LIPPER-ETF tiddlers for the chop?
(The author is Head of EMEA Research at Thomson Reuters fund research firm Lipper. The views expressed are his own.)
By Detlef Glow
The exchange-traded fund (ETF) market has shown strong growth since its inception in Europe. Many fund promoters have sought to capitalise on this, seeking to differentiate themselves from rivals and match client needs by injecting some innovation into their product offerings. This has led to a broad variety of ETFs competing for assets, both in terms of asset classes and replication techniques.
Looking at assets under management, however, the European ETF market is still highly concentrated. The five top promoters account for more than 75 percent of the entire industry. On a fund-by-fund basis the concentration is even greater.
The ten top funds by assets under management (AuM) account for 25.68 percent of the overall total, while the largest fund in the European ETF universe, iShares DAX, accounts for 11.624 billion euros or 4.75 percent of the overall market.
A closer examination of the AuM shows that only 47 of the 1,727 ETFs registered for sale in Europe hold assets above one billion euros. These funds account for 49.92 percent of the overall assets under management and are highly profitable “bread and butter” products for their fund promoters.
According to iShares, the world’s largest ETF provider, the largest funds in the markets also tend to have the highest turnover, making them attractive to institutional investors who can buy and sell large holdings without making a significant market impact. In addition, institutions such as funds of funds are, under the EU’s UCITS regime, not allowed to hold a major stake in any given fund in their portfolios, making a fund with higher AuM even more attractive.
It starts to look like a scale business, where size is its own reward.
What of the vast majority of ETFs which don’t boast the muscle of their 47 ‘billionaire’ peers? Actively-managed funds can be merged or liquidated if they don’t gather a certain amount of money over time. So are these lower-volume ETFS now more subject to possible consolidation?
The “poor funds” with lower AuM levels have to deal with a lot of pressure. All funds in a product range will incur legal, listing and marketing costs, among others, and since these exist regardless of a fund’s size, some ETFs are simply not profitable.
As long as the industry is enjoying healthy growth, where the overall AuM of a promoter are rising on a steady basis, a promoter can absorb this with the proceeds from more sought-after funds. But in an unstable environment, marked by falling revenues and an increasing regulatory burden, fund promoters are forced to review their product ranges, and may make the decision to liquidate funds that are not contributing to earnings.
Weighing the cost/benefit characteristics of an ETF is no easy matter and depends on how it is structured, listed and managed. But industry players tell me a good rule of thumb is that a fund can become profitable when AuM exceed 100 million euros. This gives the fund promoter has a solid stream of income from the management fee and they may be able to receive income from trading in the fund as well as from securities lending.
So maybe this is the level at which ETFs might suffer a similar fate to their underperforming peers in the actively-managed sector. Certainly from my point of view, an ETF that has not been able to gather at least one hundred million euros over a three-year period is in serious danger of closure.
A detailed, and updated, view of the European ETF industry which Lipper produced recently showed that 294 of the 1,727 funds fall into this category. You can view graphics from the initial findings here. Note: the totals have changed since the update.
With around one sixth of funds in the ‘danger zone’, this might sound pretty tough already for the industry, but it’s worth noting that the number of funds with subpar AuM dramatically increases if we do not apply the three year limit.
The complexity of cost-bases and income streams makes trial by AuM a bit of an unfair way of estimating the profitability of an ETF. But it can be taken for granted that larger funds are unlikely to be closed and smaller funds that fail to attract enough investors are on thin ice.
This was demonstrated by ETF Securities in June, when it liquidated nine of its funds because they didn’t meet targets for AuM or turnover volume.
Things may look grim for the minnows of the ETF market, but there are considerations aside from cold, hard cash. In a number of cases, the fund promoter will keep an unprofitable ETF purely to complete a product offering. Larger players especially like to present clients with a one-stop shop and a near-complete product offering.
And the flipside to possible consolidation in the ETF industry is a sustained pressure for innovation, notably in new initiatives toward more active indices, i.e., indices that optimize their risk-return profile, which is creating a new posse of niche products. [ID:nL2E8I9368]
Despite the fund closures we are seeing over the short term, from my point of view the ETF industry will grow further in all areas, not just in terms of assets under management. We will see more ETFs that track an even broader range of indices coming to the market in the future. This behavior is rational, since product innovation and investor demand are the growth drivers of the industry. Nobody can know what will be the next strategy index to become a mega seller, so index providers and ETF promoters need to continue to be creative, even if they do choose to embark on the odd stint of housekeeping among the back markers.