“Global exchange traded products broke the $2trn threshold in January. So far, however, exchange traded funds’ (ETF) penetration in the UK institutional market remains relatively muted. With competition becoming ever-more fierce and consolidation underway, ETF prices and liquidity are improving to a point where institutional investors, grappling to provide the best cost-efficient risk adjusted return possible, should be following these developments closely.”
Continued growth and competition will continue to drive down costs. One thing is clear: when providers battle to bring down fees, investors win.
Ben Johnson
ETFs have begun to make inroads into the institutional market on both sides of the Atlantic and a wide variety of institutions are active ETF investors. According to Michael John Lytle, chief development officer at ETF provider, Source: “Pension funds, insurance companies, asset managers, wealth managers and private banks all value access to investment exposure through ETFs. As a result European ETF assets have grown very rapidly (around 30% annual growth for the last 10 years) even when traditional funds have seen limited inflows or even outflows.”
Despite this, European institutional investors represent a significantly smaller portion of total market demand versus the US, where Greenwich Associates’ 2012 study found only 14% of institutions (including corporate funds, public funds, endowments and foundations) used ETFs.
Simon Vanstone, head of institutional at Vanguard, says: “Penetration in Europe is much lower than in the US, but appears to be following a similar trajectory.” There are signs ETFs are making progress. “Our conversations with clients suggest they are increasingly considering ETFs for strategic and tactical purposes,” Vanstone says. Of 260 European corporate pension professionals surveyed by State Street Global Advisors, only 39% said the funds they manage currently have no allocation to ETFs and 47% said they would increase exposure to ETFs over the next five years.
Change for good
The changing shape of the European ETF market will be key to increasing their role among institutions. Two notable recent events have already helped improve their chances of significant growth: In March 2012, Vanguard, one of the top three ETF players in the US market, which employs an aggressive pricing policy, brought its offering to Europe forcing prices down. Then in January this year, Blackrock announced it would be buying Credit Suisse’s ETF business. In doing so, Blackrock, already the largest European ETF player, will increase its share of the $378bn market from 42.8% to 48% by taking over Credit Suisse’s 5.1% according to research firm ETF Global Insights.
Scale and momentum are key factors for ETF providers’ profitability, particularly for those keen to attract institutions whose own scale demands ETFs be of considerable size. Liquidity is critical to institutions deciding whether to invest in an ETF. With the costs of registration and regulation on the increase, the biggest ETF providers will be most able to keep ahead of price competition and still turn a decent profit.
Ernst & Young, in its European ETF survey 2013, found a wide expectation of more consolidation with most of those interviewed agreeing the big providers would get even bigger. With greater scale, those providers will be able to further decrease prices, attracting more assets and trading, thereby bringing down bid/offer spreads in a virtuous cycle of decreased pricing and trading costs and increased liquidity.
Who, what, when and where?
However, the issue of price and its importance depends on the type of investor and the type of exposure they want. Many institutions outside the defined benefit (DB) pensions space are weathered ETF investors.
As Chris Sutton, senior investment consultant at Towers Watson says: “Other institutions have been users of ETFs for many years, including insurance companies and aggregators of private wealth. The criticism levelled at ETF fees really only applies to pension funds and only in the standard asset classes.”
ETF prices would still have to fall by some considerable margin if they are going to compete for traditional DB pension assets, especially for ETFs offering vanilla exposure on mainstream benchmarks.
“There is already a very competitive passive index fund market where a few providers have had scale and have built products specifically for that market,” says Sutton. “If a fund is looking for vanilla exposure to buy and hold for 10 to 20 years, there are cheaper products built specifically for that market, which are also more tax-efficient.”
Sutton estimates a scheme with £50m to invest could get a typical passive global equities index fund for 10-15 basis points (bps) in cost. An equivalent ETF would be around 25- 50bps. Similarly, for UK/European corporate bonds, an institutional fund might be 10- 15bps where the equivalent ETF would be 20- 25bps. The relative expense of ETFs is especially acute for larger DB pension funds, whose bargaining power with mutual fund providers leaves ETFs out in the cold. Paddy Dowdall, investment manager at the Merseyside Pension Fund, whose assets exceed £5bn, says: “Passive management can be even cheaper than two basis points.”
Even the largest ETFs cannot compete with such low charges. The world’s largest ETF, the $1.26bn SPDR S&P 500 ETF carries a total expense ratio (TER) of 0.09%, one of the lowest in the market.
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