We start this week with a table from the recent Deutsche Bank research report* on European and U.S. fixed-income ETF liquidity trends, showing the top 15 European fixed-income ETFs by assets under management.

Figure 1. Top 15 European Fixed-Income ETFs By AUM

One of the first things to note about the European fixed-income ETF sector is that proportionately it is a larger part of the overall ETF market than is the case for the U.S. In my first feature for IndexUniverse.com, I noted that fixed-income ETFs represent 16% of the overall ETF market in Europe, compared with 6% in the U.S. This reflects a long-standing bias towards a higher fixed-income weighting in the portfolios of (continental) European investors, whereas investors in the Anglo-Saxon countries have tended to favor equities. Other factors may also play a role-more on this below, in the discussion on money market ETFs.

The authors of the Deutsche Bank report, Nizam Hamid and Yvonne Sandford, also point out that European fixed-income ETF turnover, at around euros 300 million a day, is not far short of U.S. fixed-income ETF turnover, which they estimate at around euros 470 million a day. On the asset front, European fixed-income ETF funds total just under euros 20 billion, not far short of the U.S. total of around euros 27 billion (see Figure 2 below). So, by almost all measures, the European fixed-income ETF market is of an equivalent scale to its U.S. cousin.

What is noticeable in the chart of assets under management growth is an acceleration of asset gathering during the last few months, particularly in Europe. This is great news for the fixed-income product providers and no doubt reflects some flight to safety from equities during the recent sell-off. ETF design has long been focused on the equity markets, and it is encouraging to see the move into other asset classes develop apace.

Figure 2. Fixed-Income ETF AUM - Europe And The U.S.

Source: Deutsche Bank. Reuters

Money Markets Take Off

So where have fixed-income ETF assets been focused?

Figure 1 shows that the largest two European fixed-income ETFs track the EONIA money market index, in offerings from db x-trackers and Lyxor. The fifth-largest ETF in the table is also a money market ETF, from BBVA in Spain. In fact, money market funds represent over 25% of all European fixed-income ETF assets, with short-maturity bonds a further 20%.

Figure 3. Fixed-Income ETF AUM By Sector - Europe

Source: Deutsche Bank. Reuters

Figure 3 shows how money market ETFs have gone from a standing start to representing the largest European fixed-income sector in a matter of months. No doubt this has something to do with the fact that there has been a great deal of strain in money markets since last summer, with commercial rates (LIBOR, EURIBOR) trading at levels sharply higher than official rates, and so investors in the money market ETFs have had an easy way of accessing these higher rates. The relative strength of the euro has no doubt also helped to attract funds. Nevertheless this is a remarkable growth rate and has represented a great success for DB, Lyxor and BBVA.

Incidentally, it is noticeable that there are no equivalent funds in the U.S. market, perhaps due to the still-dominant position of other types of money market funds. Some of these, as we know (for example, those linked to auction-rate securities or relying on mortgage-backed securities for extra yield), have run into problems in recent months, and have faced capital losses or even freezes on withdrawals. This is surely an opportunity for U.S. ETF product providers, although the low level of U.S. interest rates (which are now below the inflation rate) may affect demand for the time being.

[The Bear Stearns Current Yield Fund (AMEX: YYY) is the closest thing U.S. investors have to a money market fund, but it is not a true money market portfolio; instead, it has a variable duration that can stretch out to 180 days at the portfolio manager's discretion.]

The other entrants in the top 15 European fixed-income ETF table (Figure 1) represent a broad mixture of bond funds - from ETFs tracking various maturity segments of the Euro MTS indexes, to the iBoxx Euro Sovereigns 3-5 year Index (an inflation-linked fund) and a number of funds in Germany and Switzerland tracking only domestic sovereign issues. Recent months have seen a sharp divergence in bond yields between the less creditworthy Eurozone governments and the better and lowest-yielding Germany, and so specific country versions offer a cleaner way of differentiating between the creditworthiness of issuers.

Does this mean we will see more ETFs tracking the bonds of other countries/sovereigns, particularly from the lower-quality, higher-yielding end of the spectrum?

Assets By Issuer

Figure 4. European Fixed-Income ETF AUM By Issuer

Source: Deutsche Bank. Reuters

The main players in the European fixed-income ETF market are familiar names - BGI has a combined 37% market share and is market leader, though its share is much smaller than its dominant (88%) position in the U.S. fixed-income ETF market. With Lyxor having a 28% share and Deutsche Bank 23%, three companies dominate the market and there is a good level of competition amongst product providers.

As in the overall ETF market, Deutsche Bank's rise up the tables is impressive, considering that it only started operating just over a year ago, and it is worth mentioning an area where it (and EasyETF) have stolen a lead on competitors. The credit markets have been the centre of the action for fixed-income investors over the last year, as spreads have widened significantly from historic lows at the beginning of 2007. db x-trackers' launch of long and short ETFs for the three main components of the iTraxx indexes has enabled retail investors to access the credit derivatives market for the first time, and to express both bullish and bearish views (the EasyETF funds offer long exposure only to two of the iTraxx indexes). The credit ETFs have raised funds quickly, and are well on the way to their first billion euros in total, having started only late last year. No doubt reflecting their relative complexity, they are also higher-margin funds than the traditional fixed-income ETF - DB prices its iTraxx crossover funds at 24 basis points, and EasyETF charges 30 bps, whereas most of the largest European fixed-income ETFs have charges in the 15-20 bps range.

Here again, we see product innovation in Europe when compared with the U.S. market, where there are no equivalent funds (although some are on the market).

While these funds have filled an obvious gap in the market, there are plenty of other areas for product providers to exploit. Domestic currency fixed-income ETFs for emerging market countries are an obvious next step. There are also almost no fixed-income inverse funds, and as we are at relative lows for interest rates historically, it would seem to make sense to add funds for investors to take a bearish view. And what about constant maturity/duration ETFs? Ameristock/Ryan has launched such funds in the U.S., though with only modest success to date, but will someone else have a go at overcoming the "lumpiness" of fixed-income indexes (as bonds shorten in maturity and fall out)?

All in all, the fixed-income market has been an area of dynamic activity for European ETF issuers, and the sector is beginning to grow very quickly. Will it overtake the U.S. fixed-income ETF market in 2008? Watch this space.

*Deutsche Bank, Fixed-income ETF Liquidity Trends, 3 April 2008