Distribution, fees, transparency and market structure are key challenges in the rapidly growing active exchange-traded funds (ETF) market in Europe, according to a panel hosted by BNY. Experts from across the ETF spectrum – including representation from market makers, issuers and fund governance professionals – met in May to discuss the changing landscape of active investment choices. While all agree the presence of active ETFs represents a clear opportunity in European markets, there are nuances that will require the industry to adjust.
Growth trends
Although the market share of active ETFs versus their established passive products is currently low – around 2%1 – it is accelerating fast, according to the panel. Citing the visible trends from the United States, where active ETFs have jumped to more than 8% market share2 (1,200+ products), members of the panel pointed out that as of May 7, 2024, almost a third of all U.S. ETF flows went to active structures. That pattern has the potential to be repeated in Europe in the coming years.
The range of opportunities cited by the panel was far reaching, highlighting the overall flexibility of the ETF wrapper and expansion of available listed products. While active ETFs first developed in fixed income, active equities flows have begun to accelerate in the past year. Among the forecasts for growth in active offerings were predictions of an increase in products linked to high concentrated active equities, low-cost rules-based portfolios and multi-asset strategies.
Ben Slavin, Global Head of Commercial Engagement and Strategic Growth at BNY, notes traditionally short-duration fixed income ETFs see strong inflows in uncertain times in the market, given their yield, liquidity profile and relative safety in the short-end of the curve. The expectation is that equity ETFs and other risk assets will realize positive flow as the market sentiment improves.
As more active ETFs are listed across Europe, it will be interesting to see if the category grows market share versus passive and traditional unlisted Undertakings for the Collective Investment in Transferable Securities (UCITS), he said.
Another trend within the European market that may benefit active ETFs is the rise of investment models, which Slavin says fit beautifully within an exchange-traded structure and may add fuel to their popularity over the next year to 18 months.
Adding impetus to ETF offerings may also be the review of the UCITS eligible assets directive, issued by the European Securities and Markets Authority (ESMA) on May 7. This may lead to an expansion of eligible assets within a UCITS structure, which in turn could broaden the active ETF universe even further. Key among the considerations is the exposure of UCITS investments in other UCITS products, including EU and non-EU ETFs.
Additionally, ESMA is looking at the eligibility for asset classes such as structured/leveraged loans, asset-backed securities, Real Estate Investment Trusts (REITS), cryptocurrencies and exchange-traded commodities and exchange-traded notes.
Importance of communication
Portfolio transparency is one of the key headwinds to growth in the European market. While that is unlikely to impede the speed of offerings, it will influence the types of active ETFs in Europe, according to the panel members. Not every investment strategy is suited to the ETF wrapper, says Slavin.
Track records are also critical to the distribution of active products, with three years being a key milestone for many investors before meaningful allocations would be considered. However, this is why rather than launching an entire new product within an ETF wrapper, some providers are considering adding ETF share classes to existing funds. This, members of the panel note, gives the advantage of an existing track record as well as viable scale in terms of assets under management.
However, this trend may cause fund boards some concern as it can increase their oversight responsibilities. Ensuring all investors are treated fairly is a key aspect of board mandates, so ETF share class additions will require greater diligence, data and review of operational frameworks to gain the necessary comfort.
Fund boards are also likely to ask for increased transparency when it comes to costs and management actions; is the fund being managed in line with expectations. By comparison, oversight of a passive ETF has fewer considerations, members of the panel point out.
Market maker representation on the panel also cited the increased need for this type of information. Active ETFs involve greater communication with counterparties involved in the creation/redemption process. Market makers need to understand the way a fund is managed on an active basis – how it is traded, its mandate as well as any big allocation shifts. Such communication, which at the moment is still largely a manual operation, is key to accurate pricing. Active ETFs do not necessarily bring greater complexity or pressure when it comes to providing liquidity.
Panel members also stressed the key to understanding the challenges around market pricing is direct communication with the issuers. Even factoring in the bid/ask spreads, the total cost of ownership for fixed income ETFs continues to decline. The average total expense ratio (TER) of ETFs are trending lower, Slavin says, noting the average expense ratio for ETFs as of 2022 was 0.37% — less than half what investors paid in 2002.3
Overall, the panel agreed that active ETFs present both opportunity and challenges, but ultimately, they represent a significant growth opportunity for those who embrace innovation and can adapt to the changing landscape of the investment industry.
1Will active ETFs take Europe by storm? Morningstar, April 24, 2024.
2Morningstar's Guide to US Active ETFs - Observation and analysis of key active ETF trends, April 2024.
3Morningstar’s guide to ETF investing, Morningstar, January 11, 2024.
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