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Can ETF’s continue inexorable rise during 2017?

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Can ETFs Continue Inexorable Rise During 2017?

Guest article by Lisa Kealy

Past performance, as they say, is no guarantee of future performance and the same applies to the growth of a market as a whole. ETFs have surged in volume and assets, but that does not mean the process will go on forever. This article examines the landscape.

One of the investment industry themes of recent years, as readers of these pages will be aware, has been the explosive growth of the global market in exchange traded funds. Regulation, technology and expanding investment demand have boosted the sector. ETFs have, however, not been without some controversy, such as over possible risks in “synthetic” ETFs (those using swaps-based sources of return), or those seeking to replicate leveraged/shorting strategies where investors might not always appreciate underlying risks. Not all ETFs are created equal. This article, by Lisa Kealy, Europe, Middle East, India and Africa ETF leader at EY, examines the European market. The editors of this publication are grateful for these views and invite readers to respond.

This has been a difficult year for many European investors and investment managers. Brexit and the US election may be dominating headlines, but many other factors are also shaking up financial markets.

Against this backdrop it has been remarkable to see European exchange traded funds steadily gathering inflows, month in and month out. What is more, ETFs look set to remain the main beneficiaries of growing allocations to passive investment. EY’s latest study of the sector expects ETFs to enjoy twice the net inflows of mutual funds over the next few years. We predict that European ETF assets will grow from their current level of just over $500 billion to more than $1.1 trillion by the end of 2020.

In fact, it seems that the current challenging market conditions are playing into the hands of the ETF industry. Like most investment managers, ETF promoters have concerns about political, economic and regulatory risks. But they also see a silver lining to those clouds. Our survey shows that a large majority view macroeconomic volatility as more of an opportunity than a threat. ETF managers also feel that the overall direction of regulatory change is working in their favour.

If this sounds surprising, it should not. Today’s markets are ideally suited to low-cost, liquid vehicles offering a wide choice of investment options. Pension funds, high net worth individuals and everyday savers are among the investors using ETFs to access exposures they would struggle to obtain elsewhere. And ETF providers continue to develop new products at bewildering speed. Hot areas include fixed income, smart beta, currency hedged products, ESG-themed funds, property and absolute returns.
So is the sky the limit for European ETFs? Not quite. Our survey shows that the industry’s rapid growth has the potential to create its own risks.

At a product level, this can be seen in the increasing difficulty of launching new products. More ETFs are being issued than ever, but a growing majority of promoters (64 per cent globally) expect success rates to decline. The reasons for this contradiction are stark. As in the US, product supply is reaching saturation point in Europe. And the growth of more complex ETFs is making it harder for promoters to test and seed new products.

Potential risks are evident at an institutional level too. Lured by growth, new entrants are flooding into European ETF markets. They include passive, active and niche specialists. American and Asian arrivals are also jostling for inflows with European firms. But growth is not the same as profitability. This is an industry of tight margins, and our study shows that only the largest providers are consistently profitable. The bar is particularly high in Europe, where fragmented markets lead to cost duplication and regulation is at its most demanding.

The study also raises some interesting questions about the future of the ETF industry. For instance, there are growing signs of convergence between ETFs and mutual funds, as many asset managers reduce mutual fund fees and issue their first ETFs. Does this convergence represent the triumph of the ETF model, or threaten the distinctions that have served the sector so well?

The short answer is probably yes to both. The fact that a growing range of financial institutions are issuing ETFs speaks volumes for their investor appeal. But it also makes it harder than ever for individual ETF providers, whether new entrants or established players, to stand out in a crowded market.

In our view, innovation, the wellspring of ETFs’ astonishing growth record, still holds the key to success in this fast-evolving market. But this is about much more than churning out new products every quarter. The industry needs to take an integrated view of innovation. That means balancing short-term ambitions with long-term sustainability. It also means applying the creative thinking that already goes into product development to other key activities, most notably market entry and digital distribution.

To continue its success, the ETF industry needs to deliver a growing range of outcomes to a wider range of investors. We believe providers need to focus on four key areas. These are smart, sustainable product development; total transparency of performance and pricing; creativity in the search for scale; and new models of digital distribution.

The European ETF industry looks well placed to enjoy lasting expansion. But this growth cannot be taken for granted. Individual firms should be under no illusions about the competitive challenges they will face during the year ahead.

This article was originally published in the Wealth Briefing on the 21st November 2016.

Lisa Kealy

Financial Services Markets Leader
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