A need for greater flexibility given market uncertainty, increased volatility and intensifying regulatory scrutiny is creating demand for ETFs from European investors.
Assets in European Union-domiciled ETFs grew to €741 billion ($842 billion) as of June 30, according to a European Securities and Markets Authority Sept. 11 report, up 14% from €649 billion a year ago, and increasing from €568 billion in 2017 and €441 billion in 2016.
Institutional inflows into European ETFs, including Norway and Switzerland, were $69 billion for the first nine months, compared with $45 billion in the nine months ended Sept. 30, 2018, and $85 billion in the nine months through Sept. 30, 2017, according to Bloomberg Finance LP data as of Sept. 30.
Boosted by dramatically falling costs, ETFs are helping investors respond to bouts of volatility by giving prompt liquid access to markets, sources said.
"ETFs have never played as big of a role in pension funds' portfolios as they do now. These investors in the past would have used futures to quickly gain exposure to equity or if they wanted to tilt allocation," said Thomas Merz, Zurich-based member of the executive board and head of distribution Europe at Vanguard Group Inc., in a telephone interview.
Mr. Merz said in the last five years European pension funds have become a larger share of the pool of ETF investors, which previously was dominated by wholesale investors such as private banks or wealth managers. "Futures have been less attractive because of low-yield environment, as they suffer from a negative cash drag due to the funding requirement for the margin account," he added.
There is growing pressure by pension funds for lower fees as well as increasing scrutiny to disclose transaction and management costs under Markets in Financial Instruments Directive II. ETF providers' fees are becoming much more digestible, falling to as low as single-digit basis points from between 40 to 50 basis points eight years ago, sources said, citing on average 12 basis points in fees.
In Europe, where well over half of the flows to ETFs are attributed to institutional investors, sources said, French and Scandinavian pension funds particularly are embracing ETFs thanks to a simplified access to the ETF market through European Benchmarks Regulation effective in January 2018. That regulation enables sellers of ETFs, indexes and underlying funds' managers to distribute across the continent. Under the undertakings for collective investment in trans-ferable securities directive, known as UCITS, framework, pension funds can tap ETF listings on all European exchanges when underlying funds are domiciled in at least one European country.
Sources also said the usage of ETFs in European portfolios is currently going beyond typical areas such as emerging and frontier markets, which investors would have bought ETFs for in the past. With MiFID II also effective in January 2018, investors' focus on cost transparency has worked to the advantage of ETFs, as ETFs help to enhance the visibility of costs.
Some investors are asking managers creating ETFs and index providers for custom ETFs due to the European Union's requirements to disclose investment portfolios' contribution to a carbon-free, sustainable economy. These requirements are prompting investors to search for flexible tools to implement environmental, social and governance policies and scan their portfolios for companies outside of the scope of their ESG policies.
The €46.5 billion Varma Mutual Pension Insurance Co., Helsinki, has recently seeded an ETF with a sustainable focus with €200 million through a collaboration with index provider Foxberry Ltd. and Legal and General Investment Management.
Timo Sallinen, senior vice president, investments at Varma, said the ETF will allow the Finnish company to exclude tobacco, controversial weapons, companies with high carbon emissions or large fossil-fuel reserves. Companies that have breached international agreements are also excluded, he said.
Among reasons for customization, Mr. Sallinen cited a lack of variety for ETFs aimed at meeting sustainability objectives.
ETFs constitute about 40% of Varma's €15 billion total listed equity exposure, Mr. Sallinen said.
Adam Laird, head of ETF strategy, Northern Europe at Lyxor ETF in London, said: "ETFs are helping investors with areas, which (simple) passive doesn't do very well such as income generation or low-risk or riskier niches at a lower cost."
Antoine Lesne, head of SPDR ETF strategy and research for Europe, the Middle East and Africa at State Street Global Advisors in Brussels, said ETFs are also increasingly used by investors for core allocations to get a prompt liquid exposure to a new asset class or specific investment opportunity instead of running a manager search.
When it is difficult for investors to manage an allocation, they can buy ETFs if the spread is suddenly tightening or if it is difficult to get a specific bloc of shares, he said.
ETFs can accommodate smaller allocations, whereas managers may want to receive at least $100 million to run a segregated mandate, said
Deborah Fuhr, managing director of research and consultancy firm ETFGI LLP in London. "Depending on the time horizon, it may not make sense for investors to start a segregated account," she said.
