Industry commentators have always been bullish about the prospects for ETF in Europe, however, there remain a number of structural issues that are preventing the vehicle from taking off in quite same way as in the US.
The growth of the ETF industry over the past decade has been nothing short of remarkable with global assets skyrocketing from $716bn in 2008 to $5.5trn by the end of August.
However, this evolution has been relatively uneven with the US capturing over $4trn of these assets while Europe, with $834bn, is yet to break the symbolic $1trn barrier.
While a part of this is down to the first ETF in Europe being launched seven years after the SPDR S&P 500 ETF (SPY) came to market in 1993, there also are a number of structural issues that continue to hamper the market.
Some of these problems are very unlikely to be solved, however, there are others that require either a change in mentality or further regulatory solutions.
Fragmentation
One key difference between the US and Europe is fragmentation. The US benefits from all trading occurring under a single federal legal system, in the same currency, in the same language and with the same clearing system.
By contrast, Europe has 28 exchanges compared to the US’s 3, different clearing and settlement systems and is dominated by more opaque over-the-counter (OTC) trading.
This has a number of impacts. Firstly, fragmentation issues entirely counteract what can be achieved with passporting through UCITS, which is widely recognised as the global standard for funds.
As Federico Cupelli, senior regulatory policy adviser at EFAMA, explained: "ETF providers find national listing requirements tricky. On the one hand, we have the UCITS framework offering European ETFs the intra-EU passport, however, the fragmentation of varying listing requirements counteracts these same benefits."
Jim Goldie, head of ETF capital markets, EMEA, at Invesco, stressed the importance of having a consistent approach to issues such as the mandatory ticket size regime, buy-in rules and fails costs as this would make the market more efficient and improve settlement rates.
“The industry would benefit from further harmonisation with the exchanges and OTC trading/settlement,” Goldie continued. “Centrally clearing OTC trades, such as those done on RFQ platforms, would also provide greater efficiency and reduce counterparty risk.
“Work has already begun on a number of these areas in order to create a more robust and efficient UCITS ETF ecosystem, which could translate into improved liquidity and cost savings for clients and help promote further growth of the industry.”
Furthermore, when an issuer is launching an ETF, it must decide which regions it wants to list. This can be more challenging than one may first anticipate, according to Athanasios Psarofagis, ETF analyst, EMEA, Bloomberg Intelligence, who points out the European fragmentation means different nationalities have different investing attitudes and processes.
“It is far harder to launch an ETF [in Europe] that appeals broadly to every investor type as a UK investor is going to have a different process to an Italian investor,” Psarofagis noted.
Finally, most importantly, fragmentation prevents investors from seeing the full liquidity of an ETF in Europe because the industry, unlike the US, lacks a consolidated tape.
MiFID II, which came into effect on 3 January 2018, has gone some way to address this by bringing some OTC trading on exchange and introducing requirements for post-trade reporting while efforts have also been made by Bloomberg to increase the visibility of ETF liquidity through its aggregate data field.
Despite these changes, investors still cannot see the full picture, however, the ETF industry remains hopeful for the introduction of a consolidated tape which should solve the liquidity visibility issue and lead to a spike in ETF uptake this side of the pond.
Distribution
While the major fragmentation problems such as multiple currencies and exchanges are unlikely to be solved in the near future, the distribution issues plaguing the European market are being addressed.
Unlike in the US where the majority of ETF buyers are financial advisers, institutional investors continue to be the biggest portion of ETF owners this side of the pond. Industry commentators tend to estimate the split between institutional and retail is 70/30 whereas in the US it is closer to 50/50.
On the continent, Psarofagis explains the majority of distribution is handled by banks, who are more likely to push their clients into more expensive products where the commission is better.
“That is why the more successful firms here are the ones with close banking ties such as DWS and UBS Asset Management,” he added.
Steps have been taken by regulators to tackle this problem. In the UK, the retail distribution review (RDR) was introduced in late 2012, which banned advisers from receiving commission from issuers.
Furthermore, MiFID II has imposed tighter restrictions on the commission payments distributors were receiving for selling the asset manager’s products. Under MiFID II, distributors can only receive retrocession payments if they are execution-only or they offer access to third-party products from competitors.
“There is still a lot to accomplish,” Cupelli commented. “MiFID II has helped distribution for ETF products that lend themselves to be not be sold behind advice and related inducements. In certain continental European jurisdictions, however, competing (i.e. non-ETF) investment products will continue to be sold through retrocessions, and this will somewhat likely brake ETF adoption in the retail space. On the other hand, institutional take-up of ETFs remains strong.”
Taxation
Another key advantage for US investors is the tax benefits ETFs bring compared to mutual funds.
In Europe, investors simply do not have the same luxury and Cupelli said this is unlikely to change anytime soon.
"I do not see things changing," he added. "ETFs are subject to capital gains tax and this falls under national rules."
Despite these hurdles, the uptake of ETFs will continue to grow in Europe as investors become more comfortable with the wrapper, however, the structural issues mean the continent will remain some way behind the US for the foreseeable future.
ETF Insight is a new series brought to you by ETF Stream. Each week, we shine a light on the key issues from across the European ETF industry, analysing and interpreting the latest trends in the space. For last week’s insight, click here.
