Brexit may stunt Europe’s low-fee ETF revolution

The exchange-traded fund juggernaut that’s transformed the US investing landscape is just starting to accelerate into Europe. But there’s a risk that misguided efforts by European Union regulators to deal with the aftershocks of Brexit will stunt the market’s potential.
After growing by more than 40 percent last year, Europe’s ETF industry added another 7 percent in January alone. It could double to $2 trillion in the next five years, according to Bloomberg Intelligence analyst Eric Balchunas.
Vanguard Group Inc., which has been at the forefront of the passive-investing revolution, has seen its European ETF business surge in the past year or so. It’s worth more than $37 billion, up about 90 percent since the end of 2016. And it’s grown almost twice as fast as Vanguard’s overall European business.
Individual investors account for about half of the US. ETF market, depending how you classify fund-of-fund investments — but in Europe the percentage dwindles to no more than a quarter at best. Sean Hagerty, Vanguard’s managing director for Europe, says the market in Europe will start to reach its full potential once retail investors invest directly into ETFs.
That shift is widely expected to be turbocharged by the introduction at the start of this year of the Markets in Financial Instruments Directive, a suite of rules that include obligations for fund managers to be more transparent about the costs of investment products. That should make ETFs, with their typically lower charges, more attractive to consumers.
But in the aftermath of the UK’s decision to leave the EU, a change in the European rulebook threatens to undermine the economies of scale the ETF industry needs to drive down costs on the products it offers.
Last year, the European Commission proposed giving more authority to the bloc’s pan-EU regulators, including the European Banking Authority, and the European Securities and Markets Authority. ESMA, for its part, raised questions about how national regulators are applying the so-called delegation system, which allows investment firms to register their funds in one nation and then sell them to investors across the bloc.
That scrutiny is inspired by the UK’s decision to leave the EU. But the implications are more widespread, given the wide geographical range from which funds registered in the EU are drawn. The Association of the Luxembourg Fund Industry pushed back, saying in October that delegation has made the European fund
industry “a success story worldwide” by allowing portfolio management to be outsourced to specialists who know their local markets.
Asset managers are concerned that attempts to restrict delegation and force firms to have the people “effectively directing” the business in the same country as the fund is incorporated, as ESMA put it, will simply increase costs.
“Delegation brings cost savings for investors, so undoing that regime is disruptive to the market,” says Vanguard’s Hegarty.
ETFs have a halo effect on the cost structure of the entire asset-management industry, bringing the benefits of lower fees even for investors who prefer active management products. It would be a shame if ESMA’s reaction to Brexit slowed the market’s growth by burdening it with unnecessary costs.

—Bloomberg