TCS Daily

Help for the Future

By Veronique de Rugy - June 17, 2003 12:00 AM

Europeans believe that the government will provide for their needs from the cradle to the grave. But this is only an illusion. Most European governments have huge unfunded liabilities, particularly for pensions. As such, it is imperative that individuals begin taking steps to secure their own retirement needs. This means more equity investment, something that is not nearly as common in Europe as it is in the US. Fortunately a relatively new financial device called an Exchange-Traded Fund is available that should appeal to the sophisticated and unsophisticated European investor alike.

The French Social Security system offers a prime example of the dilemma facing future European retirees. There is no saving, investing or accumulation of wealth in a pay-as-you-go system like France's. Under such an arrangement, benefits paid to today's elderly are financed by taxes imposed on today's young.

However, a fundamental shift in birth and life expectancy rates has drastically skewed the worker-to-retiree ratio - from 7 in 1945 to 1 as soon as 2005. At first, the French government responded by raising taxes on payroll. But even though taxes went up - and reached roughly 24 percent for a worker on the minimum wage - the system did not become more solvent or secure. As the worker-to-retiree ratio continues to drop, French workers will face more significant increases in taxes or substantial reductions in benefits, or both.

European workers need to realize that the government might not be able to provide for their old age and that they need to regain ownership and control over their retirement benefits by investing in the private capital market. To be sure, this idea of investing in the market to secure retirement income seems very counter-intuitive to most Europeans. Last year, a declining stock market only made matters worse.

It is true that the market is volatile, often painfully so. However, while it has ups and downs from year to year, it is essential to focus on the long run - particularly when considering how to build assets for retirement. According to the Private Enterprise Research Center at Texas A&M University, the US stock market provided an average annual real return of at least 6.4 percent after inflation over any 35-year period between 1872 and the present. This return easily beats the implicit return offered by Social Security systems. In other words, private investment enables people to enjoy a retirement income that is superior to anything that a government run system can offer.

What about inexperienced investors? Most people generally understand that diversification is crucial to wise investing. But for most individuals, the cost, time and effort associated with holding a diverse portfolio of stocks is extremely prohibitive. Most people would agree that this activity is best left to experts, but that begs the question of how to pick the right expert. This is no longer a problem, thanks to a relatively new financial tool called "Exchange-traded funds" (ETF).

ETF are both exchange-listed (like corporate equity securities) and open-ended (continuously offering shares like open-ended mutual funds). They provide instant diversification, like a mutual fund, by representing a portfolio of stocks designed to track one specific index. That makes them an ideal all-purpose investment for both novices and experienced investors. If you have ever wished you could buy every stock represented in a high profile indexes such as Nasdaq 100, S&P 500 or the Dow Jones STOXX without the cost of buying each stock represented in the index, you will love ETFs.

Initiated in the US and Canada as an attempt to make index-based mutual funds tradable, the ETF concept has been exported and adopted worldwide. ETFs have become particularly popular in the US where assets in ETFs rose 23.1 percent in 2002 alone. Exchanges around the world are now rushing to introduce products structured to accommodate the specific regulatory and structural requirements for distribution in their countries. For instance, in January Nasdaq - the world's largest electronic stock market - launched the Nasdaq 100 European tracker (trading under the symbol EQQQ). EQQQ is the first exchange-traded fund in Europe based on the Nasdaq's QQQ ETF.

Until now, a European investor who wanted to purchase such a security had to open an account in the US, hire a US broker, transfer his euros into dollars and wire the money to the US, then make a transaction at US hours for which he would only get a statement a month later. That aggravation is now ancient history since eQQQ is specifically structured for the European market. The fund is denominated in euros and designed to closely follow the Nasdaq 100 index (the 100 largest non-financial services firms listed on Nasdaq). As outlined by Tarek Robbiati, director of Lehman Brothers International (Europe), the fund "enhances our offer to our European customers of easy, low cost access to the Nasdaq-100 basket in Europe."

This is a major step forward for European investors who now have low cost access to some of the world's most desirable companies, including Microsoft, Dell, Starbucks, and Because eQQQ, which trades on Nasdaq Europe, follows the Nasdaq 100 index, it provides European investors with low cost access to the entire range of companies in the index on a European Market and at European hours.

Other ETFs are available to investors in Europe, too. In 2000, the first European ETFs were launched on the Deutsche Borse and began trading in Germany. Later that year, the London Stock Exchange created a trading platform for ETFs, called the extraMARK. The LSE then launched iFTSE 100 shortly followed by iFTSE TMT, an ETF tracking a basket of technology, media and telecom stocks, and the iFTSE ExUK an ETF investing in Europe's largest companies. In 2001, BGI introduced the England's first pan-European sector-based ETFs, such as iBloomberg European Pharmaceuticals or iBloomberg European Telecoms among others.

European workers deserve to accumulate wealth and secure retirement savings for their old age. The failing pension systems in Europe are very unlikely to deliver the benefits they promised. The only way out of this nightmare is to start investing in the stock market. Exchange-traded funds offer European workers and investors an exciting tool with which to do this effectively. Unless European workers are foolish enough to believe the governments' empty promises, they should seize this opportunity.

Veronique de Rugy is Policy Analyst at the Cato Institute.

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