Understanding the Evolving ETF Landscape: Insights from Franklin Templeton

The Evolution Driven by Regulation

Regulatory reforms, notably Mifid II in Europe, have been pivotal in transforming how ETFs are traded. While traditionally dominated by stock exchanges, Mifid II fostered competition by allowing alternative venues like Multilateral Trading Facilities (MTFs) to gain prominence. This has democratised access but led to a more fragmented market. Achieving 'best execution' now often involves complex algorithms navigating lit exchanges, dark pools, and MTFs to capture fair value.

Fixed Income: A Structural Shift

Unlike equity markets centered around major exchanges, bond trading has historically occurred in decentralised OTC markets. ETFs have disrupted this by listing bond portfolios on exchanges, bringing unprecedented transparency and price discovery to the fixed income asset class. This structural evolution was particularly highlighted during recent market stresses, where fixed income ETFs continued to trade and provide price signals even when the underlying bond market faced liquidity challenges. This success suggests ETFs will become increasingly mainstream for both passive and active fixed income strategies.

Contrasting Transatlantic Markets

The US remains the heavyweight champion of the ETF world, boasting the largest AUM and trading volumes, primarily conducted on exchanges. Europe, while having a similar number of ETF listings, operates differently, with a majority of trading happening OTC. Despite slower growth in 2024, the US market sees higher retail participation compared to Europe. However, Europe's ETF AUM grew significantly faster (33%) in 2024, indicating strong adoption trends.

Navigating ETF Trading

Investors and traders employ various strategies like NAV trading (transacting at the net asset value), risk trading (where a broker takes on the risk), and agency/algorithmic trading (using algorithms for best execution). Understanding the optimal time to trade, the specific objective, appropriate order types, and ensuring the ETF is trading near its fair value are crucial considerations. The flexibility to trade across exchanges, MTFs, or directly with brokers enhances the appeal of the ETF wrapper for diverse investment approaches.

How did Mifid II change ETF trading in Europe?

Mifid II increased competition by allowing alternative trading venues (MTFs) alongside exchanges. This led to more investor choice but also a more fragmented market structure, emphasizing the need for sophisticated execution strategies.

Why are Fixed Income ETFs considered significant?

They bring exchange-traded transparency and price discovery to the traditionally opaque OTC bond market, improving liquidity access, especially during market stress. This represents a structural evolution in fixed income trading.

What's the main difference between US and European ETF trading?

In the US, about 70% of ETF trading occurs on exchanges. In Europe, it's the reverse, with about 70% traded over-the-counter (OTC). The US also has significantly higher AUM and trading volume.

The ETF landscape continues its rapid expansion and evolution. Do you think fixed income ETFs will eventually overtake traditional bond trading methods? Let us know!

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