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Magazine Issues » September 2011

ETFs: Doing their own thing

Fish---blueTotal European net fund sales yo-yoed their way through the first six months of 2011, but ETFs enjoyed much steadier flows. Mark McFee asks if this shows that ETFs are set apart from the rest of the industry.

Sales of equity ETFs (exchange-traded funds), the backbone of the ETF industry, seemingly mirrored the direction of their mutual fund cousins every month with the exception of May in the first half of the year.

However, on closer inspection, ETF flows were disproportionately positive, unlike broader mutual funds which had a number of months where outflows were larger than inflows. Ed Moisson, head of UK, Ireland and cross-border research at Lipper, puts this down to institutions using the vehicles for short-term tactical plays.

Russian, and particularly German, equities saw their net sales bolstered significantly by ETFs. German equities increased from €1.2bn to €5.6bn when including ETFs.

The vehicles for this are easily identifiable: the iShares DAX (DE) and DB X-Trackers DJ Dax ETF collected a net €4.4bn between them, incidentally placing them as first and second best-selling European ETFs for the first six months of 2011. 

What has made ETFs such a popular way of  gaining exposure to the German market?

Aside from Germany being one of a shrinking number of unanimously recognised safe havens in Europe this year, Russ Koesterich, global chief investment strategist at iShares, highlights a key feature of ETFs in this move. “ETFs do offer you a very easy, transparent vehicle to access that market. I think you’ve seen it more than you would in other types of instruments because of the ease of implementation of an ETF.”

While inflows in other equity sectors look to have been supplemented by ETFs, the impact of the sheer range of equity ETF products on offer is evident in their cumulative contribution to flows. Of Europe’s €30.5bn net equity inflows in H1, €12.2bn were via ETFs, which continue to punch above their weight.

In terms of outflows, ETFs didn’t leave much of a mark on the worst-selling equity sectors, with the exception of Euroland equities. ETF investors shied away from these to the tune of €1.3bn.

Bond ETF activity was almost negligible, with H1 net sales of just €413m. This is all the more striking when compared with the previous years (€9.4bn in 2009 and €6.9bn in 2010), and somewhat perplexing in light of bonds being Europe’s top asset class overall in H1 with sales of €25.9bn. So what’s going on?

“Because the fixed income ETF markets are less developed, their reaction to a crisis is much more one of ‘wait and see’… People seem to be selling and not doing much else,” says MJ Lytle, managing director of Source ETF.

With this lack of development in mind, the relatively high bond sales of previous years can be attributed to the right products having been available at the right time rather than a large-scale move into bond ETFs.

It could be that bond ETF investors have not considered the passive aspect of bond investment in the same way they have for equities.

Moisson says: “When people think about bonds, they haven’t made the shift in their mind that ETFs are a means of accessing those sorts of underlying financial instruments. It reflects that people still think of active managers rather than the passive.”

Bond ETF flows have been eclipsed by commodities so far this year. At €1.8bn in H1, annualised sales are running lower than the previous two years, but not dramatically so. However, inflows will not have been across the board, with many commodities deemed as high risk. 

The obvious candidate for recent commodity success is precious metals, with gold leading the charge. The sixth best-selling ETF in H1 was the Julius Baer Physical Gold Fund, which netted €397.4m.ETF-specific flow data for the latest stock market slide was not available at the time of writing. But trading is reported to have been extremely brisk at the beginning of August, so it is unlikely that sales will have been as sedentary as during H1, with investors turning to safe havens.

The majority of ETFs are index trackers and so there is no escaping a market dive where performance is concerned. But the higher trading volumes are indicative of the flexibility that they afford investors, something that other funds can’t compete with.

“The most significant thing that they’ve always offered, but which is even more important during these periods, is the ability to trade intra-day. When you have a tremendous move, the opportunity to trade during market hours is a huge advantage,” says Koesterich.

While Lipper’s latest data shows total European ETF net sales to have been positive in the first half of the year, at €15.2bn, volumes are somewhat diminished compared with the previous three years on an annualised basis (and, indeed, before July and August’s stock market plunge set in). Could this product type be falling out of favour?

“I wouldn’t say demand is reaching saturation point… What we’re seeing is that institutional investors are not trading as much and this is not just in ETFs,” says Manooj Mistry, head of db X-trackers in the UK.However, it is interesting to note that ETFs really started to gain traction in 2008, as the financial crisis snowballed. The global economy is back in crisis mode but ETF flows have been more subdued. This comes down to the dynamics at play.

“When the financial crisis broke we saw a lot of success with our money-market ETFs… We saw people exiting equity positions or exiting bond positions and buying money-market ETFs and that was one of the drivers of growth… This time round there’s probably a bit more uncertainty,” says Mistry.

This uncertainty is of course by no means ETF-specific but the fact that ETF sales growth has been hit, despite the flexibility they offer, is a reminder of sentiment having become more bearish.

Lytle says: “Although ETFs can give [investors] more control over their money, that only gives more control if you know what to do with it. Quite frankly I think a lot of people are just sitting on very simple forms of cash and not making security investments.”

Where to now?
A key question for the industry is: where do ETFs go from here? On the one hand, with sales still sturdy, they seem to be on a strong footing for continued growth. On the other, apart from a total lack of predictability in the turbulence of the markets, a regulatory shadow has been cast over ETFs or, rather, synthetic ETFs. 

This issue is particularly pertinent in Europe, where synthetic ETFs account for almost 50% of the continent’s ETF assets, a much greater share of the market than in the US.

A steady roll call of regulators have been airing concerns about the systemic and counterparty risks posed by synthetic ETF asset swaps, the collateral usually being issued by banks and therefore exposed to a risk of default. Concerns were also raised that some banks could be using proprietary synthetic ETF products as a source of funding through asset swaps with illiquid portfolios.

But industry professionals are more positive on the outlook for ETFs and fully support the regulators’ intentions to improve the understanding of these products and protect consumers.

Lytle says: “I think that two years from now this will all be positive for the industry because the only conclusions you can come to with ETFs versus other funds is that they have the same regulatory standards and then they have this additional benefit of the transparency and liquidity that comes from being exchange traded.”

©2011 funds europe