The ETF industry is set to grow even faster than last year, as institutional investors increase allocations, target fund sizes increase and ETF promoters continue to take market share from other asset managers – both passive and active.
That’s according to the EY Global ETF Survey: 2015 and beyond. However, the image of ETFs as a cheap product has become a burden to the industry and promoters need to come clean on the total expense ratio (TER).
EY surveyed more than 60 leading promoters, investors, market makers and service providers across the United States, Europe and Asia-Pacific. The respondents include issuers representing 84% of the industry’s global assets.
Barring any major market disruption, EY predicts growth of 10% to 15% in the US, 20% to 25% in Europe and 25% to 30% in Asia-Pacific over the coming year. The survey shows clear potential for stronger take-up of ETFs from pension funds and insurers; half of the institutional investors surveyed plan to increase their allocation during the coming year.
Lisa Kealy (pictured), EY’s EMEIA Wealth & Asset Management ETF Leader, says: “Stable financial markets and strong equity performance have given a tailwind to ETF growth during the first three quarters of 2014 and we expect the low costs, flexibility, convenience and transparency of ETFs to push asset levels to new highs over the coming year.
“Institutional investors will drive growth in active and enhanced beta funds and active ETFs also have strong potential to attract retail investors. However, there are some headwinds. Sustaining current growth rates depends on the industry’s ability to keep improving the service it offers investors, including around transparency of pricing. Outside of the US, the industry needs to crack the code to unlock the retail investment market.”
Target fund sizes in the US and Europe hit hundreds of millions of dollars
More respondents than last year see funds of less than USD50m as economically viable (23%, compared to 8% in 2013), but this has a lot to do with the industry’s rapid growth in Asia-Pacific. There’s no doubt that overall target fund sizes are growing, especially in the US and Europe, with some (18%) now measuring the ideal size in hundreds of millions of dollars. Market makers are skeptical of fund sizes under USD50m due to perceived illiquidity. And institutional investors are setting their own size requirements for funds that often exceed promoters own targets; alert to breaching concentration limits, many institutions prefer to invest in funds of more than USD100m.
Seed capital varies considerably dependent on size of fund and location
Most promoters aim for seeding capital of up to USD30m, with USD10 to USD20m the most common overall figure. Seeding is less of a problem in the US, where many firms have tried and tested sources of capital, and 83% of respondents see USD10m as sufficient seeding for a typical fund. In contrast, weaker liquidity means that one-third of European respondents say the need USD40 to USD50m of seeding per fund.
Julie Kerr, EY’s Asia-Pacific Wealth & Asset Management ETF Leader, says: “The largest firms generally find it easier to seed funds, often using their own capital, but tend to be less patient in getting funds to viable stand-alone status. Smaller firms are more patient but often find seeding more challenging. In Europe, many promoters are struggling to raise the capital they need from the region’s capital-constrained banks and the picture is similar in Asia, where bank-owned issuers have seen in-house sources of capital being increasingly constrained by the Volker Rule.”
Pricing is under even more pressure
Survey respondents were even more downbeat on pricing than last year. In 2013, less than 10% thought fees would rise, but in 2014 no respondents expect fees to rise, the majority predict they will fall by more than 2 basis points (bps) and one-fifth anticipate steep reductions of 5 bps or more.
Promoters underestimate the sway of tracking error on investors’ decisions
Tracking error – the difference between the performance of an ETF and its benchmark – is typically low for mainstream equity index funds but it can still be a significant cost for short-term investors. The survey results show that promoters are underestimating investors’ focus on tracking error. Promoters think innovation, brand and reputation are the main drivers for investors selecting a promoter among competing products (with 25% and 20% of the vote, respectively), 15% said management fees were important and just 10% of promoters said lower tracking error was an important factor. Whereas, 50% of investors said they selected on the basis of tracking error, just 12% said size of fund, 12% said innovation, and 5% said management fees.
Matt Forstenhausler, EY’s Global and US Wealth & Asset Management ETF Leader, says: “The image of ETFs as an inexpensive product – while central to their success – has also become a challenge to the industry. An analysis of the expense ratio needs to consider tracking error, along with commissions and the effect of bid-offer spreads. In our view, promoters need to put as much effort into explaining the total costs associated with ETFs as they explain their benefits. If managers believe that the total costs of ETF ownership are typically less than for comparable mutual funds, they should have nothing to fear from transparency.”
Europe faces a unique set of challenges
The fragmentation of Europe’s ETF market continues to present challenges to the industry’s development, resulting in small average fund sizes that make efficiencies harder to achieve. Liquidity remains a particular preoccupation in Europe, where it is seen as a major barrier to growth. Cross-listing also presents a major problem for market makers, forcing them to buy and sell the same product on a number of different exchanges. In a good sign, 86% of promoters see the potential for the development of a true pan-European exchange, but it is still seen as being far off.
The retail challenge is at its most acute in Europe, where retail funds represent just 15% of the total (compared with 45% in the US).
Kealy says: “Increasing numbers of European promoters (percentage) are hoping that reforms to retail sales regulating will come to their rescue, but we do not see regulatory reform as a silver bullet. The fact that most platforms and supermarkets do not allow intraday trading is a major barrier. As is the fact that they provide far less information than in the US, where retail investors can compare a wide range of ETFs, analyse costs and receive recommendations.”
Despite these challenges, the European market remains attractive, in part because of the tax differences between US and European funds. US ETF providers continue to build up their European product ranges, and further targeted acquisitions of European houses by US or even Asian players are expected.