Exchange-traded funds (ETFs) are gaining popularity in the investment world, playing an increasingly important role in investor portfolios. They have played a pivotal role in the boom in demand for passive investments over the last decade, with passive funds now accounting for more than 50% of the US fund industry’s assets.
Europe, in contrast, has been slower in adopting ETFs. However, the most recent wave of Research in Finance’s European Fund Selector Study (EuroFSS) which surveyed almost 900 retail and institutional third-party fund buyers and distributors in Q2 2024, reveals that investors in some European markets are now allocating more to passive ETFs than traditional index-tracking mutual funds.
Passive allocations by European market: ETFs vs index-tracking mutual funds
Source: Research in Finance European Fund Selector Study Q2 2024
Passive vs Active ETFs: Insights from Financial Experts
As the ETF market matures, investors are faced with two options: Stick with the known quantity of passive ETFs or invest in the new kid on the block: active ETFs.
Awareness, recommendations, and allocations of active ETFs by market
Only 21% of European selectors are currently allocating to active ETFs or recommending them to their clients, with another 13% planning to do so by the end of 2024.
At the moment, 45% of European selectors are familiar with active ETFs but aren’t planning to recommend or allocate to them any time soon, and 22% remain completely unfamiliar with them as investment options. These figures reflect that it’s still early days for active ETFs in Europe, despite the growing interest.
Four Reasons Europe Trails the U.S. – What’s Holding Them Back?
1. Europe’s perception of a lack of tax advantages
US retail investors have significant tax perks that boost the attractiveness of ETFs, like tax deferral. European investors are not offered such advantages, or so it’s often believed. US equity dividends paid to European mutual funds usually face a 30% withholding tax, but for Ireland-domiciled ETFs this is reduced to 15% thanks to the country’s double-taxation agreement with the US. Given the important role that US equities play in European portfolios, this feature is not insignificant.
2. Incompatibility with business models
Commission payments to distributors providing independent investment advice and portfolio managers were banned under MiFID II in 2018, but are still otherwise permitted in most of Europe.
This is a blocker for the uptake of ETFs as they’re sold on the secondary market, meaning no commission payments can be paid to the distributor.
A private banker from France who was interviewed for EuroFSS said: “We are looking to offer ETFs in future, but the problem is that we run on retrocessions, and we’d have to charge very low fees to sell ETFs, which doesn’t currently fit with our business model.”
ETFs make more sense as a product for independent advisers who charge clients fees for advice, but such advisers are still in the minority in most markets – and as we can see in the UK, that doesn’t guarantee advisers will switch to using ETFs.
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3. ETFs still struggle for recognition in Europe
Despite the introduction of ETFs in Europe over two decades ago, there’s still a relatively low level of familiarity and understanding versus mutual funds among both investors and financial advisers, or a lack of impetus to use these vehicles.
One independent advisor from Research in Finance’s ongoing UK Advisory Studies (UKAS) responded “The reality is we have a long-standing portfolio of investments. I don’t think we would make the flip to ETFs… I think there are a couple of regulatory issues to using them… If it’s not broke, don’t fix it.”
4. Lack of availability through European brokerage platforms
There’s limited accessibility to ETF products on certain trading platforms in Europe. While ETFs have become a popular investment option in the US, many European investors and financial advisers still find themselves unable to access them through their preferred brokerage platforms. Likewise, a lack of fractional trading on platforms or nationally in some cases can reduce the flexibility and appeal of ETFs.
But how can ETF providers encourage a greater uptake from professional investors? Mark McFee, Editorial and Insights Director at Research in Finance explains: “Some of the structural barriers like lack of tax incentives or the continuance of commission payments are unlikely to change any time soon.
“Therefore, providers looking to distribute ETFs via intermediated retail channels should focus their efforts on education, helping advisers to understand how ETFs could complement their usage of other investment products like mutual funds. For example, through low-cost access to specific strategies, the facilitation of tactical allocation opportunities thanks to intraday trading, or additional portfolio transparency.”
