When will the ETF Breakthrough Occur?
By Jan Altmann, for Journal of Indexes
When the UK’s Retail Distribution Review (RDR) and Europe’s Markets in Financial Instruments Directive II (MIFID II) regulation first came to the attention of the exchange-traded fund industry in Europe at the end of the last decade, hopes were high.
The regulations—which, among other features, push for Europe’s independent financial advisors to consider investment products more on their merits than according to the prospect of the likely commissions paid—seem to make ETFs a natural choice for many advisory firms. ETFs are, after all, inexpensive, reliable and accessible for everyone.
How have things fared since? It’s early days yet, but it’s worth reviewing the results in two of the largest and most influential markets for financial products in Europe: Germany and the United Kingdom.
The structures for the distribution of financial products are completely different in the two countries. Germany represents a traditional continental European approach, where 90% of mutual funds are sold by banks to private end-investors. In the UK, advisors account for about 60% of all sales.
But the story across both markets is the same: there is huge interest in ETFs, but asset growth still requires a significant structural and educational leap.
Near-Term Challenges for Growth: From Reputation to Infrastructure
One thing is clear: in both markets, financial intermediaries are being pushed by the regulator to ban commissions. So far, this effort has gone further in the UK, under RDR, than elsewhere, but a push is afoot on the continent as well. Index funds are already present in the UK and account for about 7% of all mutual fund assets, still not a big number but more than double the 3% market share of ETFs.
Gordon Rose, ETF analyst of Morningstar Europe, is sceptical that the ETF providers can ride the wave of new regulations to huge success in the short term. “While RDR will undoubtedly accelerate the move towards greater use of ETFs, it won’t happen overnight. It will be a very slow process as it takes people time to change their preferences and behaviour. Also, it will take people time to educate themselves and implement new investment approaches.“
Alan Miller, CEO of wealth management firm SCM Private, is an industry outsider who has always been in favour of ETFs. He is even less optimistic about a broad breakthrough, however: „Even though the UK regulator has said that most IFAs need to look at all retail products, including ETFs, rather than just mutual funds, the sad fact is that most IFAs are yet to look at ETFs properly, let alone use them widely. This is down to inertia, combined with the damage caused by the totally misguided views resulting from the ETF witch-hunt that took place in 2011.“
Miller stresses that the public and later regulatory discussion weighing the advantages and risks of full replication against synthetic replication in ETFs has taken its toll on the ETF industry’s reputation, at exactly the wrong time.
„Ironically, in the UK, the combination of an exceptionally uninformed speech by the former chief executive of the FSA on ETFs, combined with misinformation being spouted and alarmist headlines in the press from the old guard of the UK fund management industry has led to the current nervousness and misunderstanding about the risks associated with ETFs,“ Miller says.
Beyond reputation, infrastructure also remains a problem. IFAs tend to be tied via commercial relationships to fund firms, fund transaction platforms and so-called wrap platforms. In the traditional platform model, financial advisors were paid a commission from the fund’s management fee via the platform, where all fund transactions also took place. But ETFs, which are exchange-traded, do not fit naturally into platform structures. Additionally, ETFs do not provide even a minimal trailer or kickback.
This is a strength of ETFs, of course—iShares calls this „factory good pricing”—but it’s also their weakness. To try to broaden their distribution networks, the major ETF providers have started to list their ETFs on platforms like Fidelity’s Fundsnetwork and on Cofunds, which has just been bought by Legal and General.
But the platforms also set the end-price for their clients, often making ETFs appear more costly than mutual funds when bought via the platform. Moreover, when being distributed via fund platforms, ETFs lose their „ET“ as they are processed in one transaction per day at net asset value (“NAV”).
Some providers like Vanguard, a relatively new entrant into Europe, also offer index funds that are more compatible with the platform model. Discretionary managers and large online brokers like Hargreaves Lansdown will probably benefit more over the short term than the conventional channels. In addition, many clients will buy ETFs through wrappers like funds of ETFs which can be handled the conventional way.
If the UK has taken a few steps down the pathway towards independent financial advice and greater retail usage of ETFs, Germany is just getting started.
Part of this has to do with historical differences in European financial markets and investment product regulation. RDR is a UK-specific initiative, while Germany operates simply under the MIFID II directive, with its less stringent requirements. But where ETFs have succeeded in Germany is inside other “wrapped” fund products.
Morningstar identifies 106 wrapped products registered for distribution in Germany that invest more than half of their assets in ETFs, with total assets of €9 billion.
The biggest German provider of funds of ETFs is Pioneer, the asset manager of UniCredit and formerly Hypovereinsbank, accounting for more than half of the total volume in this category. The funds are used for the wealth management clients of Hypovereinsbank.
„We see a big potential for ETFs to build active strategies with passive building blocks,“ says Dr. Franz Feldmann from Pioneer Investments, a firm rather known for their active mutual funds. „ETFs are cheap and allow easy allocation to liquid markets“, he adds. The Hypo funds may result from the earlier engagement of Hypovereinbank with the most successful ETF manager of the early days in Europe, Indexchange, which was absorbed by iShares in 2005. But apart from Pioneer other investment boutiques run successful fund of ETFs, like Veritas with 340mn. EUR AuM, and have just passed the important five year track record. Another boutique which often uses ETFs is Feri, the wealth manager and investment boutique of exchange listed IFA network MLP. According to research of 4asset-management Feri allocates more than 1 bn. EUR AuM of ETFs in their fund of funds.
In addition to heavyweights like Pioneer, many independent German wealth managers have launched their own asset allocation funds. Such “private label” funds today account for more than €47 billion in assets, according to research from Trinkaus and Burkhardt.
ETFs are still underrepresented in such label funds but the use has increased significantly over the last few years. The main reason behind the popularity of these funds is not the recent move towards fee-based financial advice, however; instead, it’s driven largely by tax reasons. Germany’s “Abgeltungssteuer” (a capital gains tax) offers advantages for wrapped portfolios, compared with a portfolio of ETFs.
As in the UK, such private label funds are also bought and sold through the existing fund transaction infrastructure. „Our portfolio ETFs track an index composed of ETFs to provide a broad asset allocation“, states Kai Bald, head of public distribution for Deutsche’s passive asset management division. A similar fund of ETFs was started in early 2012 in the UK with a cooperation between SCM’s Alan Miller and db x-trackers.
In Germany, commissions to advisors are less regulated than under the radical RDR move in the UK. Germany will have to implement MiFiD II in 2014, banning some kickbacks to fund advisors, but the pan-European move against commissions was less aggressive than RDR. Fee-based advisors are therefore still a rare species in Germany. The most popular broker pool in Amberg near Nürnberg operates services for about 1500 fee-based advisors and is quite aggressive in marketing its efficiently priced services. Another boost might push the third-largest IFA Pool, MLP, towards fee-based advisory for investment products.
What Could Turn a Trickle into a Flood?
ETF providers are readying themselves for the push that may one day come through fee-based channels by listing their products on conventional fund platforms. „We have listed our product range on the five largest fund platforms“, states Michael Grüner, Head of sales for iShares in Germany.
Other providers like db X-trackers, Comstage and others have also listed many products on the mutual fund platforms to make the products easily available for advisors. Morningstar’s Gordon Rose observes: „As iShares is pushing into the retail market trying to increase the awareness amongst private clients, we would assume that this will increase the demand from the investor base as well, ultimately pushing IFAs towards ETFs. In addition, we see especially in Germany increasing interest in complete model portfolio solutions around ETFs.“
Model portfolios seem quite ambitious for a market that is dominated by bank distribution. First aimed at DIY-investors, a portal called JustETF.com has emerged with model portfolios as one of its core offerings. After one year the startup has added a functionality to administrate client portfolios at reasonable cost. One of the two founders, Dominique Riedl, observes „a trend for IFAs from financial product advisory to coaching retail investors that invest in a DIY approach.“ Advisors will have to face far less regulation when the client himself does the investing. Model portfolios can help in this process. JustETF is not linked to online brokers but can produce files that can be read automatically by online brokers.
Online brokers have also proven to be more flexible in Germany than in the UK. There are often cost-free ETF trading campaigns which so far have not been available in the UK. Some larger online brokers have launched their own model ETF portfolios. Additionally, many online brokers offer savings plans with ETFs that would be available from IFAs or via banks’ distribution networks.
Issuers Invest For The Long Term
Regardless of whether we look at the UK or at Germany, initiatives like RDR have not fully excited advisors about ETFs yet. Top-down regulation has so far had less impact on ETFs and their providers than originally expected. A lot of marketing and operative work will have to be invested before ETFs enjoy a broader breakthrough in retail distribution. The providers feel themselves to be well on track, though: „In 2012 we have enabled access to our products, and 2013 will be the year of ETF education“, says Grüner of iShares.
But issuers are still investing for the longer-term development of their markets, even if they are unsure if it will take a few more years or another decade for things to come to fruition.
In Germany, iShares has recently sent out a marketing kit to over 2000 advisors. Vanguard has launched an internet platform on ETF education in the UK, and db x-trackers has been sponsoring ETF education seminars for fee-based advisors since 2012. Grüner is optimistic though: „Over time, we will see the same development in Europe as in the US, where big platforms adopt ETFs and make them available directly or in efficient wrappers“.