European ETFs: A Market Ripe for Consolidation

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1 December 2014 European ETFs: A Market Ripe for Consolidation Levi-Sergio MUTEMBA

2 Abstract More than 20 exchanges versus three in the United States. Multiple regulations versus a single one in the US. Several currencies, a large number of ETF providers, more than 2,000 European trackers with over 6,000 listings. This reflects how far the European market is fragmented. However, the search for economies of scales on the part of ETF providers and issuers will lead to consolidation within the industry, for the benefit of all participants: Issuers, market makers and end-investors alike. The present article discusses the various implications of a fragmented European ETF market for investors in terms of market inefficiencies in the secondary market. It also shows how these inefficiencies ultimately lead to strategic alliances as well as to an acquisition spree within the ETF industry. 1

3 Liquidity and inefficiency in the secondary market The European Exchange-Traded Fund (ETF) market is really fragmented. New entrants in a thriving industry are putting increasing pressure on the profit margins of existing participants. The fragmentation of the European ETF landscape explains much of the proliferation of issuers and number of ETFs tracking the same underlying index or assets. But the ETF market is essentially an arbitrage market. Contrary to the traditional stock market, ETF's liquidity does not stem only from the exchange order book or market activity. It is also and fundamentally a direct function of the process of creation and redemption of shares in the primary market. ETF shares are tradable on the secondary market because "authorised participants" (APs) have created them, beforehand, on the primary market. In the creation process, the AP, which is generally an investment bank or a large financial institution, purchases the basket of assets that serve as underlying for the tracker in exchange of ETF shares, which the AP will then make available in the secondary market for end-investors. (In the case of redemption of shares, the AP exchanges the ETF shares with the sponsor and recovers the underlying basket of assets it had built during the creation process). Transaction costs associated with the creation of shares squeezes profit margin for APs and explains why there is often a long-lasting discrepancy between the traded price of an ETF share and the net asset value (NAV) of the underlying assets. In a unified and consolidated market such as the US one, this discrepancy (be it a premium or a discount) rapidly disappears through riskfree arbitrage transactions by institutional investors that can trade large amounts of capital on transparent standardised exchanges. For example, if an AP observes a higher ETF share price relative to its NAV it would immediately acquire the underlying basket of assets and sell the ETF shares (thereby temporarily reducing the volume of traded ETF shares on exchanges). If the NAV is higher, then the AP would sell the underlying assets and acquire the ETF shares (thereby increasing the volume of ETF shares traded on exchanges). However, the lack of liquidity implied by the high fragmentation of the European market dissuades professional investors, such as hedge funds for instance, to undertake ETF arbitrage trades 2

4 (shorting and securities lending) on exchanges. They rather turn to the OTC (derivative) market to execute the same trades that American institutional investors realise through on-exchange ETFs in the US. Therefore, the lack of risk-free arbitrage tends to prevent ETF share prices to match those of their underlying assets. European ETFs thus behave in a less effective way than their US counterparts as a price discovery mechanism and are less efficient in reflecting the fair value of the underlying assets. Difficulty of selecting an ETF for the end-investor The various sources of additional costs encountered by the ETF industry participants make it all the more difficult for the end-investor to identify and select the pertinent product matching his investment needs [1]. Multiple listings of ETFs tracking the same underlying basket necessarily mean that many trackers listed in one exchange may trade on another exchange at a lower or higher price. For example, it is easy to find several dozens of ETFs tracking exactly the same large and liquid equity index though charging very different expense ratios and/or displaying noticeable tracking quality differences. Regardless of the rationale for such differences (diverse tax regimes, insufficient reporting requirements, different clearing systems etc.), a particular national exchange is generally unable to give a full picture of the overall and real cost of investing in an ETF. Though the second version of the European Union's Markets in Financial Instruments Directive (MiFID II) addresses this issue, it is indeed widely accepted that one of the main potential benefits for investors is the establishment of a consolidated European Order Book. This would enable them to see in a transparent way the real aggregate average daily volume for cross-listed ETFs in multiple exchanges. So far, the time-consuming and relatively costly research and analytical work required to properly select European ETFs is largely borne by the end investor. Indeed, "quote-montages" on electronic platforms, such as those offered on Bloomberg's terminals (on a paying basis, though), aggregate the trading volume of an ETF listed on several exchanges as well as the relevant bid/ask spread in each market. However, even this facility is limited by the lack of ETF trade reporting requirements. Which is a unique characteristic of the European ETF market: no legislation requires ETF trades to be reported to an exchange. "Although there is no 3

5 indisputable way by which to understand the amount of ETF trading that goes unreported, industry experts estimate that anywhere between 50%-90% of ETF activity occurs over the counter (OTC)." [2] From the offer side: size matters Finally, to reach potential investors across different countries, issuers have multiplied their ETF listings on several exchanges. However, different languages and regulation forces them to adapt each investor s documentation to the targeted regional market, thereby generating important creation and operational costs that weigh heavily on their margins (if not passed on to the endinvestor). Moreover, a Germany-based issuer will tend to issue a higher volume of ETFs in its homeland, hence benefiting from a more favourable distribution channel, than in Italy or Switzerland, for instance, thus further fragmenting liquidity across markets. Even relatively new branches or divisions of traditional asset management firms (that have come to realise how critical it is for them to compete in the ETF market to maintain and grow their share of client's assets under management) find it difficult to generate economies of scale in such a fragmented environment. The acquisition of US ETF provider VelocityShares by Janus Capital Group last September 30 th, 2014 and that of IndexIQ (an american ETF firm offering liquid hedge fund strategies) by New-York Life Investment Management (the asset management subsidiary of US insurance titan New-York Life) at the beginning of this month constitutes one more reflection of the strategic orientation chosen by asset managers. For large banks, instead of "fishing one another's clients" in a fragmented European market, they have recently entered into strategic alliances centred around the unification of their distribution networks. Such is the case of Morgan Stanley, Goldman Sachs, Merrill Lynch and Nomura around the ETF provider Source, as well as with RaboBank, Citigroup and Merrill Lynch (again) joining forces around ETF Securities. The same is true for smaller players, even those positioned in innovative niche markets (leveraged, inverse, actively managed ETFs) as revealed by recent surveys. "This is especially true in Europe, where the need for cross listings represents an additional burden. Issuers may consider US$50 US$100 million to be the viable threshold for a 4

6 typical fund, but informal conversations suggest that many promoters need at least US$10 billion in ETF assets to achieve standalone profitability."[3] 5

7 About the Author Levi-Sergio Mutemba is an independent economic reporter especially covering news on ETPs and structured products. Mr Mutemba has recently launched a blog, Bottom Up, that aims to be a "bottom-up" selection of analyses issued by financial professionals. It has also recently proposed a weekly analysis of investment products mainly listed on the SIX Swiss Exchange (essentially ETFs and yieldenhancement products such as barrier reverse convertibles, discount certificates and bonus certificates). Bottom Up's contributors are also external permanent contributors for the Swissbased business and financial daily newspaper L'Agefi ( where they publish, each Monday, a special report on structured products available for European and Swiss investors. Link: Bottom Up 6

8 References 1 Bonelli, M Exchange Traded Funds: Toward a Tailored Selection Approach. Available on SSRN. 2 State Street Global Advisors ETF Trading and Execution in the European Markets. 3 Ernst & Young Global ETF Survey - A New Era of Growth and Innovation. 7