LIQUIDITY: The nuclear option

Fund closures have increased as providers push their more popular products. Nicholas Pratt looks at the role of liquidity in ETF attractiveness.

Closures of ETFs have doubled in recent years – though from a low base – with large amounts of funds having sub-scale holdings. Fifty-one had closed by the end of June compared with 26 in the first half of 2012. In the first halves of preceding years, 27 closed in 2011 and just one in 2010, according to ETFGI, an ETF and ETP (exchange-traded products) research and consulting firm.

Of the 1,954 ETFs in Europe, only a quarter, or 500, had assets under management of more than $100 million (€72.5 million) at the mid-point of 2013 – $100 million is generally considered to be the break even point for an ETF’s viability from the product provider’s perspective.

But even when the threshold is lowered the figures are not impressive, with 1,245 ETFs holding less than $50 million in assets and 756 less than $10 million.

Closure is the nuclear option when an ETF is sub-scale. Another reaction to low demand is to reduce the number of listings across European exchanges in order to reduce costs and concentrate liquidity. Figures show there were 6,156 ETF/ETP listings with assets of $357 billion, at the mid-year point. There were 231 delistings in the first half of 2013 compared with 189 in the same period in 2012.

The number of closures and delistings show that managers of ETFs are paying more attention to costs and the popularity of products with investors, says Deborah Fuhr, founder of ETFGI. “It is expensive to deal in multiple exchanges and multiple currencies and languages, and they are trying to limit their costs. So I think the number of closures and delistings are significant.”

In October, iShares closed 15 equity and commodity ETFs, including seven ETFs from the Credit Suisse business which was acquired by iShares in July. Although there were a variety of factors involved, the principal reason for the closures was “low investor demand”, says Joe Linhares, head of iShares Emea.

In addition, there have also been adjustments by providers to their product sets. At the end of 2012, both Lyxor and Deutsche Bank’s db x-trackers launched a number of physical ETFs breaking with their traditional focus on synthetic-only products. But db x-trackers has continued to launch physical ETFs and in September launched the MSCI Turkey Index Ucits ETF and the MSCI Nordic Index Ucits ETF.

When it comes to assessing the relative success of ETFs, size is everything in the European ETF market. In part, some of this is down to the deficiencies of the market structure. On-exchange trading volume only tells part of the story because so much trading is done on an over-the-counter (OTC) basis where there is currently no obligation to report these trades, although this may change once MiFID II comes into force.

As a result, the reported on-exchange volume only accounts for approximately 30% of the market’s trading volume.

Similarly, liquidity is not always the greatest measure of an ETF’s popularity, says Fuhr. “An ETF doesn’t have to trade a lot to be liquid. It is the liquidity of the underlying assets rather than the ETF itself that is important.”

Fuhr is also sceptical of the idea that a tight spread demonstrates a high level of trading activity and therefore is indicative of investor interest and a successful ETF product.

“An ETF provider can create incentives to encourage an ETF to have a tight spread but that does not mean that anyone will want to buy it. It is the exposure, the format of that exposure and the domicile that is the primary driver for investors. After that, it is the size of the fund and the level of assets that will be the main attraction.”

“Liquidity is a very important subject for us,” says Arnaud Llinas, head of ETFs and indexing at Lyxor. “For a listed index fund, liquidity is its defining element, it is the ‘traded’ part that is the key in exchange-traded funds.”

However, the European ETF market can only dream of the kind of liquidity levels in the US market. Approximately €2.2 billion of ETFs are traded on the order book in Europe whereas the figure is more than 20 times higher in the US.

The different liquidity levels between Europe and the US are not solely down to investor demand, says Llinas.

One reason is the propensity for futures trading in Europe where there is a greater appetite for derivatives among institutional investors. There is also a much more fragmented market in Europe. There is no single order book and ETF issuers are obliged to list across multiple exchanges.

There are too many products and too many issuers all chasing the same index, says Llinas.

There are 43 issuers in Europe and you may find, on blue chip indices like Eurostoxx 50, as many as 20 ETFs tracking the same index, whereas in the US, it is closer to a maximum of four or five ETFs per index. Consequently, the average assets under management for ETF products in Europe is considerably lower than in the US – €250 million compared with approximately €1 billion in the US.

However, Llinas says it is important to differentiate between the liquidity of the product and the liquidity of the underlying assets. “The important aspect is the capacity of the ETF to absorb orders and that depends on the liquidity of the underlying assets.”

The size of the fund is the most direct measure of a successful ETF but both size and liquidity are different sides of the same coin, says Llinas. “The most important thing is to the capacity of the product to deliver what is promised and whether it can be easily traded.”

Lyxor has recently developed an efficiency indicator to compare the attributes of different products including the tracking error (how closely it follows the index it is supposed to), the trading difference and liquidity spread. “This gives us a synthetic indicator of the quality of the product and a pragmatic guide to ensuring sufficient liquidity and performance across different asset classes,” says Llinas.

In September, UBS, the fourth largest ETF provider in the European market with £8.6 billion (€10.1 billion) of assets, reduced the charges on its ‘A’ share class ETFs to make them more accessible to investors. Arguably, more significant though is the “pre-defined drag level” on its swap-based ETFs (which make up roughly 25% of the UBS ETF product suite) which provides a guaranteed tracking difference for a 12 month period. “It is a guarantee of performance and a form of insurance that is attractive to some investors, especially those that are investing in more esoteric products,” says Andrew Walsh, head of ETF sales at UBS ETFs.

However, in order for this attraction to be as conspicuous as possible, it is important that investors understand the importance of tracking difference, he says. A number of investors wrongly assume that an ETF will perform in line with the chosen index minus the total expense ratio (TER) and that the choice of index is the most important factor. But in reality, there is a lot of disparity in the performance of different ETFs tracking the same index and this is down to a combination of the costs and the quality of the asset management.

“It is important that investors look beyond the total expense ratio and look at the tracking difference and how much the ETF lags the index it is tracking.” For example, some investors with an ETF based on an MSCI emerging market index and with a TER of 0.5% may assume that when the benchmark is up by 10%, the ETF would be up by 9.5%. They are then scratching their heads when they look back a year later and discover that their MSCI Emerging Market ETF has only gone up by 8.5%.

©2013 funds europe



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