Even Ciaran Fitzpatrick, head of ETF servicing Europe at State Street, is surprised to see phenomenally strong growth in true active ETFs this year. The latest generation of ETF products, also dubbed ‘ETF 3.0’, is rapidly making its way into portfolios of both institutional and retail investors. The US is leading but Europe is not far behind.
Speaking to Investment Officer for this IO Talks podcast, Fitzpatrick observed that while the true active ETFs have been around since 2008, the real growth is happening now. “Over 63 percent of flows in the US last month were into active ETFs, which I don’t think anyone expected. This is just huge, you know.”
Europe is following the US in the active space, Fitzpatrick said, but at this side of the Atlantic, it is still a small component of the overall ETF market. “You’re talking probably shy of 30 billion euro in true active ETF assets across Europe, whereas the overall market is about 1.6 trillion, which is, you know, very significant. The growth has not been as quick as in the US, but Europe is seen to be - I wouldn’t say behind the US - but obviously advancing at a different speed.”
Innovating investments
Since the 1990s, ETFs have taken on increasing importance for investors looking at a relatively easy way to invest in an index and turned out as an important innovation in the investment industry. The first generation of ETFs - seen as passive, broad-based structures - reflected indices, with the US S&P 500 index seen as a highly popular index in which one can invest via ETFs. The second generation of ETF products added themes and narrower strategies, but would not be true active structures. In ETF3.0 products, active management is introduced, allowing managers to direct specific holdings in the fund.
In the US ETF market, dominated by the likes of Blackrock, Vanguard and State Street Global Advisors, active assets represent about 5 percent while accounting for 25 percent of net inflows. “Europe pivots the same as the US does into different types of structures,” Fitzpatrick said.
Boston-headquartered State Street both markets its own ETF products under State Street Global Advisors’ SPDR label and also offers support services to asset managers looking to create their own ETFs. From Dublin, Fitzpatrick heads that service for the European market. Ireland accounts for about two thirds of ETF assets in Europe, accounting - as per June - for a trillion euro of the 1.6 trillion European market. State Street services about 81 percent of the Irish-domiciled ETF market, he said.
Not from new money
Fitzpatrick said the current growth in ETF assets is not coming completely from new money. It’s coming from a mixture of flows, from traditional products and also from investors on the retail side.
“Europe is typically an institutional market and I believe that will continue to be so,” he said. “Probably 70, 75 percent is institutional investment in European ETFs, with the remainder being retail. But more importantly, where is the growth going to be?”
State Street foresees considerable growth in the active ETF market, referring to a potential of 25 to 30 billion euro in assets in active. “That presents a huge opportunity for the market.”
For traditional mutual fund managers who have been reluctant to challenge market leaders like Blackrock, Vanguard or SPDR, active ETFs present an opportunity to turn their active mutual fund strategy into an ETF strategy. Firms like abrdn, AXA and JP Morgan have launched their own ETF strategies this year.
Costs are a significant factor in their considerations. “Total costs of ownership is a large focus for any investor. If they can get a product in an ETF cheaper than they would in a traditional mutual fund, then that’s where they are going to go. And that is where the flow out of your traditional mutual funds into ETFs is taking place.”
Swapping Luxembourg for Ireland
In Luxembourg, Europe’s second-largest ETF hub after Ireland, that move has become visible. Heavy-weight asset managers such as Amundi for example have converted and moved Luxembourg-based mutual funds into ETFs and moved them to Ireland, considered particularly attractive for funds with US equity exposure. Under the Irish-US tax treaty, dividends from US companies are taxed only at 15% in Ireland, compared to 30% in Luxembourg.
But even without that particular Irish tax benefit, such conversions from mutual funds to ETFs are considered attractive. Fitzpatrick sees a lot of US mutual funds converting to ETFs. That brings them a different tax benefit, given that an ETF can benefits from a capital gains tax exemption. “The in-kind mechanism gets used and that’s huge beneficial.”
Europe does not have an equivalent of such a capital gains tax benefit. “But the product is where money is flowing into,” Fitzpatrick said. “If you look globally, out of the top 50 global asset managers, 34 of them have an ETF strategy. Another handful are acting as investment managers for ETFs. It’s not an if, it’s a when will I have an ETF strategy. The global asset managers have to make a decision about how to get into it.”
‘Hugely significant’ cost benefits
In terms of cost benefits, Fitzpatrick believes that ETFs can save investors 20 to 30 basis points when compared to mutual funds. “Those 20, 30, 40 basis points are hugely significant, both for the ” he said. Every point matters, he said, also referring to the impact of the US-Irish tax treaty on the European ETF market.
Amundi’s recent conversion of Luxembourg-domiciled ETFs to Icav’s in Ireland is set to be followed also by others, such as BNP Paribas, Fitzpatrick said. “Anything with a US equity exposure is going to be domiciled in Ireland,” he said. “Every manager we talk to who might have a Luxembourg range over the past four, five years is like, well, ‘Can I use my existing management company and structure in Luxembourg? Why would I move to Ireland?’. From a State Street perspective, we’re agnostic, but from a product perspective, you have to look at where the best performance is going to come from.”