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The first European ETF came onto the market in 2000, and since then the European ETF market has experienced tremendous growth. At the end of March 2019, assets under management in the European industry amounted to EUR 760 billion, compared to EUR 100 billion at the end of 2008. The market share of ETFs has increased significantly in recent years. At the end of March 2019, ETFs accounted for 8.6% of total investment fund assets under management in Europe, up from 5.5% five years earlier.

The use of ETFs has also evolved over time, as demonstrated by regular observations of the practices of investment professionals in Europe. EDHEC surveys show increasing adoption of ETFs over the years, particularly for traditional asset classes. While ETFs are now used across a wide range of asset classes, in 2019 they are primarily used in stocks and sectors, by 91% (45% in 2006) and 83% of respondents, respectively. This may be related to the popularity of indexing in these asset classes, as well as the fact that stock and sector indices are based on highly liquid instruments, making the creation of ETFs on such underlying assets easy. The other asset classes for which a large proportion of investors report using exchange-traded funds are commodities and corporate bonds (68% for both, compared to 6% and 15% respectively in 2006), smart beta factor investing and government bonds ( 66% for both, compared to 13% for government bonds in 2006). Investor satisfaction with ETFs is high, particularly for traditional asset classes. In 2019, we observed 95% satisfaction for both stocks and government bonds.

The role of ETFs in the asset allocation process

Over the years, EDHEC survey results have consistently shown that ETFs have been used as part of a truly passive investment approach, primarily for long-term buy-and-hold investing rather than tactical allocation. However, over the last three years, the two approaches have gradually converged, and in 2019, European investment professionals report using ETFs more for tactical allocation than for long-term positions (53% and 51%, respectively).

ETFs, which originally tracked broad market indices, are now available in a variety of asset classes and a variety of market sub-segments (sectors, styles, etc.). While broad market positioning is the priority for 73% of users in 2019, 52% of those surveyed stated that they use ETFs to gain exposure to specific sub-segments. The diversity of ETFs increases the possibilities of using ETFs for tactical allocation. ETFs allow investors to easily increase or decrease their portfolio exposure to a specific style, sector or factor at a lower cost. The more volatile the markets are, the more interesting it is to use cost-effective instruments for tactical allocation, especially since costs are an important criterion for choosing an ETF provider for 88% of those surveyed.

Expectations for the future development of ETFs in Europe

Despite the current high adoption of ETFs and the already high maturity of this market, a high percentage of investors (46%) plan to increase their use of ETFs in the future, according to responses to the 2019 EDHEC survey. Investors plan to increase their ETF allocation to replace active managers (71% of respondents in 2019), but also want to replace other passive investment products with ETFs (42% of respondents in 2019). Reducing costs is the main motive for increasing the use of ETFs for 74% of investors. Investors particularly want further developments in ETF products in the area of ​​ethical/SRI and smart beta equity/factor indices. In 2018, ESG ETFs experienced 50% growth, reaching EUR 9.95 billion in volume, with 36 new products launched, compared to just 15 in 2017. However, 31% of respondents to the EDHEC 2019 survey want this still have additional ETF products based on sustainable investments.

Investors also demand ETFs that relate to advanced forms of equity indices, namely those based on multi-factor and smart beta indices (30% and 28% of respondents, respectively), and 45% of respondents want more Developments in at least one category relating to smart beta stock or factor indices (smart beta indices, single factor indices and multi-factor indices). Reflecting the desire to use exchange-traded funds for passive exposure to broad market indices, only 19% of respondents expressed interest in the future development of actively managed equity ETFs.

Exchange traded funds (ETFs) are mutual funds that, like stocks, are traded throughout the day on an exchange. This differs from traditional mutual funds, which trade only once a day (based on their price at the end of the day). Most exchange-traded funds are created to track the performance of market indexes (e.g. S&P 500) by holding the same securities in the same proportion as a particular stock market or bond index. The advantages of exchange-traded funds over mutual funds include: lower costs, the ability to track the performance of the entire market rather than investing in individual stocks, and potentially better investment results since active fund managers tend to underperform the market. These advantages have resulted in the number of exchange-traded funds increasing by a staggering 2,650 percent worldwide between 2003 and 2020.

Which is the largest ETF?

Many ETF providers offer not just a single, individual ETF, but a number of different funds that track different indices and invest in different types of securities. For example, Blackrock is the largest ETF issuer in the United States with a market share of 36.4 percent (as of February 2021). However, under the iShares brand, BlackRock manages nearly half of the 15 largest individual ETFs in the U.S. by assets under management. Other leading ETF providers include State Street and Vanguard, while the largest single ETF is the State Street-managed SPDR S&P 500 ETF, whose assets reached approximately $325 billion as of February 2021.

Size of the ETF industry

Global ETF assets under management (AUM) increased from $417 billion in 2005 to over $7.7 trillion in 2020. The regional distribution of ETF assets was heavily skewed towards North America, which accounts for approximately 5, US$6 trillion of the global total was accounted for. However, Asia Pacific had the highest regional growth rate for ETFs at that time, despite accounting for a very small share of the total global ETF market.

The first ETF was created in 1989 through Index Participation Shares and was an S&P 500 ETF traded on the NYSE American and the Philadelphia Stock Exchange. This product was only sold briefly because a lawsuit by the Chicago Mercantile Exchange successfully stopped sales in the United States.

In 1990, a similar product, Toronto Index Participation Shares, which tracked the TSE 35 and later the TSE 100 index, began trading on the Toronto Stock Exchange (TSE). The popularity of these products prompted the American Stock Exchange (NYSE) to develop a product that complied with United States Securities and Exchange Commission regulations.

Nathan Most and Steven Bloom, under the direction of Ivers Riley, designed and developed the Standard & Poor's Depositary Receipts, which were introduced in January 1993. The fund, known as SPDR or “Spider,” became the largest ETF in the world. In May 1995, State Street Global Advisors introduced the S&P 400 MidCap SPDR.

Barclays Global Investors entered the market in 1996 in partnership with MSCI and Funds Distributor Inc. with the World Equity Benchmark Shares (WEBS), which later became the iShares MSCI ETFs. WEBS offered products on 17 MSCI country indices managed by the fund's index provider, Morgan Stanley.

In 1998, State Street Global Advisors introduced “Sector Spiders,” separate ETFs for each sector of the S&P 500 Index. Also in 1998, the SPDR “Dow Diamonds” ETF was introduced, tracking the Dow Jones Industrial Average. In 1999, the influential SPDR “Cubes” ETF was introduced with the aim of replicating the price movement of the NASDAQ-100.

The iShares line was introduced in early 2000. By 2005, they had a 44% market share of ETF assets under management. Barclays Global Investors was sold to BlackRock in 2009.

In 2001, Vanguard Group entered the market with the launch of the Vanguard Total Stock Market ETF, which includes all publicly traded stocks in the United States.

iShares issued its first bond fund in July 2002: iShares IBoxx $Invest Grade Corp ETF, which holds corporate bonds. The company also issued an ETF on inflation-linked bonds.

In 2007, iShares launched an ETF that holds high-yield, high-risk securities (junk bonds) and an ETF that holds U.S. municipal bonds. State Street Global Advisors and The Vanguard Group also issued bond ETFs for the first time this year.

In December 2005, Rydex (now Invesco) launched the first currency ETF, the Euro Currency Trust, which tracked the value of the euro. In 2007, Deutsche Bank's DB X-Trackers launched the EONIA Total Return Index ETF, which replicates the EONIA. In 2008, the Sterling Money Market ETF and the US Dollar Money Market ETF were launched in London.

The first leveraged ETF, i.e. with leverage, was issued by ProShares in 2006.

In 2008, the SEC approved ETFs that use active management strategies. Bear Stearns then launched the first actively managed ETF, the Current Yield ETF, which began trading on the NYSE on March 25, 2008.

In December 2014, assets under management by US ETFs reached $2 trillion, and by November 2019 they reached $4 trillion. In Europe, 1 trillion euros were managed in ETFs in December 2019.

Like normal investment fund shares, ETF shares represent a proportionate ownership of a special fund that is managed separately from the assets of the issuing investment company.

The investment strategy of exchange-traded funds is generally passive, meaning that the fund management does not invest the fund assets based on its own opinions, but instead replicates the performance of a predefined benchmark in the form of a financial index (see Index Investing). Actively managed ETFs are also offered, but these have a very small market share. The distinction from strategy indices is not clear either.

The fund management can generate additional income, independent of the development of the benchmark, by lending the securities of the special fund to other capital market participants and thereby generating lending fees.

Exchange-traded funds can be traded on the stock exchange at any time, similar to stocks. ETFs differ from normal investment funds, some of which are also traded on the stock exchange, in the following points:

Investors usually only buy and sell ETFs on the stock exchange; there are no plans to purchase them through the issuing investment company.
The composition of the special fund is published once a day.
While with normal investment funds the net asset value (NAV) of the special fund is only published once a day, the issuer of ETFs continuously determines and publishes an indicative net asset value (iNAV) during the trading day.
There are special processes, creation or redemption, for the creation of new ETF shares and the liquidation of existing ones.
The price of exchange-traded funds is determined on the stock exchange by supply and demand, but for arbitrage reasons is usually close to the net asset value of the investment fund. To ensure a liquid market, exchange-traded funds are managed by market makers who continually provide buying and selling prices.

In contrast, non-exchange-traded fund shares can only be bought and sold through the fund company. The fund company only sets a price once a day.

To be distinguished from exchange-traded funds (ETFs) are the similarly named Exchange-traded Notes (ETN) and Exchange-traded Commodities (ETC). These are not shares in a special fund, but rather special types of bonds that are similar to certificates.

Creation/Redemption Process

The issuance of new ETF shares takes place via a process specific to this type of security, the so-called creation process. Similarly, ETF shares are returned to the issuing investment company via the so-called redemption process.

In the creation process, ETF shares are created in blocks of usually 50,000. The Authorized Participant (AP) delivers cash or a basket of securities to the investment company in the value of the ETF shares to be created. In return, this delivers the shares that the market maker can now sell to investors on the stock exchange.

A special feature is the possibility of delivering a basket of securities. In the simplest case, the composition of this corresponds to the strategy of the ETF in question. For example, in the case of an ETF intended to replicate the STOXX Europe 50 index, the market maker can deliver a portfolio of securities containing the stocks included in the index according to their index weights. This approach is called “creation in kind”. If the new securities are paid for with money, this is called a “cash creation”.

Conversely, the Authorized Participant can return ETF shares to the issuing investment company, e.g. B. if he has bought back a corresponding number on the secondary market. Analogous to the creation process, he receives cash or a basket of securities back. Analogous to the creation process, one speaks of “redemption in kind” and “cash redemption”.

Institutional investors who want to buy or sell large volumes can also do so over-the-counter directly with the investment company using the creation or redemption process. If the investor delivers or receives a basket of securities when buying or selling, this can have tax advantages for him.

Reproduction error

ETF tracking error is the difference between the returns of the ETF and its benchmark index or asset. A non-zero tracking error therefore means that the benchmark index is not tracked as stated in the ETF prospectus. The tracking error is calculated based on the current price of the ETF and its reference. It is different from the premium/discount, which represents the difference between the ETF's net asset value (updated only once daily) and its market price. Replication errors are more significant when the ETF provider uses strategies other than full replication of the underlying index. Some of the most liquid exchange-traded equity funds tend to have better tracking performance because the underlying index is also sufficiently liquid and allows for complete tracking. In contrast, some ETFs, such as B. Commodity ETFs and their Leveraged ETFs may not necessarily provide full replication because the physical assets cannot be easily stored or used to gain leveraged exposure or the benchmark or index is illiquid. Futures-based ETFs can also suffer from negative roll returns, as seen in the VIX futures market.

While tracking errors do not typically occur in the most popular ETFs, they have occurred during times of market turbulence such as late 2008 and 2009 and during flash crashes, particularly in ETFs that invest in foreign or emerging market stocks, futures-based commodity indices and high-yield debt securities. In November 2008, during a period of market turmoil, some thinly traded ETFs often had deviations of 5% or more, in a few cases even exceeding 10%, although even for these niche ETFs the average deviation was just over 1% fraud. The trades with the largest deviations were usually made immediately after the market opened. According to Morgan Stanley, ETFs missed their targets by an average of 1.25 percentage points in 2009, more than double the average deviation of 0.52 percentage points in 2008.

Liquidity risk

ETFs have a wide range of liquidity. The most popular ETFs are constantly traded, with tens of millions of shares changing hands daily, while others trade only every now and then and even go untraded for a few days. There are many funds that are not traded very frequently. The most active exchange-traded funds are very liquid, have high trading volume and tight spreads, and the price fluctuates throughout the day. This is in contrast to mutual funds, where all purchases or sales on a given day are executed at the same price at the end of the trading day.

New regulations designed to force ETFs to deal with systemic tensions were introduced after the 2010 flash crash, when prices of ETFs and other stocks and options became volatile, with trading markets soaring and bids falling to as low as a penny per Stocks fell in what the Commodity Futures Trading Commission (CFTC) in its investigation described as one of the most turbulent periods in the history of financial markets.

These regulations proved insufficient to protect investors in the flash crash of August 24, 2015, “when the price of many ETFs appeared to become detached from their underlying value.” As a result, ETFs received even greater scrutiny from regulators and investors examined. Morningstar, Inc. analysts claimed in December 2015 that "ETFs are a 'digital age technology' governed by Depression-era laws."

Risks of synthetic ETFs

Synthetic exchange-traded funds, which do not own securities but instead track indices using derivatives and swaps, have raised concerns due to the products' lack of transparency and increasing complexity, conflicts of interest and lack of regulatory compliance.

Counterparty risk

A synthetic ETF carries counterparty risk because the counterparty is contractually obligated to replicate the return of the index. The transaction is completed with collateral provided by the swap counterparty. A potential risk is that the investment bank offering the ETF provides its own collateral, which may be of dubious quality. Additionally, the investment bank could use its own trading department as a counterparty. These types of constructions are not permitted under the European directive, the Undertakings for Collective Investment in Transferable Securities Directive 2009 (UCITS).

Counterparty risk also exists if the ETF engages in securities lending or total return swaps.

Impact on price stability

Purchases and sales of commodities through ETFs can significantly affect the price of those commodities.

Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to the rise in stock prices in some emerging markets, warning that the leverage embedded in ETFs could pose risks to financial stability if stock prices rise above should decrease over a longer period of time.

Some critics claim that exchange-traded funds can and have been used to manipulate market prices, for example in connection with short selling that contributed to the 2007-2009 U.S. bear market.

Investors bear the following costs for exchange-traded funds:

• Costs summarized in the total expense ratio (TER), such as management fees, index fees and other costs, e.g. B. for brochures.
• Fund transaction costs

As is usual with investment funds, these costs are taken from the special fund. However, the usual fees for stock market trading (order commission, brokerage commission, settlement fees, bid-ask spread) are paid directly by the investor.

Annual management costs are typically less than 1%.

ETFs that pursue a passive investment strategy may incur lower transaction costs and eliminate the costs of active fund management.

Since ETFs are not purchased through the investment company, there is no issue charge that often has to be paid.