The future is bright for the exchange-traded fund (ETF) market in Europe, with nearly all the ETF issuers expecting healthy levels of annual growth over the next two years, according to a recent report.

The report, published by Cerulli Associates, points out that ETFs have gone from playing a minor, tactical role in European investors’ portfolios to standing strong as core building blocks, adding that their lower costs may be sustainable as part of long-term buy-and-hold strategies.

The fastest growth is likely in Switzerland and the UK, where 50% and 45% of survey respondents respectively expect the passive ETF market to expand at an annual rate greater than 10%.

Several factors are driving European investors’ increasing use of ETF products. More than one-third (35%) of the ETF issuers surveyed in Europe consider institutional investors’ increasing adoption of ETFs the major driver of ETF asset growth. A similar number (32%) see the increased availability of fixed-income ETFs and the use of ETFs by digital platforms as two of the other main drivers of ETF asset growth.

Perhaps unsurprisingly, interest in environmental, social, and governance (ESG) ETFs is also mounting among European investors. By the end of May 2020, European ESG ETF assets had reached 36.5 billion euros (US$41.0 billion), a 28% increase from the end of 2019. Furthermore, 57% of the ETF issuers surveyed identified the development of ESG ETF products as a top priority for their firms over the next two years.

“The European ETF market has become increasingly crowded in recent years, with new players arriving and incumbents broadening their product ranges,” says Fabrizio Zumbo, an associate director in Cerulli’s European asset and wealth management research practice. “Entering these markets with a standard value proposition may no longer be enough to attract flows from sophisticated investors. ETF issuers should develop specialized offerings with robust and diversified ESG value propositions, including active and smart beta products, to differentiate themselves.”

In addition, demand for thematic ETFs is increasing and so-called “mega trends” will help drive further growth in the European ETF market. The most popular themes are expected to be linked to water, biotech, and various other forms of technology.

“Several of the distributors we spoke to like thematic ETFs largely for their attached stories," Zumbo adds. "It is easier to gain investor buy-in for a product that has a clear narrative. ETF developers need to consider this when marketing their products to wholesalers.”

Fixed-income ETFs are also set to be in high demand over the next two years and will be at the core of ETF issuers’ product development efforts. They proved their resilience earlier this year, passing the so-called “liquidity test” under stressed market conditions, and investors’ comfort with such instruments has increased following the high level of volatility in the market during the first quarter of 2020, triggered by the Covid-19 pandemic.