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The growth of exchange-traded funds in Europe over the past 10 years has been remarkable. However, with ETF assets under management worldwide recently surpassing the $1 trillion milestone, a question comes to mind about the ETF industry—particularly if we consider the global economic upheaval of the past 18 months. What’s next?
What are the arguments indicating further dynamic growth and, perhaps even more importantly, what conditions need to be met for this growth to materialize?
It may surprise some to hear a view expressed that, despite the significant growth of the past two years or so in the European exchange-traded product market, the real breakthrough in Europe is only now about to happen.
Clearly it would be an oversimplification to point toward a single driver as being capable of changing the market, yet it cannot pass unnoticed that there is a general consensus forming about this year being one of trading in ETFs.1
What is fueling this popular belief?
A False View Of Liquidity
One does not need to be a skeptic to observe that there is an end to all things, and it is no small wonder that there might be some people who think a 56.8 percent rise in assets under management in European ETFs in 2009 could be difficult to replicate in 2010 and coming years.2
One cannot deny that at least part of this impressive growth came as a result of unique market circumstances. Investor concerns about counterparty risk, compounded by plunging financial markets, moved investor interest into financial products such as ETFs, while the subsequent rally of late 2009 helped to achieve the strong asset growth figures witnessed by European ETF providers.
Still, with 215 new ETFs launched in 2009, it is clear there remains considerable room for growth in the ETF market into 2010 and beyond. Indeed, there are no reasons to assume that the European market is fundamentally different from the U.S. one, where ETFs are responsible for roughly one-third of the total activity in the equity market and where 17 years after the inception of the first ETF, assets have surpassed $700 billion, with more than $50 billion changing hands every day.3
This last figure about ETF turnover might actually hold the key to explaining where growth will come from, and points clearly to where the main difference lies between the U.S. and European markets.4 It is the deficit of liquidity, or to be more precise, the deficit of visible liquidity, that has impacted the development of ETF markets in Europe. Even in the eyes of those who have always understood the primary market creation/redemption mechanism for ETFs, this apparent deficit of liquidity has led to the misconception that ETFs are investment vehicles accessible only to institutional clients who are able to trade over-the-counter (OTC) with specialized ETF brokers.
A lot can be said about the origins of this preconception. The fact that OTC transactions have been excluded from the scope of the MiFID (Markets in Financial Instruments) directive has done the market no favors, as it has pushed the bulk of activity in ETFs into a gray zone of unreported trading. Similarly, the multitude of exchanges and trading venues alongside currency cross-listings means that the visible pool of liquidity is further fragmented and can be confusing. All in all, the final impression is that of a market with erratic activity levels and high trading costs.
This is not a fair reflection of the market. On the contrary, when looking at market structure and trends over the last two years, it is clear that there are increasing signs indicating the time is approaching for the big trading bang to happen.
One obvious indicator is the continuing growth of trading volumes. Although the 0.9 percent increase in on-exchange trading activity might not seem particularly impressive, when we include all the OTC flows that are “printed back” onto trade reporting facilities, a truer picture emerges.
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