Money Market ETFs In Europe

While overall European ETF assets under management (AUM) have stagnated this year as a result of equity market drops, certain areas have continued to grow rapidly. Commodities, for instance, is one such area, driven by the continued bull market in that space. But the fixed-income sector has also grown sharply in terms of AUM, as showcased in the chart below.

Two ETFs top the European fixed-income charts, in terms of both AUM and secondary market trading volume. Interestingly, both of them are short-term money market style funds-Deutsche Bank's db x-trackers Eonia Total Return Index ETF (Milan: XEON.MI), with 3.2 billion euros invested, and the Lyxor ETF Euro Cash EuroMTS Eonia (Paris: CSH.PA), with just under 2.0 billion euros invested.

The Deutsche Bank fund is domiciled in Luxembourg with listings in Germany, France and Italy. The Lyxor fund is domiciled and listed in France, with secondary listings in Germany, Italy and Spain. Both ETFs are offered at a 15 basis points annual fee.

The Eonia Euro money market rate tracked by the funds is calculated as the weighted average of all unsecured overnight lending transactions in the interbank market, compiled from a contributing panel of Eurozone banks.

Deutsche Bank also offers similar funds linked to sterling and U.S. dollar money market rates.

The number of ETF providers in the money market sector has recently increased to three, with the EasyETF launch of its own versions of Eonia and dollar (Fed funds rate) ETFs.

So far, the euro rate trackers have attracted much more interest than the sterling or dollar versions, mainly because they were launched earlier and because of the euro's strength. The increase in competing institutional money market products in the UK for sterling has made it more difficult for the products to grow there as well. In addition, low U.S. interest rates and the weak dollar have reduced demand for dollar cash products.

According to Marco Montanari, head of Fixed Income ETF Structuring at Deutsche Bank, the success of these money market ETFs in Europe is driven by three factors. The first is their transparency-with the overnight deposit indexes accruing interest daily, investors can see clearly how much they are earning. The second factor is the ETFs' relative safety, when compared to a certificate or deposit. And finally, the ETFs are very low cost.

Up to now, said Montanari, most investors in these ETFs have come from the institutional sector and are typically banks, insurance companies and funds of funds. For Deutsche Bank, most investors have come from Germany and Italy, but also from France, Switzerland, Spain and throughout the Eurozone. Montanari added that he thinks retail interest should pick up as well, since these ETFs enable smaller investor to access money market cash rates in the same way as institutions, basically for the first time.

I am good example of this here. On a personal note, my SIPP (self-invested pension plan) in the UK, which holds ETFs, earns interest from the plan provider on any surplus cash holdings at around 1-1.5% below official rates. So this kind of fund offers an obvious way to improve on returns.

There are also some tax advantages for certain European investors when holding money market ETFs. To give two examples, Italian investors pay a 27% tax rate on deposits, but only 12.5% on funds, and so are attracted to the Eonia ETFs. In the UK, where db x-trackers offer a sterling money market ETF, its status as a fund allows an investor to allocate the full ISA (tax-sheltered) allowance of £7,200 per tax year, whereas ISAs investing in cash deposits directly are capped at £3,600 per tax year.

How do the Eonia and other money market ETFs achieve their objective? Through swaps.

Rather than investing directly in the overnight interbank deposit markets, an investor's money is used to buy a portfolio of assets. (In Lyxor's case, this portfolio is specified in the prospectus as equities; in db x-trackers' case, it is simply defined as "transferable securities.") Using these securities as collateral, the fund enters into a total return swap with a market counterparty (presumably the parent bank in each case), delivering to the bank the return on the underlying securities in exchange for an interest cash payment tied to overnight cash rates.

The collateral held must be diversified according to UCITS rules, which specify that no single issuer's securities may exceed 10% of the fund's value, and that the value of securities in issuers which individually constitute more than 5% of the fund may not exceed 40% in total (the "5/10/40 rule"). There are some additional higher limits for EU government-backed securities and covered bonds, but we won't go into those here.

If this seems a bit technical, it is one of the core elements of the UCITS regime, and it gives a clue as to why these money market ETFs have grown so much over the last year. With the intensification of the credit crunch and the rapid loss of faith in the safety of some financial institutions, counterparty risk is at the forefront of investors' concerns. Add to that the discrediting of the agency ratings system over the past few years-which failed to warn investors of the risks in many structured finance securities-and you have a strong market for a search for even safer places to park your cash. The cash ETFs offer inherent diversification and so are seen as a safer bet than direct, unsecured loans to banks in the money markets, let alone structured finance instruments that may have been given an AAA rating a year ago but are now worth far less than face value, and may well be unsellable in any case. While credit market problems continue, demand for these ETFs is likely to increase.

It is worth pointing out that, while counterparty risk is reduced by investing via an ETF, it is not eliminated. The db x-trackers structure takes, in my view, the preferable approach, seeking to minimise the OTC counterparty risk by collateralising the swap daily and/or by resetting the swap if the mark-to-market value becomes too high. The Lyxor ETF has a looser limit-merely capping the swap counterparty exposure at 10%, which in any case would be the limit under UCITS. I haven't been able to confirm how the recently launched EasyETF funds operate in this regard.

Will money market ETFs continue to grow? Clearly their further success will depend on the level of interest rates in each currency zone, both relative to inflation and relative to longer-term bond yields. If the European Central bank were to reverse its current relatively tough stance and cut rates to below the inflation rate-as the Fed has done-many investors would no doubt cash in and leave. Also, there is increasing competition from deposit rates, with some banks paying interest at well above the market rate to attract funds. Here, investors will have to weigh the potential of earning some extra return against the increased counterparty and liquidity risk of deposits, when compared to the ETFs' inbuilt diversification and ease of trading. With bank failures on the increase, money market ETFs look well-positioned.

Paul Amery is the European correspondent for IndexUniverse.com. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .