Growth trajectory

The use of exchange-traded funds and other exchange-traded exposures continues to grow.

In Europe, as well as globally, retail and institutional investors have been steadily embracing the use of exchange-traded funds. Last year, ETFs in Europe saw net inflows of $22bn (£14bn), according to ETFGI, a research and consultancy firm, while Ucits funds suffered net outflows of $119bn ($76bn), according to the European Fund and Asset Management Association.

The move to indexing is being driven by several factors, including investors’ increasingly embracing the benefits of being diversified within and across asset classes. It is also fuelled by the recognition it is difficult to pick stocks or bonds that perform better than the benchmark.

On top of this, it is hard to find active funds that consistently beat their benchmarks, while the costs associated with stock-picking also play a role.

The use of exchange-traded funds by retail and financial advisers in the UK is expected to increase after the retail distribution review comes in, while more investors are using ETFs to implement tactical exposure to specific markets and asset classes.

Most ETFs in Europe are structured as Ucits funds, and although they account for only 3.5 per cent of all Ucits funds, they have been growing at a faster rate than these non-ETF funds -ib total an asset growth of 47 per cent per year over the past 10 years for ETFs, versus 5 per cent for other Ucits funds).

Investors in products bearing the exchange-traded label almost invariably assume they have invested in funds regulated under European Ucits rules.

In fact, the position is far from clear-cut. Whereas exchange-traded funds are listed funds with regulated exposures, exchange-traded notes and exchange-traded commodities lack either of these characteristics. The most common ETN and ETC exposures are wrapped into a debt security, whose value is linked to the performance of designated investments.

Broadly, one type involves a senior, unsecured, unsubordinated note issued by a bank where an investor is not only exposed to an investment risk but also the ability of the issuing bank to meet its debt obligations

The other is generally created out of special purpose vehicles and possible collateralisation programmes. As the structure is unregulated, it is up to investors to ensure they understand the risks and mitigating factors the promoter introduces – or fails to introduce – to mitigate any future loss and create the protections implicit in a regulated fund structure.

Some significant differences between Ucits ETFs and ETNs and ETCs are: the investor often has 100 per cent counterparty exposure to the issuing entity of the ETN or ETC – so, in the case of bankruptcy of the issuer, the investor may not receive back their full investment; fees for ETNs can be higher and less transparent than ETFs and fee disclosure for ETNs is not standardised (or regulated); and there are often additional fees for transaction costs, hedging and index licence costs on top of the annual investor fee.

Far from an open market deal, ETN deals may be struck in private. It is left to product providers to decide whether exposures are appropriate and fund protections are efficient. And investors may shoulder the risk.

Additional protections end up incurring additional costs, leaving the risk/reward analysis for the investor.

While this is not unacceptable in itself, the retail investors may not appreciate the difference, not least because brokerage accounts fail to make a distinction between note structures and ETFs covered by European Ucits regulations nor will the investor necessarily see any prospectus or summary information documents in advance of their purchase. This lacuna needs to be addressed.

The term ETC is used to reference notes backed by the underlying commodity or equivalent security, but also describes credit-backed commodity notes which may – or may not – be collateralised. If it does exist, the collateral may not be of sufficient quality. Yet other variants use the term ETC to refer to exchange-traded currency products.

The utility of these instruments for the informed and experienced investor is not in question. But the near collapse of banking institutions has drawn attention to the risks of non-fund exchange-traded exposures.

In our analysis at the end of this year’s second quarter, the European ETF industry had 1334 ETFs, with 4708 listings, assets of $277bn (£177bn), from 39 providers on 21 exchanges. Including other types of exchange traded exposures such as ETNs, ETCs at the end of this year’s second quarter, the European ETF and ETP industry had 1932 ETFs and ETPs, with 5933 listings, assets of $311bn, from 45 providers listed on 22 exchanges.

What asset classes are investors using ETFs and ETPs to access? The most popular are equities which account for 59 per cent of all ETF and ETP assets in Europe, commodity exposure account for 20 per cent and fixed income for 19 per cent of the total $311bn. Year to date through end of this year’s second quarter, ETFs and ETPs saw net inflows of $8.3bn (£5.3bn). Fixed income ETFs and ETPs gathered the largest net inflows with $3.2bn (£2.04bn), followed by commodity ETFs and ETPs with $2.0bn (£1.3bn) and equity ETFs and ETPs with $1.8bn (£1.5bn).