Despite the name, exchange traded funds (ETFs) are largely traded off-exchange in Europe among big institutions. Although this might seem like a harmless paradox, most over-the-counter (OTC) trades are not reported.
As a result, investors cannot easily gain an accurate idea of secondary market liquidity and pricing, ultimately hindering the industry’s growth on the continent.
As it stands, ETF trades on-exchange are reported, much like shares, so investors can see trading volumes and pricing. However, European Union regulations do not require OTC trades to be reported, although a couple of venues, such as the London Stock Exchange, do reveal them.
On the surface, it might not seem problematic that these trades go unreported but the OTC market accounts for about two-thirds of ETF trading in Europe. Consequently, a significant amount of ETF trading goes unrecognised, especially by smaller investors who are unaware of this process. Such a lack of transparency also means it is tough to find out how much buying and selling is taking place, and hard to get an idea of the aggregate trading price.
Day of the Mifid
However, regulatory developments are in the pipeline that could change the reporting of ETF trading in Europe. The second instalment of the Markets in Financial Instruments Directive (Mifid), expected in 2015, will potentially include the requirement that OTC trades are reported, and will introduce a consolidated tape – an electronic program providing real-time data on volume and prices for exchange-traded securities.
‘Consolidated tape and reporting of all trades is beneficial because it gives better transparency on what is happening,’ says Deborah Fuhr, a partner at ETFGI. ‘It gives retail investors comfort as they can see what’s on-exchange. If they can’t see trades being reported, they will feel uncomfortable.’
Indeed, consolidated tape would help overcome the issue of liquidity fragmentation in Europe, whereby ETFs are listed and cross-listed on a range of more than 20 exchanges. Having one ETF listed on multiple venues means it is tough for the end-investor to work out the total trading volume, as they have to add it all up across exchanges.
A consolidated tape would aggregate trading data for all on and off-exchange trading of ETFs, which would help investors identify the best prices in terms of the tightest bid/offer spreads and the greatest liquidity in the secondary market.
‘Having a consolidated tape is important as ETFs are listed across so many exchanges. It’s fragmented, so you only see only a snapshot on one exchange,’ says Fuhr. ‘However, there is still a lot of uncertainty as to how consolidated tape would work. Who would run it and what fee would they charge?’
Earlier in the year, BlackRock partnered with Bloomberg to offer a consolidated tape, albeit only for iShares ETFs, allowing investors to see the best bid and offer prices and liquidity. The partnership means iShares can use Bloomberg’s European tickers, which aggregate volume and trading data for reported iShares ETFs across European exchanges.
Consequently, there are a smaller range of tickers – about 500 instead of 1,400 – from which investors can see trading information in each currency. In the past, for example, investors would have to look at the iShares S&P 500 in every different currency across every venue to determine the total trading volume.
However, although this consolidated view will be beneficial, it only applies to iShares ETFs and does not take into account OTC trades. As Fuhr says, having these OTC trades reported is essential, especially as the market is moving more towards retail investors.
‘It’s a big deal, because people are afraid to ask questions if they feel they should know the answers. They are afraid to ask what is liquidity and when they see low, on-exchange volumes it puts them off,’ adds Fuhr. ‘It’s a stumbling block now for greater usage.’
Furthermore, having greater visibility of trading will boost competition among ETF issuers as they will fight to offer the tightest spreads, ultimately benefiting the end-investor. As industry proponents say, liquidity begets liquidity, so the more ETFs are seen to be traded, the more investors will want to trade them.
There are also other measures coming through to improve trading. Tradeweb, for example, has just launched a multi-dealer platform for trading ETFs listed in Europe. The platform is designed to accommodate bigger OTC trades with competitive pricing.
It provides investors with access to a consolidated pool of liquidity for the entire range of European-listed ETFs, while a number of market-makers compete to get the best price. At present, there are 11 dealers providing liquidity to the marketplace.
Enrico Bruni, head of European markets at Tradeweb, says: ‘Proving best execution is increasingly important for our institutional client base and we expect this requirement will continue to be a focus in upcoming Mifid II regulations. Electronic trading helps asset managers meet best-execution requirements.’
In Europe, the majority of ETF investors are still institutional, which is why the OTC market is so big. ‘When you want a significant size of ETFs, instead of going on-exchange you go via a market-maker over the counter,’ says Alain Dubois, chairman of Lyxor Asset Management.
‘It’s important we have transparency on this process because the figures we get on exchange don’t show the OTC figures. Transparency in general is a good thing; liquidity is very important – the size and depth of the market, and the bid/offer spread.’
He adds that bid/offer spreads are significant costs and could end up being greater than the annual charge, especially for investors who sell after only a few months.
Another factor that will enhance trading and liquidity in Europe is the move to ban commission or inducements to advisers.
In a paper entitled Restoring investors’ trust in Europe’s markets, chairman of the European Securities and Markets Authority Steven Maijoor says: ‘Getting the incentives right for providing good advice to clients is in all our interests. I therefore hope the European Union will follow the example of some member states, including the UK, and move to ban inducements.’
Maijoor also says he fully supports the ban on inducements in certain situations as included in the proposal by the commission for Mifid. ‘At a minimum we need to ban inducements in the case of discretionary portfolio management and when an adviser wants to use the independent label,’ he says.
ETF proponents agree a Europe-wide ban of inducements would boost the industry, as these products, which have not paid commission, have typically been ignored in such instances.
Fuhr says: ‘This will also help liquidity because they [advisers] will be able to embrace ETFs more.’ This will especially be the case as advisers find it tougher to find actively managed funds that can actually deliver alpha and justify their higher fees.’
However, as Fuhr notes, ETF liquidity does not just boil down to how much these products are traded on the secondary market. ‘ETFs are as liquid at the underlying,’ she says, arguing it is the liquidity of the basket of constituent stocks investors really need to look at.
Indeed, an ETF has two main sources of liquidity, based on the stocks underlying the fund and what it is trading at. Liquidity can be affected by market conditions, such as if the underlying market is closed or at times of investor uncertainty.
For example, ETFs on the US market are pretty liquid, versus a product on Vietnam. There is an established futures market covering the US, so it is easier to gauge where the markets will be and price from this. Conversely, emerging markets do not have such a developed futures market, meaning it is more a case of taking a view, which could lead to these ETFs having wider spreads.
Dubois at Lyxor says: ‘We make sure we have a strong secondary market; we don’t do marginal indexations where secondary market trading is not good.’
Indeed, there are some underlying asset classes where investors may have concerns as to the level of liquidity. Corporate bonds funds, for example, have come under the FSA’s scrutiny in the UK, with the watchdog questioning how managers can meet redemptions.
Although the ETF market is small compared with the broader European Ucits fund industry, there are new types of products coming to market that help address some of these concerns. Deutsche Bank, for example, recently launched a liquidity-focused corporate bond fund, which tracks an index comprising bonds that have been screened for liquidity.
To form part of the index, the bonds must have a remaining time to maturity of at least two years and a minimum outstanding of £400 million. By focusing on liquidity, the ETF can more efficiently track the index based on liquid components.
Manooj Mistry, head of db X-trackers for the UK, says: ‘There has been a strong demand for corporate debt exposure this year, so having this liquid, low-cost access tool will be useful for investors. This is a big advantage over traditional corporate bond ETFs, where the investor has to accept tracking difference risk, which can be substantial because of the potentially illiquid nature of the underlying.’
As well as monitoring the liquidity of the underlying, investors should look at the trading volumes of the ETF, while taking into account that the number is only a snapshot of the true amount traded. With Mifid II on the horizon and the RDR imminent in the UK, the amount of trades is set to increase, spurring liquidity as more investors pile in to buy these low-cost, efficient and transparent products.