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Comment: The potential of the European ETF market

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Manooj Mistry, head of equity ETF structuring at Deutsche Bank, outlines the factors that prompted the bank to enter the exchange-traded fund market earlier this year with its db x-tracker

Manooj Mistry, head of equity ETF structuring at Deutsche Bank, outlines the factors that prompted the bank to enter the exchange-traded fund market earlier this year with its db x-trackers range.

When Deutsche Bank launched its range of db x-trackers exchange-traded funds in January this year, many people asked why someone would want to enter the ETF market seven years after the launch of the first products in Europe. The answer was easy – the ETF market in Europe still has a long way to go fulfil its potential.

Although there are currently more than 360 products available and assets exceeding USD110bn, the ETF market in Europe is less than a quarter of the size of the market in the US, where ETFs have been available since 1993.

Many analysts predict that the ETF market in Europe is predicted to grow threefold over the next few years. This article attempts to outline the factors driving this growth and the reasons why Deutsche Bank has entered the market.

1. Institutional demand

ETFs assets account for less than 1 per cent of the total assets under management in Europe. This is very much just the tip of the iceberg and the demand for ETFs will continue to grow from institutional investors such as pension funds, insurance companies and fund of funds.

Regulatory changes such as Ucits III now allow institutional investors to have greater flexibility to use ETFs. Under the old regime, the maximum allocation to ETFs in total was limited to 5 per cent of the portfolio but now it is possible to have up to 100 per cent allocated to ETFs. In addition ETFs provide institutional investors with a means to gain access to new markets, such as emerging markets, or asset classes for instance commodities or credit, which may be difficult for them to access easily.

Although Ucits III has made it possible for traditional long-only funds to use derivatives as part of their investment policy, many still lack the back office infrastructure and knowledge to take advantage. ETFs are regulated funds that trade on recognised stock exchanges that can be bought or sold without the need for any of the documentation or the need to maintain margin or collateral accounts associated with the use of derivatives. In addition ETFs are a viable alternative for investors who cannot use derivatives in their portfolios regulatory or internal reasons.

With increasing emphasis on pension provision in both the developed and developing economies, the demand for passive products such as ETFs will increase. ETFs provide the ideal long-term low cost investment for pension funds.

2. Retail demand

The retail market for ETFs in Europe is still undeveloped and presents another area of growth. In the US the retail market accounted for around 50 per cent of new inflows into ETFs in 2006. In Europe, the figure is estimated to be around 20 per cent.

Traditionally investment products such as funds and structured products have been sold on a commission basis in Europe by independent financial advisors, who are compensated by the product provider. As ETFs have a low fee structure, it is not feasible to pay commissions, and hence to date ETFs have not been embraced by IFA community.

However, with more regulatory scrutiny and accountability being placed on advisors, ETFs can benefit. Increasingly there is a trend toward fee-based advice, where advisors charge a fee to their clients rather receiving commissions. This is advantageous for the growth of ETFs, whose low-cost structure makes them an ideal product to include as part of an investment portfolio.

Once again taking the lead from the US, the inclusion of ETFs in savings or investment plans is another area that will contribute to the growth of ETFs. Although there are some funds of ETFs or savings products already available in Europe, it is not on the same scale as in the US. Furthermore, ETFs should be eligible for inclusion in investment products such as Isas and Sipps in the UK and PEAs in France, where they can be used as part of the core investment.

With ETFs listed on 18 stock exchanges in Europe and 41 globally, and more new product providers announcing that they will enter the ETF market, there is a momentum for new asset inflows and the market to grow further.

3. Winds of change

The asset management industry has probably seen more change in the past few years than in the previous two decades. The investment emphasis has shifted from return versus risk to benefit versus cost. It is now generally accepted that passive instruments such as ETFs have a role to play in portfolios allowing managers to reduce costs and enhance returns.

However rather than using ETFs as a part of the core in a core satellite asset allocation strategy, they can also be used as part of a portable beta strategy. As traditional active fund management becomes more commoditised, the search for alpha is becoming more difficult and pure uncorrelated alpha is becoming scarce.

So instead the beta component of a portfolio can be actively managed to generate alpha. ETFs provide the perfect tool kit of beta products to do this. The variety of ETFs now available enables fund managers to use their asset allocation skills to generate alpha in their portfolios.

Portable beta strategies are a better alternative to portable alpha strategies as they are cheaper to implement, more transparent and scalable. Pure alpha is not scalable without subjecting the portfolio to higher risks.

4. More product choice

The first ETFs were plain beta products linked to mainstream benchmarks, but now they are expanding to encompass almost all markets, including emerging markets, and asset classes, such as fixed income, credit and commodities. ETFs have been at the forefront of the emergence of alternative indices such as fundamentally weighted strategies.

Products such as the db x-trackers DJ Euro Stoxx 50 Short ETF provide exposure to the inverse performance of the long index on an intraday basis. Investor that are not able to use derivatives to hedge their portfolio or position themselves in falling market have now an ideal instrument which is a fund rather than a derivative.

With more than 1,000 ETFs available globally there is more product choice compared to other traded synthetic index products such as futures, where there are fewer than 100 products available.

The universe of ETFs provides fund manager with a broad variety of underlyings to use in the asset allocation decisions and can allow them to undertake portable beta type strategies.

5. More efficient index tracking

The way ETFs replicate the performance of the underlying index is becoming better. The traditional structure for ETFs has been to replicate the index performance through owning all or a representative sample of the underlying benchmark. This method has worked well for indices such as the FTSE or the Dax, where there are a small number of liquid constituents.

However, this approach is not necessarily the most efficient solution for broad indices such as the MSCI World with 1,900 index constituents, or less liquid indices such as those on small or mid-cap stocks or emerging markets.

Also, the way indices are designed means they do not always reflect what is happening in the real world. Even if full replication was possible there are other factors which cause the tracking error from the benchmark performance. The timing of dividend payments is a major source of tracking error. Many total return indices work on the assumption that dividends are paid and reinvested as soon as the stock goes ex-dividend. For example, the average time between the ex-dividend and payment date is 22 days for US stocks and 74 days for Japanese stocks. This time lag in the payment can cause a drag on the performance, especially in a rising market.

Index turnover for periodic rebalancings and corporate actions can have an impact in terms of transaction costs and market impact.

Developments under Ucits III has resulted in the emergence of swap-based ETFs, which can utilise index swaps to replicate the index performance. Swap-based ETFs provide a more efficient solution and are designed to overcome the disadvantages of direct replication. The use of the index swap ensures that the ETF will receive the exact index performance before any management fees. The risk, costs and responsibility of tracking the index performance are effectively passed on to the provider of the index swap. From the ETF and ETF investor perspective, they will receive the precise index returns and not be impacted by the drags on performance. The only tracking error in performance should result from the impact of the annual fees/total expense ratios.

The tracking error performance can be off set or completely eliminated through enhancements achieved from lending revenues and tax-efficient treatment of dividends. For example, the db x-trackers DJ Euro Stoxx 50 ETF showed an outperformance of 0.52 per cent after management fees of 0.15 per cent versus the benchmark for the period between January and July 31 this year.

Conclusion

The fund management industry is changing. The differences between traditional long-only and hedge funds are increasingly becoming blurred and everyone is competing in the same middle ground to deliver alpha.

ETFs helped to establish indexing and passive investment as part of the mainstream but they can now make a contribution to active fund management. In an increasingly competitive environment, ETFs have the perfect features and characteristics to take active management to the next level.  As well as the breadth of ETF products available, the products themselves are becoming more efficient in delivering performance. This makes them more and more attractive to both institutional and retail investors.

Therefore, the dynamics are in place to drive the growth of ETFs in Europe over the next few years and provide the justifications for Deutsche Bank to enter the market and contribute to its success. With a product portfolio of 49 ETFs and more to come this year, the db x-trackers ETFs and Deutsche Bank are establishing themselves as one of the leading ETF providers in Europe.

The opinions or recommendations expressed in this article are those of the author and are not representative of Deutsche Bank as a whole.

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