Lipper’s Glow: How ETFs overtake index funds

Given that we have witnessed many headlines concerning passive investing and the popularity of ETFs, confirmed by the inflows and increasing assets under management in the European ETF industry, one could conclude that European investors like index products. It seems European investors follow the academic research and invest in products that appear from the scientific evidence to be superior at helping them achieve their investment goals.

But a look at the underlying trends shows that Europeans don’t like all kinds of index products. Mutual funds that track an index seem to no longer be in the favor of European investors. These products enjoyed high net inflows for 2015 and 2016, but they faced net outflows for 2017, while ETFs enjoyed another year of record inflows.

Chart 1: Estimated Net Sales for ETFs and Index Funds in Europe (in Billion EUR)

Source: Thomson Reuters Lipper

As Chart 1 depicts, the year 2017 marked a ninth year of net outflows from index funds over a 14-year period, while ETFs continued to enjoy net inflows. The chart shows that the general trend towards index products was strongly related to the development of ETFs.

Product features seem to be the drivers for the trend toward ETFs

Generally speaking, both product types should participate from the trend toward low-cost passive investment products. But, obviously ETFs are the preferred solution of European investors. From my point of view the reasons for this can mainly be found in the product features: ETFs can be traded on exchanges roughly every second, while investors have to wait T+1/T+2 until a deal in an index fund is settled and they find out the price they paid (or got) for their shares. The high liquidity of ETFs seemed to be the reason investors preferred these instruments over index funds during the financial and euro crises (2008–2011).

In addition, the high transparency of the portfolio constituents might be an advantage for ETFs, since ETFs publish their holdings every trading day, while many index funds publish their ten top holdings and other portfolio metrics only once a month. In periods with positive developments in the stock and bond markets, a high level of transparency might not be the most important reason for an investor to buy an ETF, but during rough times either in a single sector or in the markets in general, transparency might be very important.

When it comes to fees and expenses index funds might have an advantage over ETFs, since the management fees of some index products are below the management fees of ETFs. That said, this picture changes when an investor bears in mind the cost over the full holding period. ETFs have a unique creation and redemption process, which keeps the transaction costs associated with investors’ buying or selling shares of the fund outside the portfolio. These costs are paid from the portfolio of index funds and therefore by all investors in the funds.

Nevertheless, there are reasons some investors prefer index funds over ETFs. The most important one is that some investors are simply not allowed to buy ETFs because of their internal investment guidelines (which might be subject to change in the future) or by regulation (some investors are not allowed to buy products that employ derivatives, etc.). Since taxation is always an important driver of fund flows, especially for the professional investment community, some investors might be able to realize tax advantages coming from the different product structure of index funds in comparison to ETFs.

Summary

I have no doubt that both products, ETFs and index funds, are useful components in an investor’s portfolio, especially if the investor uses the product type that generates the highest benefits for him. That said, I strongly believe ETFs will continue to outgrow index funds, since investors in the future will further appreciate the higher transparency, liquidity, and efficiency of ETFs. While this does not mean index funds will disappear from the product landscape in Europe (there is also a market for these products), the growth rate for ETFs will probably be much higher than for index funds.

Detlef Glow is head of EMEA Research at Thomson Reuters Lipper

The views expressed are the views of the author, not necessarily those of Thomson Reuters.

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