Exchange traded funds have seen explosive growth in the US and fund sponsors are licking their lips at the prospect of replicating the success in Europe. Flows into European-based ETFs have been encouraging but differences between the two markets mean the popularity of ETFs in Europe may not match the US.
Globally, approximately £1.6trn of assets sits across 2,500 ETF structures. The largest is the US-listed, £130bn State Street SPDR S&P 500. A handful of big funds constitute a large proportion of the market by value: the 10 largest represent 30 per cent and the top 100 cover more than 66 per cent. In contrast, the smallest 500 have a tiddly share of 5 basis points. The most popular funds are the giant regional passive equity funds, virtually all of which are domiciled in the US.
You might expect passive investors to have holding periods measured in years or decades, but turnover rates of many US-domiciled ETFs indicate weeks or days are more typical.
The State Street SPDR S&P 500 ETF is the most actively traded security on the US Stock Exchange, often by an order of magnitude. Its trading volume frequently exceeds that of blue-chip equities, some of which have a significantly larger market capitalisation. The annualised turnover across the State Street-sponsored ETF range is more than 2,000 per cent. The aptly named VelocityShares range has a turnover rate of more than 10,000 per cent.
Institutional ownership of the main US ETFs is high, typically 40-60 per cent. These financial institutions seem to use ETFs as trading tools, to speculate, to hedge and to implement short-term strategies. Some US institutions evidently see ETFs as a cheaper alternative to the futures markets, since the structures have no associated roll costs. Changes to banking regulations since the credit crisis have lifted the costs of futures, though it is uncertain whether European institutional investors will take to ETFs with the same fervour.
A further difference is that some US investors benefit from tax advantages by investing in ETFs that are not available to US investors in open-ended mutual funds. In the UK, HM Revenue & Customs recognises funds as investments and taxes them at the fund level. For investors investing in accounts liable to capital gains tax, it is more tax-effective to hold an individual fund as opposed to a portfolio of securities. The CGT is liable only when the investor sells the fund, not when the fund manager sells an underlying security. The US IRS, however, is not so generous. It effectively looks through the fund structures and taxes investors at the underlying security level.
Meeting IRS requirements is a headache for mutual funds. which have to account for the profits and losses on individual holdings and distribute capital gains on a regular basis. In theory, the same regulations apply to ETFs. However, the mechanism in which ETF units are created and redeemed means any security with a tax liability can be passed ‘in kind’ through to the Authorised Participants. The APs are typically investment banks that act as a conduit between the investors and the ETF structure and they presumably don’t encounter the CGT issues faced by typical US investors. This leaves ETF investors with little to worry about from a capital gains distribution standpoint and makes the vehicles a more attractive structure for US taxable accounts.
ETFs do offer unique advantages to European investors, however. Despite the passport prov-ided by the Ucits regulations, cross-border fund flows face impediments caused by the bespoke nature of the trading platforms. If I wanted to buy a Deutsche Bank fund, there is little likelihood I would find it listed on a UK-based platform. To trade, I would probably have to deal with the fund administrator in Europe and arrange settlement in euros. ETFs don’t have this headache.
A fund can be listed on exch-anges throughout Europe, inc-luding the UK. Settlement and trading denomination can be established based on the individual exchange quote. This will facilitate economies of scale for providers and may make it easier for investors to transact. Differences in the two ETF markets include institutional appetites, tax differences and ease of trading. The European ETF market is different to the US market and its growth rate should be expected to be different.
Jason Broomer is head of investment at Square Mile