Not Enough Money, Too Many Funds Mean ETFs Sputter in EuropeBy
ETF assets represent only 3.4% of those in mutual funds
Overhaul of market rules will address liquidity issues
The world’s fastest-growing investment vehicles -- exchange-traded funds -- are failing to gain traction in Europe.
A preponderance of options, a shortage of customers and a dizzying array of regulations are stifling the business in financial centers from Dublin to Frankfurt. Traders and providers alike are having a problem with the very thing ETFs were designed to excel in: liquidity.
The region is home to more than 35 percent of all ETFs in the world, and yet it only holds about 20 percent of the money invested, data compiled by Bloomberg show. Its slice of global trading volume is even smaller, at just 4.1 percent in August, according to Deutsche Bank AG. Only about $63 billion worth of exchange-traded products swapped hands in Europe last month, compared with $1.3 trillion in the U.S.
“Of course liquidity in Europe doesn’t look to be as strong as it does in the U.S.,” said Erol Steiner, a managing director at Crossflow Financial Advisors GmbH, a Munich-based ETF brokerage. “You’re fine if you’re a professional, specialized investor who knows who to call up when you want to make a trade. But it will always have to be a much smaller club.”
Unlike mutual funds, ETFs can be traded in real time and in the U.S. are growing increasingly complex and diverse since the first one came about in 1993. In contrast, European ETFs, a product developed by Merrill Lynch more than seven years later, are trapped in a vicious circle: there’s not enough trading to make an efficient market that attracts new investors.
Liquidity is an important factor for the securities because it differentiates them from more traditional, unlisted funds that don’t allow for intraday trading, according to Simon Klein at Deutsche Asset Management. In the U.S., that advantage has helped ETF assets grow to the equivalent of 17 percent of those held in mutual funds, Deutsche Bank data show. But in Europe that number is just 3.4 percent.
“There’s a perception that these products aren’t quite as liquid as they should be,” Klein, head of passive sales for Europe, the Middle East, Africa and Asia, said by phone from Frankfurt. “Europe is very fragmented and most trades are done off exchange by big institutional players. That discourages small investors, who are already very conservative.”
Individual investors, or those who buy and sell securities for their personal accounts, haven’t caught on to ETFs in Europe even though costs can be a lot lower than with mutual funds due to the absence of management fees. Societe Generale SA’s Lyxor, the third-biggest provider in the region, estimates that retail clients own only 2 percent of the market directly through stock accounts and savings plans. That proportion rises to just 10 percent if you include holdings via private banks. In the U.S., mom-and-pop investors own about 50 percent of the ETF market.
Increasing invested assets is not the only potential benefit from attracting more retail money. It would also help improve liquidity and transparency by moving more trades onto exchanges, according to Lyxor’s Arnaud Llinas. Big players like pension funds and asset managers are still mainly buying and selling directly with market makers because they can’t source the liquidity needed on exchanges. It also allows them to conduct most of their activity behind closed doors. IMC, a Dutch speed-trading firm, estimates that over-the-counter ETF trading is twice the size of on-exchange trading in Europe.
“Europe is an institutional market,” Llinas, head of Lyxor ETFs and indexing, said by phone from Paris. “These clients prefer to trade bigger tickets. When they can find liquidity on exchange for medium-size trades, they will. As soon as they are looking for something like 20 million, 50 million or 100 million euros, they will not find it on exchange, and they’ll have to ask various banks for an OTC price.”
Greece’s market shutdown last year illustrated what can go wrong when volume on exchanges is thin. Regulators suspended trading in the Lyxor ETF FTSE Athex 20, which has listings in Germany, France and Italy, leaving investors stuck with their holdings even though volume for a U.S. version soared. While Europe’s big players could still make orders off exchange, banks didn’t handle the smaller trades required by retail clients.
With researcher ETFGI counting funds listed on 25 exchanges in 21 different countries -- each with their own regulatory jurisdictions -- the fragmentation means assets are spread thin across similar products.
Attempts are being made to address Europe’s ETF liquidity problems. An overhaul of market rules known as MiFID II -- a successor to the Markets in Financial Instruments Directive -- will require trades to be formally reported, starting from January 2018, or a year later than initially planned. BlackRock Inc.’s Stephen Fisher says he welcomes the proposal, which is among the first to address the funds as separate instruments. The idea is to increase transparency and move more trades on exchange, which should in turn improve liquidity and attract more retail money, he says.
“ETFs are designed to be liquid and to trade like equities, but in reality what happens is that these funds mostly trade OTC,” Fisher, a managing director on BlackRock’s iShares public policy team, said by phone during a business trip to Brussels. “Liquidity in the European ETF market is fragmented. This makes it difficult for investors to get a true picture of the liquidity of any given fund, which has had an impact on the uptake of ETFs. It is our hope that this will change with MiFID II.”