Exchange-traded funds (ETFs), which are a subset of exchange-traded products (ETPs), originated in the US and have been the success story of the asset management industry for the past decade.
Industry growth started at a snail’s pace in the US but has gained incredible momentum to become an industry with trillions of dollars of assets under management (AUM).
In spite of the European ETF market being much smaller in AUM terms than the US, the changes to the European ETP market are likely to be far more dramatic in the near term.
The structural changes in the ETP market are largely being driven by investors’ perceptions that ‘physical’ replication is preferable to ‘synthetic’ replication through swaps.
With physical replication, the view is that investors ‘own an asset’, but that with swaps they ‘own bank risk’ – an argument banks have clearly lost. In reality both methods have their advantages and whichever technique is used, ETP structures are arguably more robust than mutual funds.
Given the increasing preference for physical replication, ‘core’ products will gravitate in that direction, with synthetic replication filling in the gaps where physical either can’t be used or is not efficient.
With well-thought-out and appropriate collateral arrangements for counterparty protection, synthetics are generally accepted by investors for this supporting role. Indeed, synthetics are increasingly used for innovative investment strategies and to improve tracking efficiency.
The battleground for the next five years and beyond will be among the top five or six providers fighting to break BlackRock’s European dominance, particularly in the ‘core’ range offerings. The provider making the running here is Vanguard.
The fight is likely to intensify and mirror the story in the US, with Vanguard’s low-cost approach increasingly difficult for BlackRock and others to compete against in the provision of plain vanilla ETFs. Fees are dropping as a result of this competition and investors are the ones to benefit.
The second major structural change will be regulators moving towards requiring investment bank providers to accept the majority, if not all, of their swaps from third parties.
Preventing ETPs from using swaps would be throwing the baby out with the bath water, especially where physical doesn’t work or isn’t efficient. However, ensuring that providers get their swaps from a third party and therefore not concentrating their risk within the same company does seem sensible.
For the investor, this new model means a provider can change counterparties at any point if it is in the best interests of investors and that such decisions become independent of any conflicts of interest.
The main battleground for innovation is, and will be, what is lazily coined the ‘smart beta’ space.
‘Smart beta’ is a catch-all term for all index methodologies other than market capitalisation, which invites the criticism that it overweights overvalued stocks and underweights future value.
It is already clear ‘smart beta’ is where the main area of innovation is going to be focused on by providers. Particular success has been evident for dividend, earnings, equally-weighted and minimum-variance index strategies.
