A Review of the European ETF Market in 2009

The Big Picture
As part of our expanding coverage of the global exchange-traded fund (ETF) industry, we are glad to be putting the rapidly growing European markets under our microscope. The European ETF industry enjoys some strong secular tailwinds. Regulatory hurdles are being gradually eliminated, allowing ETF companies to enter new markets. Trading information across different exchanges is being fine tuned in order to provide more transparency on market liquidity, which should reduce trading costs. A move away from commission-based investment advice and towards fee-based arrangements--best evidenced by the UK's Retail Distribution Review (RDR)--could spur broader ETF use amongst advisers. And finally, the growth in the number of self-directed investors, many of whom have access to increasingly low-cost online trading platforms, could further fuel adoption of ETFs. With this in mind, now is a crucial time for investors to develop an understanding of the promise and potential pitfalls associated with this low-cost investment vehicle. We think a look at the numbers is a good place to start, not only to better understand the industry, but also to get a feel for where investors have been placing their bets over the past year, and to see where they have gotten burned.

The European ETF market continued to expand at a rapid clip in 2009. Assets under management (AUM) rose 53% versus year-end 2008 levels to EUR 160 billion, and have compounded at a 46% annualised rate over the trailing five-year period. The number of products also continues to multiply; growing 36% during the course of 2009 to leave investors with over 1,000 different ETFs to choose from at year's end. We believe that the breadth of offerings will continue to widen in coming years as ETF companies invent new products that slice, dice, mince, julienne, leverage, and invert investors' exposure to an ever-expanding array of assets and indices.

At just over EUR 105 million in AUM, equity-focused ETFs accounted for roughly two-thirds of total industry assets at the end of 2009. Three of the top five equity ETFs by AUM are designed to track the return of the Dow Jones EURO STOXX 50 Index, the largest being Lyxor's offering. Emerging markets equity ETFs--namely db x-trackers MSCI Emerging Markets Total Return Index ETF and iShares MSCI Emerging Markets ETF--broke into the top 10 in 2009, thanks to a combination of new investor interest in the space and a sharp rebound in emerging market equities. Fixed income ETFs had the second largest share of AUM by year's end at about 20%. iShares Euro-denominated corporate bond ETF is by far the largest fund in this segment. Lastly, while commodity-related funds claimed only about 13% of total AUM in 2009, the segment experienced substantial new interest as many investors got bitten by the gold bug and new commodity funds were rolled out en masse, with ETF Securities leading the way.

While the synchronised rebound in equity, debt, and commodity markets played a large role in the heady growth of ETF assets in 2009, the industry also continued to rake in new cash. If we drill down to the cash flow level, we can see that new money drove a good sized portion of the growth in European ETF assets in 2009. At EUR 34 billion, net new inflows represented 31% of year-end 2008 assets under management. The largest beneficiaries of this cash infusion were equity-focused ETFs, which saw just over 60% (about EUR 21 billion) of the net new flows come their way as investors' appetite for risk gradually returned over the course of the year. Commodities grabbed the second-largest share of new money flows into ETF Land, with about 29% of the new money (or approximately EUR 10 billion) added to the category over the past twelve months. An out-sized portion of new funds flowing into the commodity category wound up in gold-related funds, with ETF Securities being the big winner in capitalising on investor interest in the yellow metal. Unlike equities, new commodity inflows slowed substantially over the course of the year. In fact, the amount of new flows into the commodity category in the final quarter of 2009 was less than a third the level that piled in during the first, as fear once again took a back seat to greed and investors went to chase more promising potential returns in stocks.

A Look at the Numbers
Having taken a look at the big picture, let's now take a closer look at some specific figures and the important trends which they highlight.

0% - Competition is driving down costs

In July, db-xtrackers reduced the total expense ratio it charges shareholders of its Dow Jones EURO STOXX 50 ETF from 0.15% per annum to zero. The fund had been outperforming its underlying index by an average of 0.61% on an annualised basis (after fees) since its January 2007 launch. The firm attributes the fund's consistent outperformance to "enhancements" generated by the its tracking methodology and has enough confidence in the sustainability of its track record to commit to sharing the benefits with shareholders in the future. Given that product differentiation is difficult--if not impossible--in the business of replicating blue-chip benchmarks, we would not be surprised to see similar moves by competitors to generate excess returns (which come primarily from interest earned through securities lending) and hone their execution in hopes of minimising expenses in order to attract assets.

#1 - The biggest continue to get bigger

The iShares family of funds continued to dominate virtually all corners of the ETF landscape in 2009. With over EUR 56 billion in assets, the firm is nearly twice as large as next-closest competitor Lyxor, and it owns the top spot in both the equity and fixed income categories. Blackrock also absorbed the most new money of the bunch, bringing in over EUR 8 billion, thanks in large part to parent company Blackrock's fixed income expertise. Fixed income inflows represented 37% of the firm's 2009 total.

At year end, the top five European ETF providers accounted for 80% of ETF assets under management. This fact underscores the substantial first-mover advantages that accrue to players in this space. Once a firm has brought an index fund to market it is difficult for others to successfully launch a competitive fund tracking the same index, barring a much lower fee structure or access to a captive asset base. Liquidity is also an important consideration as the largest funds also tend to trade the most frequently, which in turn serves to minimise trading costs in the form of narrowing bid-offer spreads. These advantages compound over time, as a larger asset base affords providers economies of scale and the means with which to generate additional sources of revenue that can help to offset fund expenses.

99% - Regulatory hurdles are being toppled

This figure marks the year-on-year increase in ETF transactions in Spain in 2009. The coming year should see a continuation of the strong growth of ETF popularity in what is currently Europe's fifth largest ETF market as measured by assets under management. The recent elimination of regulatory hurdles that prevented key players like iShares and db x-trackers from entering this market in earnest should help to drive substantial growth in ETF inflows in Spain in 2010. We think that new ETF-friendly regulation could continue to break down barriers to industry growth in coming years.

144% - Emerging markets lead the way, but keep a close eye on currency exposure

Emerging markets were amongst the most badly bruised by the 2008 market meltdown and have subsequently been some of the strongest performers off recent lows. As such, it comes as little surprise that in 2009, the best performing non-leveraged ETF was Lyxor's ETF Brazil, which tracks the Ibovespa index. The value of the fund's shares increased 144% over the year. Meanwhile, the Ibovespa index itself gained 82.7% for Brazilian investors during 2009. Most of the fund's outperformance relative to its benchmark can be attributed to currency exposure, because the fund's net asset value is denominated in Euros while its benchmark is pegged to the Brazilian real. As luck would have it, euro-wielding investors were handsomely rewarded for taking on this additional risk in 2009, as the real strengthened versus the euro. While this currency kicker was a welcome windfall for shareholders, currency exposure can just as easily cut into one's returns as it can enhance them. It is essential to take the time to fully understand the risks associated with investing in a fund that is denominated in a currency that is different from its benchmark's currency or an investor's home currency.

-84.4% - Beware the pitfalls of investing in commodities with ETFs (especially when leverage is involved)

Investors who held onto ETF Securities' Leveraged Natural Gas ETC through 2009--which uses synthetic replication to match 200% of the daily percentage price change of the DJ-UBS Natural Gas Sub-Index--were badly burned. The fund lost 84% of its value during the year as a combination of a contango-driven negative roll yield (with futures prices higher than spot prices, the underlying index was forced to buy high and sell low every other month) and leverage (compounded daily) proved disastrous for shareholders. For those sharp enough to steer clear of this fund, congratulations, you've learned an invaluable lesson in the risks of investing in commodity-focused and leveraged ETFs. And for those amongst you who gave into the temptation of a levered bet on what was a reasonable investment thesis, sorry, but you have learned the hard way.

There's more to come…
Don't fret if some of the topics we have touched on here are at first difficult to grasp. We will be going into further detail on each of them in the coming weeks and months as part of our ongoing coverage of the ETF market. Also please don't think that some of the examples that we have highlighted are representative of the ETF category as a whole. The vast majority of ETFs have functioned as advertised, providing investors with a low cost vehicle that provides instant diversification and a means to access portions of the market that were previously all but off limits to some.