Hedge Funds and the European ETF Market

How product innovation has redefined liquidity

Originally published in the September 2010 issue

Over the past few years, US hedge funds have become some of the largest users of Exchange Traded Funds (ETFs) – they trade in size and often represent more than 30% of daily turnover on US exchanges. The opposite is true in Europe, where many large institutions are waiting for on-exchange liquidity to reach US levels. Critics argue that while the US ETF market has daily on-exchange turnover levels of 10-12% of total AUM, the European market remains static at a mere 1%. There are several factors that weigh against increased on-exchange liquidity in the European market in its current form, and most of them revolve around fragmentation.

According to recent data from BlackRock, even though the European ETF market is only one third as large as the US market ($250 billion versus $850 billion in AUM), there are more ETF providers (28), more ETFs (829), and many more exchange listings in Europe (18). The net result is significant fragmentation of the European market, and no standout trading vehicles such as the SPDR S&P 500 ETF – the world’s most liquid security and surely the ETF industry’s defining product.


Most observers say that these differences between the two markets are to be expected. Multiple exchanges, multiple regulatory approaches (even under UCITS III), multiple currencies, domestic bias, differing tax regimes and captive distribution channels all make fragmentation inevitable. In contrast, the US is a vast and homogenous market. Retail investors account for a higher proportion of the ETF market in the US (50% of the investor base rather than 10% in Europe), and they are significantly more self-directed in their investment approach. More importantly, US hedge funds are large ETF users across several asset classes including equities and commodities, whereas historically they have not used European ETFs. This disparity results in a chicken-and-egg situation − the market in Europe is not liquid enough to entice them, alongside the structural issues of there not being an active market in lending and shorting European ETFs. Bid/offer spreads are not competitive, and market makers aren’t used to putting up sizes on-exchange greater than €1 million. The result has been that European hedge funds have resorted to the OTC derivatives market for exposures that, in the US, they would achieve through ETFs.


Is there any valuable innovation occurring in the European ETF market that will increase on-exchange liquidity and increase participation of hedge funds, or do participants have to wait for organic, incremental change to occur? Perhaps the increase in liquidity is inevitable: the European market is already large, it is growing quickly (outpacing the mutual fund industry), and it is receiving increasing investor and media attention. Incremental changes in liquidity will naturally occur as AUM grows, but a tenfold difference in trading activity between the US and Europe is still a big gap to close through organic, incremental change. Real change will require the elimination of structural barriers that will not simply be eroded by the tides of organic growth.

As a case study, let us look at European sector ETFs. In the US, sector investing through ETFs is a vibrant market. Some 11% of ETF assets are invested in sectors, trading turnover is high (8-10%), and hedge funds are actively involved. In Europe, historically, sector assets were less than 5% of overall ETF AUM and on-exchange turnover was at or below the market average of 1%. However, there has been a small revolution occurring. At the end of July 2009, Source, the ETF provider established and owned by some of the world’s leading financial institutions including BofA Merrill Lynch, Goldman Sachs, J.P. Morgan, Morgan Stanley and Nomura, launched 18 sector ETFs benchmarked to the new STOXX Europe 600 Optimised Supersector indices.

Index innovation is not uncommon in Europe, but there were two differences in this case. First, the index innovation was not focused on outperformance but rather on tracking a more liquid basket using both average daily turnover and stock lending data to enhance the index. Second, when Source launched ETFs linked to these new indices, it also focused on the liquidity of the ETFs themselves, creating a seamless stock lending market for these new ETFs. To date, lending and shorting of ETFs in Europe has been limited, so the market has been focused instead on trading from the long side. Selling has been the result of investors reducing positions. This naturally constrains trading volumes and has a tendency to further exclude hedge funds which are as likely to want to short as to go long. When Source launched its European sector ETFs in July 2009, it used this microcosm of the European market to determine whether it was structurally possible to reach US levels of liquidity. The results have been startling and encouraging. Today, Source has an actively traded range of European sector ETFs that has raised over $1.8 billion in assets, daily turnover equivalent to 20% of AUM, and as much activity shorting the product as going long. From an AUM standpoint, prior to launch of the Source products total European sector ETF AUM was approximately $6 billion – over the last year, European sector ETF assets have increased to just over $9 billion, with Source products capturing 50% of new inflows. More importantly, total turnover in these products reached €10.1 billion in July, representing 90% of total European sector ETF flows reported in Cascade.


Turning the tables on the chicken-and-egg European liquidity issue, hedge funds are now actively using these products – this demonstrates that US levels of trading turnover are possible in the European ETF market. This is a big step forward. The next stage is to create an intersection between the OTC and on-exchange markets. They currently remain separate with on-exchange flows focused on small tickets, with most institutional clients finding liquidityOTC. An increase in on-exchange turnover would increase transparency as well as offer anonymity to investors. OTC market makers would benefit from being able to trade between the two markets, laying-off risk by trading the ETF on-exchange rather than hedging by trading the underlying basket or relevant futures. In a major break from other European ETF providers, Source took the bold step of using only one exchange listing per ETF in Europe. While other providers continue to fragment liquidity by listing the same ETF across multiple exchanges in Europe, Source is focused on drawing liquidity to one listing – this strategy will encourage market makers to put up larger sizes on-exchange, and eventually drive down bid/offer spreads and trading costs for all participants. Source expects investors to eventually shift some of the growing OTC volume in its European sector ETFs onto the exchange.

Even more surprisingly, turnover in Source European sector ETFs has rapidly caught up with underlying futures volumes. Most investors would assume that liquidity in the underlying futures would be greater than ETF liquidity, but Source sector ETFs track a more efficient benchmark, and as such have succeeded in attracting strong trading volumes. Furthermore, some investors have taken the view that these particular ETFs are more efficient to trade and hold in the short-term versus the underlying futures which are based on the original STOXX Europe 600 sector indices.

Another way of looking at the developing liquidity of a market is to look at its ability to support products like options that trade off the back of the liquidity of an underlying. This past June, Eurex introduced the first options on Source ETFs, including contracts covering the European banks, basic resources, industrials, oil & gas, telecommunications and utilities sectors. Fundamentally, options markets need highly liquid reference assets, which historically posed a challenge to trading options on European ETFs. Given the strong turnover for Source’s European sector ETF range, options were a natural extension in the direction of increasing usage and liquidity in these products. Since launch of the options in June 2010, Source’s share of options volumes is 92%.

To conclude, the European ETF market is opening up to hedge fund investors but only for products with true, realised liquidity – proven and significant turnover. Hedge funds now have one example of a product that has broken the mould. It is now up to investors to vote with their AUM and turnover as to where they want the market to go next.