Source's launch of 13 new funds last week marked the arrival of a major new issuer in the European exchange-traded products market.

The launch of an ETF "platform", with backing from several financial institutions, was a topic that we covered in a recent feature. But Source's pricing policy went against the grain of recent competitor launches, which have been characterised by falling fund fees. Is this a sign that a long-standing trend towards cheaper management charges is about to change? And what should one make of the issuer's decision to list funds on a single European exchange, the Deutsche Boerse, rather than cross-listing its ETFs in different European countries?

In a recent blog, we highlighted some recent research from Debbie Fuhr's team at Barclays Global Investors, which showed that European ETF average fee levels had converged with those in the US, at 31 basis points per annum.

There are still some differences between the two markets-to give two examples, Europe still cannot match the ultra-low fees on offer from US large-cap equity ETFs, which average 12 basis points, while the more institutional investor base in Europe means that there is no real equivalent to the multi-billion US leveraged and inverse leveraged funds sector, which is popular with retail investors, and where the typical fee is 95 basis points.

The downward pressure on European ETF fee levels has been helped by competitive pressures, which are driven, in turn, by the arrival of new issuers. Prior to Source's debut, there were three major launches in the European exchange-traded products market over the last year-by ETFlab, CASAM and Comstage. When promoting new ETFs tracking commonly-used indices, each of these firms has generally undercut the prevailing fee levels in order to attract business. This policy was explicitly stated in recent interviews with Index Universe by Valerie Baudson of CASAM and Ralph Stemper of Comstage, available here and here.

The three firms' ETF ranges have met with modest success so far, if assets raised are used as a measure. According to the latest edition of the Deutsche Bank ETF Liquidity Trends publication, ETFlab, CASAM and Comstage currently have funds under management of €1.4, €1.5 and €1.9 billion, respectively, representing 1.2%, 1.3% and 1.6% of overall European ETF assets. Both CASAM and Comstage have stated targets for future funds under management: €10 billion in assets by 2011 for the French issuer, a top three position for the Commerzbank subsidiary. Fund fee levels have clearly been set as a means to achieve these objectives.

The 13 Source equity ETFs launched last week are conspicuous for failing to continue the trend of declining fees. With the exception of the Source DJ Stoxx 600 ETF, which is cheaper by one basis point than the comparable db x-trackers ETF, all the Source funds have fees that either match or exceed the cheapest equivalent European fund, as is shown in the table below.

Index Universe asked MJ Lytle, director of marketing at Source, to comment on his firm's ETF pricing policy, and to explain why fees were in some cases set at a premium to those on competing funds.

Lytle explained that Source has decided to match the fees of the lowest-priced, most relevant fund, but didn't want to chase the lower fees being set by some competing firms. In other words, Lytle said, the size of a competitor's fund was more relevant than the absolute level of fees quoted when Source decided how to set its own expense ratios.

When asked how Source intends to gain assets if fees are set only to match those of existing benchmark ETFs, Lytle said that Source views the undeveloped part of the European fund management industry as a much more important opportunity than gaining market share from competitors. In the US, he added, ETFs represent 4.6% of the total fund management sector, whereas in Europe the €120 billion invested in ETFs represents less than 1.5% of the total €9 trillion or so in the funds sector. The ETF "penetration gap" in Europe is therefore over €200 billion, suggesting that there's a lot more to gain from sharing in the overall market expansion than in engaging in a market share grab, argued Lytle.

Source's analyses of the US ETF market's growth rate show that an inflection point occurred around eight or nine years after the first fund was launched in 1993, said Lytle, with a shift to a higher rate of expansion from then on. European ETFs are at a similar point in their development, he added. Source acknowledges that there are differences between the US and European ETF markets, notably regarding the involvement of retail investors, who control more than 50% of invested assets in the US, and less than 10% in Europe, according to recent estimates. 

Also, the greater historical activity of high-volume traders like hedge funds in the US ETF market is reflected in greater turnover figures there—Source calculates that 17% of US ETF assets under management are turned over daily, compared to only 2% in Europe.

Source therefore argues that closing the trading "liquidity gap" will be critical in ensuring that European ETF assets continue to grow at a rate comparable to that witnessed in the US. If ETFs are a trading vehicle, said Lytle, then it becomes very important how large the secondary market bid-offer spread is, and if this is in the region of 30 or 40 basis points, then it will represent the major part of an active investor's costs, with the management fee becoming a secondary consideration. Source maintains that its decision to list its ETFs on one European exchange only—the Deutsche Boerse XETRA platform—will help to concentrate trading liquidity and reduce bid-offer spreads.

Commenting on Source's pricing policy, Nizam Hamid of iShares agreed that investors typically focus on an all-in cost of ownership when assessing an ETF, including issues such as secondary market liquidity, rather than making a decision to invest purely on the basis of the headline fee. Hamid noted that Source's decision to list its funds only in Germany was a sign of the firm's intention to target a largely institutional client base, something that is reflected in the new issuer's website, which only recognises readers who log in as institutional investors, he added.

iShares still believes, though, said Hamid, that cross-listing has its purpose, since many investors value the flexibility of being able to trade ETFs on any one of the three major European exchanges—the Deutsche Boerse, Euronext and the LSE. The German exchange's insistence on euros as the trading currency for its funds may cause some investors to shy away from funds whose "natural" denomination is in another currency-the FTSE 100 ETF, for example—and to seek listings elsewhere, said Hamid. 

Another London-based ETF issuer said that Source's backing by three major securities houses, with their multitude of distribution channels, should ensure that the firm gets off to a successful start. Having said that, the competitor argued, the premise behind the open architecture platform that Source is seeking to establish—that it will reduce the current European market fragmentation and become a single "source" of liquidity for certain funds—was somewhat contradicted by the firm's initial launch programme, which featured 13 already-existing trackers. It would have been more consistent with the firm's stated objectives, had Source chosen to try and establish its own benchmarks, this commentator suggested. 

A third European ETF expert took issue with Source's argument that it can achieve a step-change improvement in European ETF secondary market liquidity by concentrating its listings in Germany: "If listing on a single exchange were Nirvana, then all of us - iShares, Lyxor, db x-trackers and the others - must have missed it, and we've all been paying unnecessary costs for extra listings, legal structures, global prospectuses ... we've been fooled for years!" In this competitor's opinion, Source's decision was simply motivated by considerations of cost and concerns over the time it might take to launch if multiple listings were required. With retail investor involvement in ETFs the next big growth story in Europe, this commentator argued, Source is shutting off potential asset flows by failing to cross-list its funds.

In summary, Source's decision to abstain from the recent trend towards ETF management fee discounting may well mark a turning point in the long-standing trend towards lower headline expense ratios. At the same time, the firm's aim of refocussing investors' attention on all-in costs, including those resulting from the secondary market, has set up an intriguing debate over the ideal mechanism of listing and trading ETFs in Europe. With opinions on the best way to operate an ETF issuance programme still highly divergent, there are big prizes to be won for the fund providers that get it right.

This article previously appeared on www.IndexUniverse.eu.