Deutsche Bank believes that its db x-trackers range of exchange-traded funds (ETFs), listed on the London Stock Exchange this month, provides a wealth of opportunity for many types of investor
In the midst of one of the worst periods of market volatility in recent times, now might not seem the best moment to bring a range of index tracking funds to a British audience. But Deutsche Bank believes that its db x-trackers range of exchange-traded funds (ETFs), listed on the London Stock Exchange this month, provides a wealth of opportunity for many types of investor.
"We'd see it as an opportunity rather than a disadvantage," says Manooj Mistry, head of db x-trackers ETFs UK at Deutsche Bank, of the timing of the launch. "The first ETFs in Europe were launched in 2000, around the time of the dotcom crash, and they proved quite resilient - they survived and became established. It's definitely an opportunity. What you will see as the range of products increases is more and more opportunities to find a different strategy or gain diversification."
Deutsche Bank entered the ETF market with the launch of the db x-trackers in Germany in January this year. "Although we are a relatively new product issuer, we have a lot of experience of the ETF market," says Mistry. "We have been a market-maker for ETFs for a number of years and provide full research coverage. So we have not come in from the cold to launch these products - we have spent time assessing the market and analysing the competition."
In Germany, the January launch consisted of eight products, with another 41 listed in Frankfurt in July. "We started with the basic approach, covering indices such as the EuroStoxx 50, the Dax and the MSCI US, Japan and World indices," says Mistry. "With the later tranche we branched out into new markets - we have nine emerging markets ETFs, both country and regional; sector ETFs; the FTSE 100, 250 and All-Share - and also into other asset classes. We have 14 ETFs tracking fixed interest indices, mainly European sovereigns; a money market index and three ETFs tracking credit default swaps, as well as one following a commodity index. There are 49 products in total, tracking indices at global, market and asset class level. We have taken subsets of the Frankfurt range and listed them on different exchanges in Europe - we also have listings in Switzerland and Italy."
The London launch
Deutsche Bank has brought 18 equity ETFs to list in London, and sees these as the first of many London-listed offerings. These first 18 offer global exposure to developed and emerging markets (all nine of the emerging markets ETFs available in Germany are now also available in London), as well as the FTSE indices, the MSCI World, Japan, US and Europe and dividend strategies tracking specially constructed European and global indices. Subject to regulatory approval, the bank hopes to bring the rest of the Frankfurt-listed range to London too.
"From a UK investor's perspective, we have a good choice in terms of equity markets - UK, European, international and emerging - so there should be enough of a range for them to get familiarised with the db x-trackers," says Mistry.
Who are ETFs for?
When retail index-tracking funds first appeared in the UK market in the 1990s, they were aimed very much at a mass-market audience. But with tracking gaining currency in the institutional market too, Mistry says the db x-trackers will appeal to a wide range of investors.
"The good thing with ETFs is that they are truly democratic - they are the same instrument for you or me as for a big institution," he explains. "Our target is a mixture of both. In terms of the institutional market, institutions see ETFs as a good investment tool. There are multiple uses of ETFs for institutional investment managers, from short-term trading tools to long-term investments. They can be used by discretionary managers, private banks, pension funds, insurance funds, funds of funds, tactical asset allocators - there is a wide range of applications for ETFs, and most institutions can use them. On the retail side we are looking at the self-directed, sophisticated investor who probably already has an online brokerage account and is familiar with equity investing, who can see that ETFs are a good-value, efficient investment tool."
With ETFs eligible for inclusion in Isas and Sipps, and with funds of ETFs now available, Mistry says it is only a matter of time before retail investors catch on to ETFs in a big way. "In terms of the retail market, ETFs were established in the US in 1993, and by 2006 50% of new ETF assets were coming from retail investors. In Europe that figure is still less than 15%, so while it is a much less developed market, there is lots of potential for growth," he says. "As more providers come into the market, awareness and choice of ETFs will increase, driving the growth of the market for retail investors."
The reason ETFs are set to become part of the investing mainstream, says Mistry, is that they are the most efficient way for most investors to gain index exposure. "There are alternatives, but ETFs are the best all round products: they are low-cost, they track their benchmark indices efficiently, they are tradable on an exchange with no additional documentation or infrastructure required, and, where institutions could trade derivatives but do not have the necessary experience, ETFs are a good alternative. They can be used by institutions to reduce costs and manage the risk profiles of their portfolios. They are a very flexible investment tool that can cater to specific requirements or objectives."
How the db x-trackers work
In terms of how you can track an index, there are three ways. The first is full replication, where you buy all the stocks in an index and rebalance your portfolio whenever the index changes. The second way is sampling, where instead of buying, say, all 100 stocks in the FTSE 100, you might hold 80, and try to minimise tracking error. The third - and probably the most efficient - way is to use index swaps, with which you can eliminate sources of tracking error. This is the model that Deutsche Bank has chosen for the db x-trackers range. "Full replication is OK for a liquid, blue-chip index like the FTSE 100 or the S&P 500 - it is easy to track such indices," says Mistry. "But more illiquid or diverse indices, such as mid and small-cap indices or emerging markets, can give rise to issues with tracking error at times of rebalancing and so on, where the fund manager might not be able to buy the stocks he needs to replicate the index fully. Index swaps eliminate that tracking error - the fund gets the performance of the index. The only source of tracking error is the management fee; problems with dividends and turnover costs are eliminated, and that gives performance in line with the index.
"For the db x-trackers, we chose index swaps as we believe they are the best way to deliver the most efficient performance. Since we launched our first products in January we have shown superior performance in terms of low tracking error, and in some cases we have even offset our management fees with slight positive performance."
Most of the products in the db x-trackers range track pre-existing indices, giving investors exposure to familiar indices with the benefits of low cost and low tracking error. There are also more innovative products to meet particular needs. Two of the products in the range available in London track unique indices - one is the Global Dividend Strategy, where Deutsche Bank worked together with Dow Jones Stoxx to create a global benchmark weighted by dividend yield, not market capitalisation. There is also a European dividend yield strategy. In Germany, there are a couple of other funds that have been developed with index providers. Mistry explains: "A couple are short indices tracking reverse index performance - so if the main index goes down 1%, the ETF goes up 1% and vice versa. We worked with Dow Jones Stoxx and Deutsche Boerse to develop these. As the range develops, we will see more niche offers in conjunction with major index providers."
Building a portfolio with ETFs
For most investors, the search for alpha - or outperformance of the market - is a key part of their strategy, and building a portfolio entirely out of index-tracking funds might seem at odds with this. But done correctly, says Mistry, it is possible to outperform with a portfolio built of ETFs.
"If you look at the core/satellite approach, you might typically use passive funds such as ETFs for the core, while the satellites might be stocks, funds or other ETFs, which you actively manage to produce performance. You can do that wholly with ETFs," he says.
"With the increase in research coverage, the search for alpha is more difficult, as alpha is limited in availability. Many analysts are now saying you can actively manage ETFs to generate alpha through a phenomenon known as 'portable beta'. For instance, if you think small-caps will do better than large-caps, or emerging markets will outperform developed markets, you could overweight these areas using ETFs. Or you could use ETFs tracking dividend strategies or alternative strategies to generate outperformance. This is portable beta, and we will see it developing more and more over time."
A lack of enthusiasm in some areas of the intermediary market has so far meant ETFs are not as widely used as they might be. But Mistry is confident this will change, particularly if the FSA succeeds in its aim to move financial advice purely on to a fee basis.
"I don't think a lot of IFAs fully appreciate the benefits of ETFs," he says. "Unlike open-ended funds where IFAs can get commission, there is no scope for ETFs to pay commission as they are designed to be low-cost, so advisers are probably not so incentivised to recommend them. But the development in terms of moving towards fee-based advice will suit ETFs, and, as more advisers move towards that model, it will drive the growth of ETFs."
This is happening across Europe as advice moves increasingly to a fee-based model, says Mistry. Furthermore, as the market for ETFs grows, there will be more of a requirement for the likes of the London Stock Exchange to educate consumers about ETFs, which in turn should drive growth even further.
The future for ETFs
So far, the British ETF market has been dominated by the iShares products offered by Barclays Global Investors. But, says Mistry, the market is going to grow and there is room for other participants than iShares. "We want to establish ourselves as one of the leading providers of ETFs in Europe and gain a reputation for offering low fees, more efficient tracking and easily tradable funds, as well as bringing different ideas and solutions to market, not just 'me too' products," he explains.
"We will continue to expand the product range. We hope to bring some more of the products we already have listed in Frankfurt to the UK - which will bring in fixed interest and commodities - and we will continue to expand the range to offer coverage of markets we do not currently have."
The plan is to bring products continually to the UK as they come out in Germany, though regulatory requirements may mean a slight delay in some cases. As more of these products come on-stream, investors will have even more ways to cope with the volatile times we are experiencing.
"You should be able to use ETFs to take advantage of falling markets," says Mistry. "For example, in the German launch of our short index ETFs in July, we have seen a lot of trading in the volatile market. Our money market ETF that tracks Eonia, a European equivalent of Libor, has raised E500m of assets within two months. By offering a whole range of products, people will find something in our range that suits their needs. We are offering a wide range of investment solutions and ideas and we hope investors can take advantage of them."
