One thing you should never forget about ETFs is it’s just a wrapper, so it’s only as liquid as it’s underling.”
He says, though, the ETF wrapper adds a layer of liquidity and if an investor wanted some exposure to the asset class through the secondary market, investors could buy or sell whenever they wanted, without having to access the underling basket of securities.
The passive revolution
While it is true the majority of European assets are still actively managed, the use of ETFs is growing markedly.
Marchioni at BlackRock says ETFs are substituting other instruments such as futures and swaps in the institutional space. In what amounts to a self-fulfilling prophecy, the more these products are used, the cheaper they become, making them even more attractive than they were.
A growth in assets makes them more liquid which is pointedly true in the fixed income space, but is equally true of the entire ETF industry, according to Marchoni.
Hector McNeil, co-chief executive officer of WisdomTree Europe, has seen the exponential growth of his firm’s products. “We’ve gone from £180 million [in assets] at the start of the year, to just over £750 million now. Growth has been spectacular.”
McNeil is buoyant about future prospects. “I think we’re going through a technological revolution with ETFs,” he says. “Active ETFs will be bigger than any other segment.”
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