For many years Exchange Traded Funds (ETFs) have proven an attractive proposition for retail and institutional investors alike, says John Bohan, Head of Business Development, Ireland at Apex Group.

Offering an instantly diversified portfolio and a reputation for long-term growth, ETFs have become a go-to product for investors looking to mitigate the highs and lows of the market. 

As such, the last 20 years have been characterized by significant growth for the ETF market, in Europe and globally. Total assets under management in ETFs globally reached $10trn in 2021, while the number of ETFs has grown from 276 in 2003 to almost 8600 in 2021.

The European ETF industry accounts for a significant portion of this market, worth €1.2trm  at the end of September 2021. 

So, the story of ETFs thus far in Europe and globally has been one of steady growth and increasing popularity. Even as recently as the beginning of 2022, a BBH survey noted that 71% of European investors expected to increase exposure to ETFs.

Eight months is a long-time in politics however, and an even longer-time in the economy. 

With much of Europe now falling into recession and interest rates heading north as inflation bites, pressure is piling up on the European ETF market.

The situation has been further compounded by the outbreak of conflict in Ukraine, something few would have priced in back in January. This has brought an extra dimension to an already difficult situation, with commodity and energy prices impacted across the continent - hitting businesses and consumers.  

The (re)balancing act

Alongside increasing pressure on commodities and energy, inflation busting interest rate rises are also likely to stymy tech and equity growth in coming months - sectors which have long been a go-to for ETF fund managers. 

As such, we can expect to see a rebalancing through the remainder of 2022 and into 2023, as fund managers swap out some of these suddenly higher-risk investments, for more traditional, and reliable investments. This isn't without challenge, however. With increased competition for fewer reliable investments in commodities, venture assets or unlisted opportunities, portfolio managers will have to work hard to build viable ETFs. 

Alongside changing economic circumstances, fund managers will also need to factor in changing consumer behaviour. As the economy contracts, risk averse investors will become far more discerning about where to invest than they have been over the last decade. Efforts by fund managers to pivot toward safer - but lower-yield - asset classes also present a challenge in a world of higher interest rates. 

While higher rates hit borrowers, they reward savers and the challenge for fund managers will be to demonstrate that low-yield ETFs - still subject to market fluctuations - are more attractive than more rewarding savings options. 

Riders of the storm

With a smaller basket of listed winners to back and a more discerning audience, manager selection will become ever more important for ETF success. After rapid growth in the ETF market since 2003, we are likely to see some arbitrage and consolidation, reflecting similar dynamics across the economy at large. 

To compete with higher-interest savings options, we will likely see more fund managers offering fixed return ETFs too. This will offer investors a means of building a portfolio in anticipation of economic recovery, while also hedging against short-term turbulence. The fund managers who get this balance right, will be the ones who successfully weather the economic storm. 

ETFs have traditionally been used by fund managers as a balanced hedge within a wider fund. Just as equity managers are re-balancing changing strategies, so mutual fund and UCITS managers will also be looking hard at their ETF exposure. There will be little room for error for ETF fund managers in this environment. 

Room for growth 

While circumstances will grow more difficult for ETFs as the economy continues to suffer, there is nevertheless still room for growth in Europe's ETF market. Managers will increasingly require the support of a trusted service provider with a progressive and flexible approach to help managers enhance their operating model, diminish risk and reduce costs while they concentrate on their ETF products.

European ETF trends tend to follow the successes of the more established US market strategies. The EU's single funds market via the UCITS and AIFM passporting regime has sought to create a unified investor market to equal the US. 

Similarly, regulatory and tax convergence across the EU would be a significant boon to the ETF market in Europe, in particular in jurisdictions where enhanced registration requirements apply such as Germany, Austria and France.

So, while the outlook is difficult, with the right management and a suitable regulatory framework, the European ETF market will remain attractive. The coming months, however, will see a separation of the wheat from the chaff, as the pressures of recession and war continue to grow. 

By John Bohan, head of business development, Ireland at Apex Group, at global financial services provider to over $3trn of assets.