Magazine Issues » May 2016


RollercoasterDavid Stevenson takes a short ride on the ETF train and sees the industry landscape changing as competition intensifies, providers grow in number and the range of products gets broader.

The Federal Reserve’s interest-rate normalisation process, the UK’s ‘Brexit’ referendum and the extent of China’s slowdown have been weighing on investors’ minds. Yet passive exchange-traded funds (ETFs) have still grown in popularity. So, how exactly have they prospered in these uncertain times?

Let’s start by going back to the beginning of last year. When the European Central Bank (ECB) introduced quantitative easing (QE) – its asset-purchase programme aimed at buying sovereign debt to support recovery – its actions gave European equity ETFs a shot in the arm. 

In January 2015, investors pulled $24.9 billion (€22 billion) from US equity funds and put $22.8 billion into their European equivalents. Investment gurus such as George Soros and Robert Shiller also sought to ride the new wave in Europe, in what was described by many as “the only game in town”. 

Then the V8 engine of emerging market growth, China, stalled.
Last summer, investors got the jitters when the Shanghai Composite Index saw a third of its value wiped out in the course of a month – though ETFs still managed to finish 2015 with a record level of inflows. 

But this was only the first time that China stalled. There were global repercussions once again on the opening day of 2016, when trading was suspended on China’s main exchanges. Next day, Europe’s second-largest ETF provider, Deutsche Bank’s db X-trackers, saw its Harvest CSI 300 China A-Shares ETF slump nearly 9% in US midday trading. 

Recent headline figures suggest that European investors are focused on safe-haven assets such as fixed income: in April, there were inflows of $3.7 billion into fixed income ETFs, according to BlackRock, and outflows of $2.5 billion from European ETFs. But this doesn’t tell the whole story.

April also saw inflows of $1.3 billion into broad emerging market ETFs and $1.67 billion into US equities. 

“European ETF investors have made an important distinction between buying US and emerging market equity exposures on the one hand and selling domestic equity exposures on the other,” says Ursula Marchioni, chief strategist for iShares, Europe, Middle East and Africa.

While there were continued flows into fixed income ETFs in April, she adds, the funds attracting the most money were those tracking European corporate bonds and emerging market exposures. Figures from BlackRock show that European investment grade debt ETFs saw inflows of $1.5 billion in April, while emerging market debt funds had inflows of $1.3 billion.

The ECB’s extension of its asset-purchasing programme in March – to include corporate bonds – probably bolstered that asset class. It means investors now have a buyer of last resort. Traditional safe havens such as government bonds have seen outflows. European sovereign ETFs suffered $1.5 billion in outflows in April; it seems that investors are tired of paying governments for the privilege of lending to them in return for negative yields.

But what about providers? New entrants in Europe over recent months include WisdomTree and Fidelity. The European ETF train is hard to stop.

“You really need to get an ETF business to $15-$20 billion in order to have scale going forward. Also, you need breadth of funds and not just one idea,” says Lee Kranefuss, executive chairman of ETF provider Source, who came up with the idea of starting iShares at Barclays Global Investors.

Source is fast gaining market share. In March, it came second in terms of new money into its products, gaining €567 million, according to market data provider ETFGI. Kranefuss credits its independence. 

“In times of market stress, independence [from a bank] takes worries off people’s minds,” he says. “In times of market turbulence, people worry about banks – it’s the nature of beast.”

But banks with ETF offerings think these fears are groundless. Andrew Walsh, head of ETF sales at UBS for the UK and Ireland, says that, as a fund, ETF assets are ring-fenced and not owned by the bank sponsor. Any kind default by the issuer should note be a problem.  

“If you have a fear of banks, then you could argue that you’ll be scared of anything they offer, not just ETFs,” add Walsh. 

UBS is fourth in the ETF league table, having carved out its own niche in the ETF market. Last year, before the equities markets imploded, it offered the broadest range of currency-hedged equity ETFs in Europe. This year, fixed income products are making headway.

UBS offers the Barclays US Liquid Corporates ETF suite, which has seen assets grow to £417 million, up from £232 million six months ago. Its one-to-five-year version of this fixed income ETF has seen assets grow by £124 million to £382 million during the same period. 

As Walsh notes, while currency hedging was of great importance to clients last year due to fears over a potential Brexit, it is now less of a concern. Investors are choosing UBS’s unhedged versions of European Monetary Union (EMU) ETFs.

Lyxor, the third-largest ETF provider in Europe, has also seen a big change over the year. Head of ETF sales in the UK and Ireland, James Waterworth, says Q1 of 2016 was one of the least productive asset-gathering periods for some time, with €5.7 billion raised compared to €29.3 billion the previous year. “The run rate is somewhat muted, uncertainty is due to weakening growth,” he says.

By offering a range of products to satisfy the shifting risk appetites of investors, big players dominate the ETF market. As Waterworth says, investors like scale – but there’s room for niche providers, such as specialist equity houses or smart beta players, where firms may be able to get on to buy lists and attract flows.

It’s said that the ETF industry has low barriers to entry but high barriers to success. As Marchioni notes: “It will be key for investors to be active with their passive exposures and pay close attention to asset allocation both tactically and strategically.” To aid this, economies of scale are surely needed.

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