A Roaring Trade

The global exchange traded products (ETP) industry is booming. Worldwide demand for exchange traded funds (ETFs) soared in 2010 as more investors, both retail and institutional, learned about the benefits of these versatile financial instruments. Products and assets under management (AUM) grew by 26.6% in 2010, according to BlackRock’s year-end ETF Landscape. The asset manager reports that growth has continued thus far in 2011, with worldwide AUM as of the end of January rising to more than $1.33 trillion with the number of products surpassing 2,500 in January 2011.

With the global ETF industry expected to grow more than 20% annually for the next three years, and AUM for all ETPs expected to surpass $2 trillion by early 2012, Markit sat down with ETF industry leaders at roundtables in Paris in December 2010 and New York in January 2011.

Armins Rusis, Markit’s executive vice president, led the discussion in New York, while Bernie Thurston, managing director of Markit, hosted the Paris roundtable. Both meetings sought to assess the major issues confronting the industry, what was being done to solve the problems and the overall outlook for ETFs globally. The roundtables were notable for bringing together ETF sponsors on the sell-side, their buy-side customers, the investment advisers, as well as the authorized participants (APs), or traders, involved in the creation and redemption process that makes ETFs such a transparent, flexible and cost-effective investment tool.

What’s inside the fund?

One of the major benefits of US ETFs over other portfolio products, such as mutual funds and hedge funds, is
the transparency of the portfolio. This transparency results from the process undergone to create shares of the ETF. Brokers who bring shares to the secondary market, known as APs, need to trade a basket of shares of all the stocks in the portfolio in order to receive shares in the ETF. To facilitate this, the fund must post a full account of its holdings every day after the market closes.

This transparency can be difficult to achieve, particularly in Europe. Fabien Dornier, a partner at Ossiam in Paris, said that because many European ETFs are synthetically replicated, it can be difficult to see what is actually inside these funds. Additionally, in Europe, due to the region’s market structure many securities are traded in the over-the counter
market. Whereas in the US, exchange traded products are typically created from securities openly traded in the secondary markets. This difference in execution could also impact actual fund expenses. However, participants at the European roundtable noted that a fund’s performance would expose suboptimal transaction costs.

The transparency dichotomy is due primarily to a fundamental difference in the European ETF industry’s structure. While most ETF issuers in the U.S. are asset managers, most European issuers are banks. The market is quite different in Europe because the banks and brokers are the fund managers, and the ETFs reflect this. ETFs are products that use many parts of the bank including legal, trading, borrowing, lending and execution.

“The [European banks] have a swap desk that sells a swap to the fund,” said Deborah Fuhr, BlackRock’s global head of ETF research and implementation strategy, at the New York roundtable. “The swap desk can do securities lending, yield enhancement and synthetic shorts based on this inventory backing the swaps for the ETFs. So there’s a large potential revenue stream from this. And for many of them, this income stream was one of the real reasons to get into the ETF industry.”

For the rest of this story go to Markit Magazine.


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