Structured products: Articles

The European exchange-traded funds (ETFs) market is continuing to go from strength to strength, with the launch of non-equity ETFs over the last couple of years.

These have been largely bond-index trackers, but there was a flurry of interest recently in a gold ETF launched by the World Gold Council, and plans are afoot for the listing of a real-estate ETF in the near future.

The arrival of ETFs tracking bond indexes like the IBOX or MTSNext indices is offering the same ease of access to this asset class as the original European ETFs provided for equities. With management fees in the region of 15-16 basis points they compare favourably with even indexed bond mutual funds, and are already attracting interest from small and medium-sized pension funds as well as large institutions seeking to securitise cash quickly. They have even started to make headway in the more conservative retail market in Europe, although we are still only seeing the first glimmerings of interest in this.

"It gives immediate exposure to the bond market, if you need to get exposure as quickly as possible," said Scott Stark, CEO of MTSNext, a joint venture between Euronext and MTS which provides bond indexes. "You can go long, short, or move along the yield curve."

The vehicles have also attracted attention from hedge fund managers, and are being used as the basis of OTC options, having quickly moved into the acceptable mainstream amongst European institutions. This is partly thanks to the educational job that has been done by the proponents of equity ETFs, like Barclays Global Investors and State Street, as well as the major players in euro-denominated ETFs: Indexchange, Axa, SocGen, and Merrill Lynch.

"There's a huge potential market there, but we have to teach each side about the asset class," Stark says. "Everyone's jumped on the bandwagon because they know this will be a significant product going forwards. The educational process is key here."
Nobody has any illusions that retail outlets like banks and brokers will not want to replace traditional investment funds with ETFs: ultimately they will stand to make less money, both in fees and commission. "ETFs are bought, they're not sold," Stark admits.

But non-equity ETFs will play a big role in institutional portfolios, especially as the satellite holdings in a core/satellite strategy, and it is the institutional dollar - or euro - that those building future ETF products are interested in at the moment.

Bond ETFs

Indexchange, the German provider of ETFs listed on Deutsche Boerse, has four bond-based ETFs up and running, and has been happy with the €2.1bn it has taken into its ETFs in the first quarter of this year. It added three new German government bond ETFs to its eb.rexx range last June, covering specific maturity ranges.

"Retail and institutional investors buy Indexchange ETFs, but our main focus has been so far on the institutional investor. Since the European ETF market is still a very young market, institutional investors are the pioneering customers," says Thomas Meyer zu Drewer, chief investment officer and member of the board at Indexchange.

He says institutional investors are not used to acquiring their bond exposure via the stock exchange, having traditionally bought and sold fixed income securities via the OTC market. But bond ETFs are a much more hassle-free way for these clients to maintain their fixed income exposure, and it is also easier for Indexchange to manage their portfolios, buying as they do from 'designated sponsors', than an active manager, who has to call around to get the bonds at the prices he wants.

There is demand for ETFs buying corporate debt, with spreads of between 0.5% and 1.0% between corporate and government paper, and this might be something that would merit an ETF going forwards. Meyer zu Drewer says he sees a demand for corporate bond ETFs because they are flexible, transparent and cost efficient.

Although US dollar-denominated fixed-income ETFs are available in Europe (Goldman Sachs has listed one in London), there has been less demand for these. It partly reflects an overall lack of demand from major investors for US government debt or dollar exposure, rather than a lack of faith in a US bond ETF per se. Getting asset allocators to start buying ETFs for their bond exposure in the first place is the main focus of marketers.

Other asset classes

Outside the fixed income sphere, Axa has blazed a trail in the real estate market with an ETF based on the EPRA index that measures the performance of listed companies with 75% or more of their revenue coming from commercial real estate. Axa says it expects the fund to go live in the next few weeks. The EPRA index was launched in 2000 to meet a demand for real-time indices created and managed by real estate professionals. "This is a huge step forward for the European real estate sector," says Nick van Ommen, CEO at EPRA. "The EPRA ETFs will enable the sector to compete, on an equal footing, with other sectors and asset classes where derivatives already exist."

Axa's EasyETF family of funds is listed on Euronext. Bruno Guiot, head of EasyETF development at Axa, agrees the launch of this vehicle is a coming of age for the European real estate sector as a liquid asset class. "It is the only way of achieving an actively-managed property investment in this period of time," he argues. "You can move in and out on very short notice - this is a way to simply jump into it. It is as close to the property market you can get short of buying real estate yourself."

It has been argued that a 'true' commodity ETF should hold the commodity itself, and that an ETF that invests in companies specialising in that commodity is really an equity fund by another name. Guiot disputes this, however. "Considering the risk-return profile and risk correlation, you cannot just consider this another sector in the equity spectrum," he says. "Once you want to achieve diversification, the only way to do it is via listed securities."

There are three real estate ETFs listed in the US, but the Axa product represents the first ETF foray into the European property market, and Guiot is expecting plenty of interest from European investors. The US vehicles are solely invested in US real estate companies: "The real estate market is much more a local market for the local investor," he explains.

The launch of a London-listed gold ETF sponsored by the World Gold Council prompted massive capital inflows when it was listed, and its has been seen by some investors as a pure commodity-based ETF, founded as it is on the price of bullion held by the WGC itself. In its first day of trading volume exceeded the volumes of the entire mid-cap sector. The London Stock Exchange, on which the ETF was listed, is pleased with the level at which the fund was traded. "Our concern was there would be massive inflow and it wouldn't be traded that much," said an LSE commentator.

To launch a credible commodity ETF, one European-based ETF specialist argued, you have to be a serious player in that market in order to maintain the requisite liquidity of the underlying assets. Simply issuing an ETF which tracks the prices of companies in the precious metals sector is not offering the market an efficient play on the commodity in question. "I guess you have to have that link with the physical world," he says.

Others see it differently, arguing that the fund is little more than an asset-backed bond.

Rumours are already abroad that other precious metals ETFs could be in the pipeline. One source close to the metal markets said access to the palladium market, for example, would be greatly facilitated by an ETF. The question is whether such specialised vehicles would achieve the assets under management that would make them worthwhile. Specialist commodities like palladium are not the province of most investors, be they institutional or retail.

"We want to see how gold runs before we look at other commodities," said the LSE source. "If there was a commercial case it might be something we'd like to explore. We have seen the warrants market, including oil and platinum, trading quite heavily."

Conclusion

Going forwards, Europe's ETF market is facing an over-proliferation of funds. It already plays home to more ETFs than the USA, but with only a fifth of the assets under management in these structures compared with the US market. It is expected that, while new products will emerge, others will not achieve sufficient volume to make them worthwhile.

"A few clear winners are emerging - people are focusing on more intelligent product," said the LSE spokesman.

For example, it is likely we will see more ETFs focused on the market for corporate debt, while the government debt market moves closer to saturation. Some kind of shake-out in the non-equity ETF space could be on the horizon, and product designers will have to measure future launches carefully against the requirements of the institutional market they so value. The prospect of specialist commodity funds could be interesting, though, as they may provide institutional investors with a means of circumnavigating less efficient market processes in order to gain the exposure they need.