Still The Mainstay

The latest edition of Deutsche Bank's European ETF Liquidity Trends publication shows that country equity ETFs represent three of the top four most actively traded funds across the region (these are, in order, the iShares DAX (DE), the iShares FTSE 100 and the Lyxor ETF CAC 40). Country equity ETFs (including those tracking non-European indices) also make up six of the top 10 funds by assets under management (see the table below, where country ETFs are shown in bold).

According to Nizam Hamid, head of sales strategy at iShares in London, country equity ETFs should remain a dominant part of the ETF market in Europe. A few years ago, said Hamid, there had been a general expectation that investors might switch to ETFs selecting companies from across the single currency zone, for example by sector or size criteria, but investor flows in futures and ETFs show that this hasn't yet happened.

In Hamid's view, there is still a very strong country bias amongst European investors when it comes to the trading vehicles and investment exposure that people wish to acquire, with the UK investor a particular example of this, since there is also the question of taking on currency exposure when investments are made in the non-domestic market. But, in continental Europe also, there is a strong residual demand for ETFs linked to home country benchmarks, such as the DAX, CAC 40, S&P/MIB, IBEX, AEX, said Hamid.

Manooj Mistry, head of db x-trackers' UK operation, reinforced this view, explaining that his firm's clients still tend to construct portfolios using country equity ETFs as building blocks. Other types of equity ETFs, such as sector-based funds, are often used as "satellite" products, complementing investors' country holdings.

Claus Hein, executive director at ETF issuer Lyxor, added that his firm had seen significant inflows into the large, blue-chip country equity funds at the beginning of this year, suggesting that fundamental investor demand for these products remains strong. Hein also attributed the increase in ETF purchases to the realisation by many investors that it's difficult to beat these benchmarks through active management, and that going to broad, passively-managed country funds is the obvious next step.

Hamid of iShares added that the bias that European investors have towards maintaining the core of their equity portfolio in the benchmark domestic index is not confined to the retail end of the market; institutional investors follow the same pattern.

It's worth mentioning, also, that the popularity of home country benchmark equity ETFs has enabled certain issuers to establish comfortable niches for themselves in some of Europe's smaller markets: for example, XACT, DNB and Seligson in the Nordic countries, and Alpha Bank's asset management arm in Greece.

In the table below, we give the key characteristics of the major European equity index benchmarks - the number of constituents, any maximum weighting for individual stocks, the index base level and date, any minimum free float requirement, and whether the index is based on price or total return (that is, with dividends reinvested). All of these indices are tracked by European-listed ETFs.

All these indices use a modified market capitalisation-weighting methodology as the basis for their construction. In other words, stocks are weighted according to their market value, but subject to certain adjustments. The typical modifications to "pure" capitalisation-weighting are a cap on single stock weightings, and a minimum free float percentage. These can vary quite considerably.

Does this matter for investors? Yes, as the rules can lead to some indices being much more diversified than others. This can have quite dramatic real-life consequences for their performance, as recent months have reminded us.

From the point of view of the number of constituents, the FTSE 100 has the broadest spread, with 100 stocks, although, significantly, there is no cap on any individual company's weighting. The effects that a bubble can have on index weightings was shown in 2000, when telecoms company Vodafone hit a 13% index share, massively outweighing the other 99 companies in the benchmark.

FTSE responded to demand from some investors for less concentrated versions of its equity indices by bringing in capped versions of the FTSE 100 and FTSE All Share in 2005, although these have yet to gain traction amongst investors.

Looking at the number of constituents and the maximum single stock weightings in conjunction, in theory the DAX and the BEL 20 are the most diversified, since they combine a relatively small number of constituents with a relatively low maximum individual stock weighting.

However, the events of last October, when a record-breaking short squeeze in Volkswagen shares sent the company's weighting in the DAX to around 30%, and caused an emergency revision of the index (we covered this story on www.indexuniverse.eu/ at the time) show that it is important to check the minimum free float percentage as well.

The DAX index rules had traditionally allowed the inclusion of stocks with a relatively small free float of 5%, but this was raised to 10% in November last year, a month after the Volkswagen squeeze occurred. Even so, the DAX permits a smaller minimum free float for its index constituents than the other European indices in the table, perhaps reflecting the predominance of family and other non-traded share holdings on German companies' registers.

Another unusual feature of the DAX is that it is calculated on a total return basis (including the reinvestment of dividends). With the exception of Norway's OBX index, which follows a similar methodology, all the other equity indices in the table are price indices only. This, incidentally, means that ETFs tracking the DAX have to be domiciled in Germany (if the ETFs are using a physical replication methodology) in order to avoid withholding taxes, which would otherwise prevent them from tracking the index.

Moving to the other end of the diversification scale, the main Swiss equity benchmark, the SMI, has a very significant concentration in its largest stocks. According to the latest index factsheet from the Swiss exchange's website, three companies - Novartis, Roche and Nestle - jointly represent over 60% of the SMI. The Norwegian OBX index also has a heavy bias towards a few large stocks, with energy giant Statoil's weighting exceeding 30%.

Despite the recent rise in popularity of ETFs tracking equity sectors, country funds are still the mainstay of many investors' portfolios, whether retail or institutional. According to the ETF market participants we surveyed, this situation looks as though it will continue. But there's a surprising variety of index construction methods across Europe, which can lead to some benchmarks being more diversified than others. So, if you're going to build an equity portfolio using country ETFs, it's worthwhile knowing about free floats and maximum stock weightings!