Introduction

There has been a particular excitement about exchange traded funds (“ETFs”) for the past 12 to 18 months following their excellent performance in maintaining and gathering new assets during the volatile financial markets of 2008 and 2009.

Since 1999, ETFs have been domiciled in Ireland and during this time we have seen the range and sophistication of the Irish domiciled ETF offering grow exponentially.  Today, ETFs domiciled in Ireland have assets under management in excess of €44 billion. This exposure to ETFs has given both Irish service providers and the Irish Financial Regulator considerable experience of the ETF product and this expertise has helped Ireland to move to the forefront of European domiciles for ETFs.

The question is, what has made Ireland so successful in attracting ETF providers and maintaining its position at the cutting edge of ETF product development?  To answer this question, one needs to firstly assess the history and evolving nature of ETF products.

The Past

Traditionally, ETFs tracked large, well known equity indices and provided investors with a return that closely matched the return of the relevant index. They achieved this by holding the constituents of the index in the same weightings as the index.

The traditional ETF product range expanded over time and now covers a whole myriad of both bond and equity indices. These include country (e.g. Canada, Brazil, Taiwan), region (e.g. North America, Europe) and sector (e.g. European property, timber and forestry, emerging markets infrastructure) specific indices.

The Present

The second phase of ETF products focused largely on tracking indices by synthetically replicating the index performance through the use of total return swaps (“TRS”). Synthetic ETFs aim to carry a lower tracking error (i.e. the difference between the performance of the index and the ETF) than traditional ETFs as synthetic ETFs generate the actual performance of the relevant index without incurring the trading costs associated with buying and selling the constituents of the index.

While the use of TRS by synthetic ETFs is now well established, the swap operating model used can vary greatly between synthetic ETF providers. A number of unique swap operating models have been developed which are tailored to suit the needs of each individual synthetic ETF provider.

Any discussion concerning the future of ETFs generally cannot escape without addressing the possibilities for active ETFs.

Although active ETFs have been established in the United States and in Canada and are gaining some market traction, thus far there has been little movement to bring this product type to the European market. The reasons for this are probably twofold: (i) the difficulty in bridging the gap between the transparency of ETF portfolio information versus the sensitive nature of an active funds’ portfolio information; and (ii) identifying a market demand for active ETFs. For example, the principal advantage which an active ETF would have over a regular active mutual fund would be the ability to trade the active ETF intra-day. However, is intra-day trading really necessary for active funds where shareholders are expected to commit to the product for the medium to long term? If the issues of portfolio transparency and market demand are overcome, investors can expect to see active ETFs really take off.

ETFs which track single commodity indices are another possibility provided operational and diversification challenges can be overcome. Leveraged ETFs, inverse ETFs and inversed leveraged ETFs have already been established in Ireland and further refinements and developments to these product types are also likely.

Ireland’s ETF Experience

ETFs are a product type that contain a number of unique and complex features. The experience which Irish service providers and the Irish Financial Regulator have gained during the eleven years that ETFs have been established in Ireland has built up an invaluable knowledge base of the specific requirements in establishing a successful ETF platform. For example, the fact that we have seen a number of different swap models utilised in Irish domiciled synthetic ETFs gives Irish service providers a unique understanding and expertise in synthetic ETF products and allows them to match synthetic ETF providers’ needs with appropriate and effective solutions.

By choosing to establish their ETF product in Ireland, new entrants to the ETF arena can tap into this pool of knowledge. They can benefit from working with Irish service providers who know the ETF product, who understand what their clients are trying to achieve and who add value in the product design and structuring stage. In addition, choosing Ireland means that an ETF provider will be working with a regulator that has a significant base of knowledge and that is open to considering new and novel product features. For ETF providers, this adds up to (i) a shorter time to market; and (ii) smoother operations during the lifetime of the ETF with less likelihood of experiencing the operational errors that can occur when using an inexperienced service provider.

Given the complexities and specific requirements of ETFs that are not found in regular mutual fund products, it makes good sense for ETF providers to choose a domicile populated by experienced and expert service providers. For the European ETF marketplace, the domicile to choose is Ireland.