In the early days, ETFs were typically linked to mainstream equity market benchmarks. Now the ETF market covers a wide range of indices covering all asset classes (fixed income, commodities, currencies as well as equity), structured strategies (short and leveraged), alternative weighting methodologies and more recently ‘active’ ETFs in the US. ETFs are becoming the product wrapper of choice for index innovation.
The growth in indices and index products such as ETFs, swaps and securitised products can be attributed to how fund managers are changing the way they run their portfolios. With the principle of the separation of ‘alpha’ and ‘beta’ widely accepted in the market, ETFs provide fund managers with the tools to access ‘beta’ in a convenient and cost efficient way. As well as providing the ‘beta’ exposure, ETFs can be used to reduce costs and better manage risk or as an access tool to gain exposure to new markets and asset classes. Rather than being solely stock pickers, fund managers are becoming ‘asset allocaters’ using their skills to time and choose the appropriate beta exposure.
Deutsche Bank recognised this trend towards beta investing and it was one of the factors that prompted the launch of db x-trackers ETFs platform in Jaunary 2007. The strategy with db x-trackers was to offer a comprehensive product range and provide the beta toolkit to access a wide variety of markets and asset classes. With over 80 products, the db x-trackers ETF range includes standard products on indices such as MSCI Emerging Markets, FTSE 100 and DJ Euro Stoxx 50, but there are also many “firsts” in the db x-trackers range. These were created through the development of new indices which could be used for ETFs and some examples are highlighted below.
ETFs on short indices
Although short or bear ETFs have previously been available in both Europe and US they did not tracking an official ‘short index’. Instead they tracked inverse performance of the ‘long’ index without any defined parameters. Working with index providers such as Deutsche Börse, Stoxx and S&P, db x-trackers has launched ETFs tracking official short indices. On a daily basis the short index provide the ‘inverse’ exposure to the long index with an adjustment to reflect the relevant overnight money market interest rate earned on both the initial investment and the proceeds from selling short the securities in the index. The cost of borrowing the securities is not included in the calculation as this is a variable factor and not consistent. The indices are calculated in real time providing the same transparency as the long index. The investment objective of the db x-trackers ETFs is to track such indices. These db x-trackers ETFs have proved popular with both retail and institutional investors who cannot use derivatives providing a convenient and easy way to hedge their portfolio or take a directional view (see figure 1).
ETFs on currency indices
During 2007, the research team at Deutsche Bank started a project to develop an investable currency benchmark or beta which culminated in the launch of the Deutsche Bank Currency Returns (DBCR) Index. The DBCR Index incorporates the three most widely used currency strategies – Carry, Momentum and Valuation. These strategies are linked to taking long and short positions on a basket of G10 currencies with regular rebalancings. An advantage of currency as an asset class is the low correlation with equities and bonds, which in the case of DBCR is 5 per cent and -21 per cent respectively. In February 2008, db x-trackers launched ETFs tracking the DBCR and the Carry, Momentum and Valuation strategies and thus providing fund managers with a means to diversification in their portfolios and access strategies traditionally found in hedge funds for much lower fees (see figure 2).
ETFs on money market indices
The db x-trackers Eonia ETF was launched in June 2007 and has become not just the fastest growing ETF but also the largest fixed income ETF in Europe. The concept behind this was very simple - to provide exposure to the Euro overnight market interest rate (EONIA – Euro Overnight Index Average). The ETF tracks this index with a very attractive all in fee of 0.15 per cent per annum. With the convenience and flexibility of ETFs combined with an attractive rate of return, money market ETF concept has proven to be an attractive alternative to traditional cash funds and deposits for both retail and institutional investors. As well as the Eonia money market ETF, the db x-trackers product range also includes ETFs tracking US Dollar and sterling money market rates (see figure 3).
Tracking indices
One of the reasons why Deutsche Bank (and some other ETF providers) can provide products linked to innovative index solutions is because of changes in the way ETFs can track indices. The way ETFs replicate the performance of the underlying index is becoming better and more flexible in terms of the types of asset classes that can be accessed.
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 or on alternative asset classes such as commodity, currencies or credit or structured strategies such as short or leveraged.
Developments under the Ucits regulations (Undertaking for Collective Investment in Transferable Securities) 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.
Firstly, the use of index swaps means that a wider variety of asset classes can be accessed. As long as the relevant index complies with the diversification, transparency and accessability criteria stipulated under Ucits then it should be possible to create an ETF linked to such as index.
Secondly, 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 (TERs).
To conclude, there has been a hand in hand development of indices and ETFs to satisfy investor appetite for beta products in general but also more product variety. Regulatory changes under Ucits has created an environment where it is possible to create products in line with index innovation.
This means that ETFs are the perfect vehicle to deliver index innovations and should ensure that they continue to grow in popularity.
