By Kit Rees
LONDON, Feb 10 (Reuters) - European investors are piling into exchange-traded funds, favouring those that mimic active fund managers, in a market where traditional trading relationships between assets are breaking down.
Investment in ETFs, securities which track an index or basket of assets, rose to more than half a trillion euros at the end of last year, a record. A combination of low costs and flexibility kept investors hooked even though this break-down of so-called correlations should favour actively-managed mutual funds.
For fund managers, who have had to deal with risk-on, risk-off central bank-dominated markets since 2009, a return to fundamentals since mid-2016 as stocks increasingly move independently of each other is a welcome departure.
However, rather than a rush of money into mutual funds, flows into ETFs have held firm, Thomson Reuters Lipper data shows.
High fees coupled with persistent underperformance at traditional funds and a nimbler set of low-cost ETF offerings that slice and dice markets to mirror some of the traits of "active" fund management, are among the main reasons that cost-conscious asset-allocators remain hooked, market participants say.
Some of last year's most popular European ETFs included those that target stocks trading at below-average valuations, some that pick stocks with minimal intra-day price swings and others that offer currency hedges and can protect investors from seeing stock gains wiped out by currency volatility.
Since most of these decisions are made automatically by algorithms, index providers and ETFs can offer these features to investors at much lower costs than the traditional fund management industry.
A typical European equity ETF's fee margins are half those of traditional fund management groups at around 29 basis points, according to Goldman Sachs analysis.
"We try and create a diversified portfolio but spread our risk right across the globe and right across different asset classes. And the most cost-effective way of doing that is through index funds," Justin Onuekwusi, multi-asset fund manager at Legal & General Investment Management, said.
So far this year investors have pumped about $35 billion into global equities according to latest data from Bank of America Merrill Lynch. However, that is largely due to more than $50 billion via ETFs while traditional funds have seen $17.5 billion pulled out.
COUNTRY RISK
The rally in equity markets since last summer has favoured banks, resources and industrial stocks at the expense of telecoms, healthcare and utilities leading to wide variation in returns between sectors.
In Europe, where political risk has increasingly become a dominant theme in the past year, different countries, currencies and politics provide more scope for discerning investors to take advantage of markets overshooting one way or the other.
Goldman Sachs says "country risk" has picked up again and could increase further ahead of elections and if concerns resurface over the European Central Bank cutting back on its bond-buying programme.
Since the introduction of the euro, taking a view on sectors rather than countries has been more important in Europe, Goldman says, apart from brief periods of the euro zone sovereign debt crisis when lines were drawn between the periphery and the core.
With a busy election year ahead as well as uncertainty over the UK's Brexit negotiations, country risk could become a factor again and should benefit discerning investors over broad index investing.
However, European ETFs that give investors exposure to countries, sectors and other specialized investment styles is proving alluring.
Lipper data shows that ETFs focused on Germany, Spain, Europe excluding the UK have been among the most popular among investors seeking to pump money into Europe but avoid the pitfalls of investing too broadly.
Andrew Herberts, head of private client investment management (UK) at Thomas Miller Investment, said his firm has started to go a little more into individual countries in Europe, and has moved into a tracker for Germany's DAX index over the last month.
"If we've done the work, and we like Germany for a variety of reasons, why should we be hostage to what an active manager thinks?" Herberts said, adding that they were taking money out of a euro zone tracker and moving it into a DAX tracker over the past month or so.
"It can mean that you can be much more precise in how you target particular areas," Herberts said.
Other popular offerings such as ETFs focused on low-volatility stocks, dividends or those with inbuilt currency hedges have also seen popularity soar.
A lot of an active manager's outperformance or underperformance over time can be explained by "style biases," or mandates, under which the fund operates, such as value, growth or income, Legal & General Investment Management's Onuekwusi said.
"A number of smart beta strategies can effectively emulate - or basically copy - those style biases. So it gives you those style biases ... in a more cost-effective way."
(Editing by Vikram Subhedar and Toby Chopra)