Mifid 2 should accelerate adoption of exchange-traded funds (ETFs) in Europe - a market that already grew by over 40% last year, and will finally create a transparent record of ETF trading activity in an industry, which despite the 'E' in its name, has seen the majority of trading occur in private bilateral over-the-counter markets, obscuring the full extent of market activity around these popular products, according to Hector McNeil (pictured), founder & partner at independent 'white label' Ucits ETF platform HANetf.
Prior to Mifid 2 there was no requirement to report ETF trades, meaning that investors could only view the tip of the trading iceberg relative to the real level of underlying activity. Now all ETF trades will need to be reported, meaning investors will be finally be able to gain a clear picture of the depth and breadth of ETF trading activity across all European trading venues, according to McNeil.
'This is important because liquidity begets liquidity,' said McNeil. 'In this case, the comparative lack of transparency deterred some investors from participating in European ETF markets on the scale they otherwise would. They could not see activity of peers and competitors reflected on screen and deprived of an aggregated view of trading activity, European investors perceived a far less vibrant, far smaller, less energized market than exists in reality. Unimpressed with the view, they have frequently looked across the Atlantic for the liquidity they could not easily see in Europe.'
According to McNeil, greater certainty about the depth of European trading will mean that European investors will have less incentive to look abroad for the trading efficiency and liquidity they value and will start to repatriate liquidity back to domestic markets. 'Add this to the convenience of local trading hours and European-listed Ucits ETFs should stack up well versus their US cousins which don't start trading until the European afternoon,' stated McNeil.
Volume transparency will also uncover the diversity of participants in the European ETF market, drive down costs and create more choice for the end investor.
'ETFs are often described as a 'democratic' investment, as all investors from individuals to institutions can gain the same exposures through the same ETFs with the same availability of information and pricing, with market makers and brokers competing for their business along the way,' said McNeil, noting that better knowledge of daily trading activity in European markets will further support the idea that ETFs offer a transparent, level playing field accessible to all types of investors. 'In turn, this should propel yet more participation in the markets. To compete for this new business, exchanges and other trading venues will need to provide investors with greater optionality around execution and reduce the costs of trading, further reducing the attritional impact of fees on portfolios.'
New Tools
According to McNeil, bringing Europe up to speed with US levels of market transparency should promote greater confidence and begin a new phase of asset growth, but it can also catalyze greater use of ETFs in lending programs - a common practice in the US that benefits the holders of ETFs in the form of additional fees.
'As ETFs become more accepted in securities lending, there will be greater incentives for institutions to hold ETFs over other structures and greater availability of shorting and hedging inventory means that new risk management and hedging choices will be made available,' stated McNeil. 'Growing competition, more trading activity and more participation should create efficiencies that continue to ensure ETFs remain a compelling investment proposition. One of the greatest, most revolutionary qualities of ETFs is the way they have forced down the cost of creating a diverse portfolio to extremely low levels. Now the average investor can quickly and easily buy exposure to thousands of bonds and equities for just a few basis points and include asset classes and investment strategies that would have been out of reach only a few years ago.'
The focus on fee disclosure in Mifid 2 will make it much easier for investors to understand and compare the overall cost of the various funds that provide exposure to core holdings like FTSE 100, MSCI Emerging or S&P 500 on an apples-to-apples basis. From there investors can judge the most cost-effective means for them to obtain the exposure they want. Why buy an apple for £1 when you can buy one from the next stall for 10p?, according to McNeil.
'European ETFs now provide a huge range of low-cost core building blocks, thematic twists and active strategies for use in portfolio construction and are superbly positioned to be big winners in an age where value-for-money is under the spotlight and comparisons between investment products are much easier,' said McNeil
With strong regulatory tailwinds in the sails of ETFs, it's reasonable to think the European industry can comfortably exceed US$1tr of assets this year. As ETFs continue to take more market share from traditional funds, asset managers can take advantage of the continued focus on ETFs by developing their own range, increasing distribution of their best and most popular ideas in a wrapper that's well-positioned to address investor needs in the new regulatory climate, according to McNeil.
Related stories: