Deutsche Bank’s exchange traded fund platform, db x-trackers, has seen its assets under management rise by 4,802 per cent since early 2007, to become the third largest ETF provider in Europe. If the ETF platform’s success is anything to go by, investment banks are right to be piling into the ETF business.
The opportunity comes thanks to Ucits III, the updated regulations covering pan-European investment funds. These allow ETFs to replicate the performance of the underlying index through derivatives rather than holding the index constituents. This is the approach used by both db x-trackers and Lyxor, the second biggest European player, which is a subsidiary of Société Générale. The biggest player, iShares, which Barclays is in the process of selling, sticks mainly to physical replication in its range.
“It is more profitable for an investment bank than for an asset manager [to use swaps to create index-tracking products],” says Thorsten Michalik, head of db x-trackers. “When you look at what can be made out of the ETF business, there’s the asset management, there’s the sales and there’s the trading. Why should we not combine them all in-house?”
Other investment banks are following behind, and they have big ambitions.
Credit Suisse is in the process of launching a comprehensive range of ETFs, mixing physically-backed and swap-backed ETFs. “We are not in to become the third or fourth player in the space,” says Oliver Schupp, managing director alternative investments at Credit Suisse.
But the real talk of the town is Source, the ETF platform set up by Bank of America Merrill Lynch, Morgan Stanley and Goldman Sachs. The open platform – which uses all three banks as swap issuers – also hopes to claim one of the top places, with the help of its backers’ distribution capabilities.
“The investment banks are the largest distributors of existing ETF products,” says Michael John Lytle, director of marketing at Source.
“A large percentage of over-the-counter ETF business is done by the three banks behind Source.”
Fearghal Woods, director of business development at the Bank of Ireland Securities Services, says investors access ETFs through market participants such as Goldman Sachs, JPMorgan and Morgan Stanley. “They have a 70 per cent share of the market.”
ETFs are also an opportunity for investment banks to diversify their revenue base. In Europe, ETFs have seen growth of 6 per cent in assets under management, year to date, to $150bn (£94bn, €108bn), which is a lot more than can be said of many trading desk products.
Deborah Fuhr, global head of ETF research and implementation strategy at Barclays Global Investors, says: “Trading desks at many banks and brokers have seen a decline in the use of certificates, swaps and structured products, while the use of ETFs is increasing. Investment banks have decided to launch their own ETFs.”
Investment banks believe they can draw new investors to ETFs by providing increased liquidity to the market. “We want to be in the bracket of meaningful players, but it is less about taking market share from existing providers, and more about expanding the overall opportunity in the ETF market,” Mr Lytle says.
He adds: “If you look at the European asset management market, ETFs represent 1.5 per cent of all assets (actively managed assets included). In the US, 4.6 per cent of that market is in the form of ETFs.” This difference represents $300bn worth of ETFs.
Source is listing its 13 ETFs – 100 before the end of the year, it says – on one exchange only. The platform also invites other banks to join in as issuers of swaps and as distributors.
Mr Lytle says hedge funds will start investing when volumes increase. “OTC trading is less transparent and does not lead to the momentum you get from exchange trading,” he says.
Taking advantage of their distribution capabilities, banks may still have to deal with investors’ perception of counterparty risk – a potentially massive hurdle to large asset growth.
Source says it has addressed the issue by grouping different swap providers together, and appointing an independent asset manager. “If there is a credit event at one of our providers they will not be affected in any way by that,” Mr Lytle says.
Exposure to derivative counterparts will be limited at 4.5 per cent, which is well under the 10 per cent limit set by Ucits III.
However, such reassurance may not be enough to convince investors. A recent survey by Edhec Risk and Asset Management Research Centre shows a strong preference among European investors for ETFs that buy underlying securities over swap-based ETFs.
Trading desk sales forces will also face a culture shock. “The challenge for banks and brokers entering the business is they are not used to taking fiduciary responsibility, which is the role asset managers play,” says Ms Fuhr. “The client service model is very different; the way products are developed is also different.”
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