Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Europe's ETF Boom Hides a Liquidity Risk
Transcript
- Lucas: European equity ETFs have had an incredible run. Just look at the VGK — the Vanguard FTSE Europe ETF — it's up over three percent in the last five days alone. And the iShares MSCI Eurozone ETF, ticker E-Z-U, has gained more than four percent. Luna: It's not just the rally that's striking — it's the velocity. Those are big moves for broad-market funds. Lucas: Right. And it reflects a broader story: European equities are back in vogue. The euro is weakening, which helps exporters, and the ECB is signalling it will keep tightening until inflation is under control. But there's a structural shift happening beneath these flows that I think is worth drilling into. Luna: What do you mean? Lucas: I'm talking about liquidity. Specifically, the liquidity of the underlying stocks that these ETFs hold. As more and more money pours into passive funds, a larger share of the free float gets locked up in ETF creation units. That means fewer shares are actually available to trade on the open market. Luna: So when everyone piles into the same ETFs, the underlying stocks become harder to trade in size without moving the price? Lucas: Exactly. And this isn't just a theoretical concern. A study from the Bank for International Settlements last year found that in markets where ETF ownership exceeds a certain threshold — around 15 percent of free float — the liquidity of the individual stocks actually deteriorates. The correlation between ETF flows and stock-level volatility increases. Luna: And Europe is particularly exposed here, isn't it? Because the free float in many European companies is already smaller than in the US. Lucas: That's the key point. In the US, the free float as a percentage of market cap is typically around 85 to 90 percent. In Europe, it's closer to 70 percent. Many companies have large blockholders — families, governments, other corporations — so the pool of shares available to trade is thinner to begin with. Luna: And ETFs are now hoovering up a growing slice of that thinner pool. So the marginal impact is bigger. Lucas: Precisely. And here's the specific number that caught my eye: the total assets under management in European equity ETFs has grown by about 18 percent year-over-year as of this past quarter. Meanwhile, the number of listed companies in Europe is actually shrinking. There have been more delistings than IPOs for three years running. So you have more ETF dollars chasing fewer stocks. Luna: That sounds like a recipe for higher correlation. Everything moves together because everyone owns the same basket. Lucas: Yeah. And that can amplify moves in both directions. When sentiment is positive, as it is now, the inflows push prices up faster. But if sentiment turns, the outflows could be equally violent. And the ETF structure itself could amplify that — because authorized participants, the market makers who create and redeem ETF shares, they have to buy and sell the underlying basket. In stressed markets, they may widen their spreads or step back entirely. Luna: Which is what we saw in March 2020, briefly, in US Treasury ETFs. The spreads blew out because the underlying bonds became illiquid. Lucas: Exactly. And the ECB has stepped in with liquidity facilities in the past — but those are designed for sovereign bonds, not equities. So if we get a sudden reversal in European equities, the ETF market could amplify the downside in ways that the official sector isn't fully prepared for. Luna: Let's talk about what listeners can actually look for. What are the warning signs? Lucas: One metric is the premium or discount of the ETF relative to its net asset value. During calm markets, ETF prices track NAV closely. But if you see persistent discounts or premiums widening beyond a few basis points, that's a signal that liquidity in the underlying basket is strained. Luna: And that can happen even when the headline index is calm. Lucas: Right. Another thing to watch is the bid-ask spread on the ETF itself. If the spread widens significantly, it means authorized participants are getting nervous about their ability to hedge. And ultimately, that's where the vulnerability lies — in the plumbing, not the direction. Luna: So the rally we're seeing in VGK and EZU right now — it's not necessarily a signal of deep market health, just strong flows? Lucas: I think that's a fair reading. The underlying economic data is mixed. Real GDP growth in the eurozone has picked up to about two percent annualized, which is decent, but the inflation picture remains sticky. The ECB's own data showed core inflation still above three percent in April. So you have this tension: strong ETF inflows pushing prices higher, while fundamentals suggest a more cautious outlook. Luna: And if you're a retail investor looking at European ETFs, what should you do with this information? Lucas: I think the key takeaway is: don't assume that liquidity in the ETF equals liquidity in the market. If you're investing for the long term, that's probably fine. But if you're trading these ETFs, or using them for tactical allocation, be aware that in a stress scenario, your ability to exit quickly might not be as seamless as it appears. Luna: It's a paradox — the very tool that gave millions of investors access to European equities might also be the channel through which a correction hits hardest. Lucas: Yeah. And that's worth keeping in mind, especially when the market feels as good as it does right now.