Challenges to growth in Europe

April 01, 2001

"Harmonization...would contribute greatly to this product being more liquid in Europe"

With the growing popularity of global sector funds and the partnership agreements being formed between US and European exchanges, the stage is set for an explosion of exchange-traded funds in Europe. In recent months, the level of innovation in the European ETF market has made many industry observers sit up and take notice. Most notable was the November launch of actively traded equity funds on the Frankfurt-based Deutsche Börse; these funds are managed by the mutual fund management arm of Deutsche Bank, DWS Investment GmbH.

The European ETF market will develop at an accelerated rate to that of the US market, according to Michael Schanz, president of Frankfurt-based Michael Schanz Financial Consulting MSFC AG, who is providing consulting services to S&P. He sees two of the major challenges in the development of the European ETF investor community being the relative lack of liquidity and the need for uniform tax treatment throughout European Economic Community.

Schanz, who prior to his career as an ETF consultant was head of STOXX, takes pains to clarify what he sees as a misperception by the US market that European investors are not equity friendly. "In the last five years, interest from European investors in equity products has changed tremendously. A lot are already very familiar with derivative instruments like guaranteed notes, warrants and index certificates. So it is not a big jump to take to an ETF."

 According to Larry Larkin, senior vice president of exchange-traded funds at the American Stock Exchange, the characteristics that drive the increased growth of ETFs in the US are clearly duplicated in Europe. "Although Europe is not quite as well advanced in terms of trends as the US, we see the seeds, if not the reality, of the exact same things that led to successful ETF activity here in the US," says Larkin.

These characteristics include the low cost of ETFs when compared to existing fund products in the European marketplace. In support of his view, Larkin cites the fact that the expense ratios on most active funds and index funds in Europe are meaningfully higher than those on ETFs. Also, Larkin believes, European investors will be attracted by the ease of access and the availability of intraday pricing that will enable them to know the price at which they transacted and not have to make a trade at the end of the day at an unknown price.

Special tax considerations

While there are similarities between the US and European marketplaces, the issue of the ETF taxation treatment highlights differences between the two regions. Whereas in the US, much has been made of the potential capital gains tax advantages provided by ETFs, this is not as large a factor in Europe where many countries do not have capital gains tax.

But while the tax issue is not a selling point for European investors, it certainly can be a deterrent for fund issuers. The European Community has issued directives that outline a set of standards for national regulators regarding exchange-traded funds. Although at this point it is not incumbent on national regulators to enforce these directives, says Schanz, sponsors are required to adhere to EC directives that address the exporting of ETFs from one country to another. As a result, differing tax rules across the region create a regulatory challenge for fund issuers.


"Harmonization of these tax rules would contribute greatly to this product being more liquid in Europe," says Schanz. "It is a big political question. A lot of people talk about it, a lot of people say it is extremely important, but the EC is a body that is working within certain constraints."

Schanz says that while there will be no relief in the regulatory minefield in the near future, he sees the adoption of a uniform taxation standard for ETFs across Europe as inevitable.

Lacking liquidity

Another challenge to the growth of the ETF market in Europe, according to Schanz, is the relative youth of the market itself and the lack of liquidity that entails.

He expects the path determining the success of the European ETF products will be no different from the rise of the SPDR in the US. Although the SPDR began with institutional money, it was the retail market that raised the product's liquidity to a point where other institutions would consider it as a viable alternative.

"Interest from institutions is really high, but it hasn't really been followed through to a great extent," says Schanz. "Whilst a lot of institutions are waiting for these products for asset allocation purposes, at the end of the day, to create liquidity in these products, you really need the retail interest."

Larkin thinks that gaining the interest of European retail investors looks promising in light of the February announcement that the American Stock Exchange and Euronext intend to cross-list and trade US, European and other internationally sourced ETFs. Larkin believes this agreement, and others like it, will accelerate the interest of European investors who will be able to access an already established level of liquidity.

"Clearance and settlement will be done in a way that we will be able to service non-US investors while at the same time permitting them to tap into the everyday US liquidity in these various portfolios," he says. Larkin believes that US ETFs will be well received in Europe where he sees a very significant trend of European investors purchasing US securities.