The future for ETFs looks bright in Europe. Global assets are gaining traction, currently hovering around $3 trillion, and have surpassed hedge fund total assets this year. New providers are entering the market, and advisers are dipping a toe into more exotic waters, including smart beta.

Although hurdles remain on the horizon, like fragmented liquidity across Europe and a lack of comprehensive ETF information to help investors choose a product, it seems clear that growth will continue. ETF Report UK interviewed 123 investors, of which 63% were IFAs, between May and June this year to find out what challenges they face, where they want to see more innovation and what they consider to be the biggest benefits of ETFs. Andrew Craswell, vice president, Global ETF Services at Brown Brothers Harriman, and the ETF team partner with ETF sponsors to consult and provide critical custodial and operational services.

BBH has approximately $308 billion in ETF assets under custody as of June 2015. Craswell helps ETF Report UK analyse the survey results.

What did you think was the most interesting result of the survey?

I thought it was interesting that 98% of the respondents intend to maintain or increase their allocation to ETFs over the next 12 months. This is a reflection of the hard work carried out by ETF issuers and the industry to promote the benefits of ETFs to all investor types.

Slightly contrary to the previous point, nearly 50% of respondents stated that they received no calls from ETF salespeople in any given month. I think this highlights there is still some work to be done around promoting the ETF story in Europe.

In the US, flows into ETFs have now overtaken mutual funds, and a number of successful US ETF issuers—like Vanguard, WisdomTree, First Trust, Invesco PowerShares—are positioning themselves for growth in Europe by establishing UCITS platforms. There is still room for new issuers to come to market with their own products, particularly asset managers that may already have strong distribution capabilities and brand awareness in Europe.

Half the respondents believe ETFs and mutual funds can complement one another in the same portfolio. Why?

I believe that this is a reflection of a broader theme around passive and active management complementing one another in the same portfolio. The efficiency of the ETF structure makes it a great allocation tool, given its flexibility and low-cost nature. Both passive and active management strategies have their benefits, depending on the asset class, style or sector. So the question becomes, what is the most efficient delivery mechanism for the investment strategy? And ETFs are gaining credibility for this rather than just being viewed as ‘market cap’ beta products.

We’re also seeing increased usage of ETFs in multi-asset funds, which have enjoyed strong asset flows so far in 2015. I think this reinforces the idea that there is a place for both active and passive management in a packaged product focused on asset allocation. Asset managers are starting to offer products across the continuum of passive, smart beta and active strategies in order to provide a complete solution to investors.

Advisers_Call_For_More_Innovation_in_European_ETFs

Platforms and robo advisers are playing their part by showing people how to use different products and strategies to build a portfolio. But there’s more work that can be done around blending, in terms of raising awareness of how ETFs and active mutual fund strategies can work together.

A large proportion of respondents only invest a small portion of their AUM in ETFs. What factors will drive future growth?

There are a number of factors that will drive future ETF growth in Europe. However, these factors vary by market, given its fragmented nature and the differences in distribution channels across the region.

Firstly, if you take a look at the UK, increased awareness and education on the benefits of ETFs and how they can be used in clients’ portfolios will be a key driver for growth in Europe, across retail and institutional channels.

However, particularly in the retail and adviser space, I think it’s going to require some pretty significant developments in infrastructure to support ETFs, particularly around platforms, and improving capabilities to support exchange traded instruments. A number of the UK platforms have ‘workaround’ solutions for supporting ETFs today.

Increased liquidity in European ETFs is also going to be a driver, and it is likely to have a snowball effect. Now that we’re starting to see UCITS ETFs gain traction and liquidity, I think we’ll also see an increased allocation of assets that have previously been in US-listed ETFs reallocated to comparable European products. The UCITS ETF may also have preferential tax treatment for certain underlying investor types.

With regards to regulation, initiatives such as MiFID II will increase transparency and give investors a greater understanding of the actual liquidity and trading costs for on-exchange and OTC activity for these products. The enhanced pre- and post-trade reporting requirements will make the European model more aligned to the US, where transparent price discovery is more easily achieved across multiple exchanges.

Finally, with new ETF entrants coming into the European market, investors will be offered ever more choice of smart beta, multi-asset and active ETFs.

What factors are ETF investors using to assess products, and does this highlight a knowledge gap?

Survey respondents indicated that the total expense ratio (TER) is the most important factor when selecting an ETF. It’s important to note that your fund might have a low TER, but if it’s not accurately tracking the index, then you’re not necessarily seeing the outcome you might expect.

Therefore, investors shouldn’t just be looking at the lowest priced product. The on-screen liquidity and bid/ask spread ranked relatively low in terms of the top factors for consideration when selecting an ETF. Yet these are certainly important factors, as they have an impact on the cost of buying or selling the ETF.

Overall, there are a number of other factors—such as the tracking difference, tracking error, replication method, size and liquidity—that should be considered in addition to the ETF’s TER. The results show there is still more work to be done around ETF education.

The survey shows that investors want to see evidence of past performance and fund size before investing in a new fund. What does that mean for smart beta ETFs?

Similarly to active investment strategies, investors want to see an established performance track record—generally of three years—before they’re willing to invest.

Smart beta strategies may need to follow this same path and establish a track record before gathering significant assets. Smart beta ETFs have a major advantage—over active strategies—as they replicate a rules based index methodology. It’s possible to generate backtested performance, which an index provider or an issuer can point to as an indication of how the strategy might perform over time across different market cycles.

Smart beta offers investors a middle ground between passive and active, with the benefits of broad market exposure, diversification, transparency and low cost. At the same time, you have the potential to either outperform the market cap index, or have a strategy that’s lower in volatility or more geared towards income. Smart beta can give you exposure to those active trades, in a rules based methodology.

Advisers_Call_For_More_Innovation_in_European_ETFs

Where do investors want to see innovation in the European ETF market?

The survey indicates there is more opportunity for innovation in the equity and fixed income smart beta space. We’re now entering a period of equity market uncertainty, and many investors want to diversify away from pure market cap and attain some form of protection against volatility. The survey results support this argument. They show that 66% of respondents intend to maintain or increase their allocation to smart beta over the next 12 months.

I also see some potential for active ETFs. Only 22% of respondents said that they would not be interested in investing in an active ETF, which I thought was relatively small. The demand for multi asset and developed market equity products ranked highly with advisers, and could be fulfiled by potential new active equity ETF entrants, which is different from the fixed income dominated active ETF marketplace today.

Overall, 10% of respondents thought that there were enough currency hedged products available in Europe today. Currency hedging could become a powerful distribution tool in Europe, given the fragmented nature of the market and the trading in multiple currencies across the region. It looks like we are set for more innovation in the near future.

The positions expressed in this material are those of the author as of 12 August, 2015 and may or may not be consistent with the views of Brown Brothers Harriman & Co. This material should not be construed as legal or tax advice.

BBH is not affiliated with ETF Report UK and does not monitor or maintain any of the information available on the external website mentioned nor represent or guarantee that such website is accurate or complete, and it should not be relied upon as such.