Cost-effectiveness determines profit
European private investors are not making sufficient use of index investment.
Actively managed investment funds lose out against their index in the long term, a view backed by several studies. Index investment offers a cost-effective alternative to private investors. Exchange-traded funds, or ETFs, are a particularly cost-efficient option
as they combine the advantages of direct investment in shares and fund investment. This gives investors diversified investment with one investment.
“Unfortunately, European brokers are not keen to offer index funds to private investors,” says Guillaume Prache, Managing Director of the European Federation of Financial Services Users, EuroFinUse.
“And when the funds are marketed, they are usually the high-fee investment and index funds, not the low-cost ETFs.”
Prache stresses that while stockbrokers have no incentives to offer ETFs, index funds are cost-effective and secure investment products. They do not involve the risk of portfolio management typical in fund investment.
ETFs tracks a predetermined index. The investment decisions of the fund are not affected by market sentiment or other human factors, to which stockbrokers are constantly susceptible.
Two types of fund units
EFTs come either as traditional, cash-based funds or synthetic swap-based funds. The traditional index funds invest directly in securities forming the target index fully or nearly in the same proportion as in the target index.
“The traditional cash-based ETFs are naturally more transparent and therefore lower risk,” Prache says.
ESMA, the European Securities and Markets Authority, has updated its guidelines on ETFs. From the beginning of 2013, the issuers have been obliged to publish information on, for example, the difference in the earnings of the fund and the index.
“According to ESMA guidelines, asset managers are required to return all profits from the securities loans to the fund, that is the investors.”
Synthetic ETF portfolios are based entirely on index derivatives. A synthetic ETF is constructed so that the ETF issuer owns a collateral basket, which often includes the securities making up the underlying index but may also be completely independent of the underlying index of the ETF.
Against this collateral, it enters into a total return swap: a contract for the exchange of cash flows, where the return of the collateral is swapped for the total return of the underlying index with the counterparty of the swap contract.
The advantage of synthetic ETFs is that the manager of the ETF does not have to adjust the portfolio in connection with index rebalancing, dividend distributions or other corporate events, but trading costs are limited to the costs of buying and selling the index derivative.
Modelled after US funds
There are tens of thousands of investment funds in the European market. Few have the capacity to compare the competence and performance between different asset managers.
“Personally, I seldom invest directly in individual companies,” Prache says.
“I don’t have the time to follow them up and analyse them. I mostly invest in index funds or ETFs because of their low costs.”
Prache admits that there are highly successful portfolio managers in the market who return better earnings than the index. However, these winners can only be announced after the fact. Past track record is no guarantee of future earnings.
ETFs and index investment are clearly more popular among American than European investors. The reason for this is historical.
Index funds were invented in the United States in the 1970s. Similarly, ETF investments first started in the United States, before spreading to Europe.
“Fifty per cent of ETFs are subscribed by retail investors in the US versus only ten percent in Europe”, Prache says.
Text: Juha Europaeus