March 2012

ETFs: Too small to make an impact

GaugesMore than half of the exchange-traded funds in Europe may be subscale, finds Stefanie Eschenbacher, as evermore products are being launched. It was the story that for a decade wrote itself: monthly statistics for the exchange-traded fund (ETF) market are published, assets under management have surged, and so has the number of product launches. But the story hardly ever reported, is that more than half the ETFs in Europe may not be economically viable because they are too small. According to Lipper, there are 1,243 ETFs in Europe. Of those, 740 have less than €50 million of assets and 300 have less than €10 million. Last year saw 247 launches, fewer than in previous years, and 39 closures. Ben Johnson, the director of European ETF research at Morningstar, has observed closures for a number of years. “Certain products fail to gather interest, mostly because the exposure they offer may not hit the trend that is popular,” he says. While it is a provider’s aim to offer investors a diversified product range, Johnson says the success rate diminishes for highly specialised products. Being more concentrated, these products carry a greater degree of risk. “To make an ETF economically viable, it is often said that it needs $50 million [€37.2 million], but that is a narrow definition,” he says. “A handful of small funds can be subsidised by larger, more successful products. Some of these exposures may not be in vogue now but they may become attractive in the future.” Products with a broader exposure appear to have done better. The SPDR S&P 500 is with £62.7 billion (€74.4 billion) the biggest product worldwide. Second is the SPDR Gold Shares with £45.1 billion and third, the Vanguard MSCI Emerging Markets ETF with £34.3 billion. The iShares MSCI EAFE Index, that tracks the performance of Europe, Australasia and the Middle East, ranks fourth. Index providers confirm that their more mainstream indices are the most widely tracked. There are 32 ETFs tracking the performance of the MSCI Emerging Markets index, 25 ETFs tracking that of the S&P 500 and 16 the FTSE 100. In fashion
Some providers are operating different models that allow them to offer more specialised products, even though they may be small in size. ETF Securities, for example, floats multiple products on the same prospectus. This can reduce the ongoing operating costs on a per-product basis. If these products are not very costly to operate, they are less likely to be closed in the hopes that some day in the future they will gather assets as the exposure they offer comes into fashion. ETF Securities says its products must reflect the diversification requirements as set out under Ucits. Therefore, they can only track indexes which represent underlying baskets of securities. For example, its ETFs track a range of diversified thematic indexes such as the Dow Jones Global Select Dividend Index and the DAXglobal Gold Miners Index. Exchange-traded commodities (ETCs) meanwhile trade just like ETFs. If they are, however, not structured as funds, they are able to track the returns of just one asset, such as gold, oil, copper, wheat or natural gas.  ETF Securities says this structure has enabled it to make commodities more accessible to a broader range of investors. “Prior to the introduction of the ETC, commodity investing was mainly the preserve of specialist investors such as investment banks and endowments,” the company says. “Because our ETCs are structured as physically-backed and fully collateralised notes rather than funds, we are able to provide a full platform of commodity exposures to investors in one prospectus. This reduces the administrative costs of our ETC platform and allowed us to provide investors with a comprehensive platform of commodity exposures.” Global X, which specialises in niche ETFs, is in the process of closing eight of its products because they have failed to attract assets. These tracked, for example, Mexican small caps, farming stocks, fishing industry stocks, food stocks, and waste management stocks. Another provider, FaithShares, withdrew from the ETF market altogether, closing all its five faith-based products. Ed Moisson, the head of UK and cross-border research at Lipper, says whether an ETF is economically viable or not will depend on the asset manager. Charging structure and ability to generate revenue from other sources, such as securities lending, are key. Asset managers may also choose to cross-subsidise products.
“Large players may be comfortable having what they deem to be subscale funds in place to appeal to as wide a range of clients as possible,” says Moisson. “As groups so far have tended to launch funds and keep them even if they are very small, as is the case for very many mutual funds, I would not be surprised if one of the key reasons for ETF closures is if the asset manager sells them to another provider.“ iShares, the ETF platform of BlackRock, bought German provider Indexchange in 2007. Last year, iShares merged several of its smaller swap-based products into respective physical-based ETFs. It had launched the swap-based sector ETFs in 2006 to provide investors with Ucits III-compliant investment vehicles for the individual European sectors. Physical-based ETFs became Ucits III-compliant in January last year. After the index provider Stoxx had introduced caps for these indices, they complied with the guidelines for diversification of the European directive.  Popularity surge
“iShares continues to primarily focus on creating swap-based funds only when the exposure cannot be efficiently constructed in accordance with Ucits III rules using a physical-based approach and where the swap-based structure offers added value for investors,” the company says. Since ETFs were first made available to European investors, they have surged in popularity. Assets have risen steadily while providers have launched new products, even throughout the finanical crisis. Commodities dominated launches last year, with Morningstar counting 20 new ETFs tracking the performance of precious metals, eight energy, another eight industrial and broad metals, six a broad basket of commodities and six a broad agricultural theme. There were 14 new ETFs pursuing trading strategies of leveraged/inverse equity. Surprisingly, perhaps, there were nine ETFs launched that track the performance of European government bonds and five European corporate bonds. “The number of launches was down,” says Moisson. “But as we are now at such a large number, and at a time when investors were often pulling money from funds, that is not so surprising.” At the end of last year the BlackRock Investment Institute reported the first ever fall in assets in Europe. This was thought to be mainly because of challenging market conditions. ©2012 funds europe

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