Why Passive Is Massive - And Growing

[This article is sponsored by Deutsche Asset & Wealth Management and first appeared in the June issue of ETF Report UK. To read the full issue and subscribe click here]

The passive investment market is growing exponentially. Roger Bootz, Deutsche Asset & Wealth Management's head of public distribution for passive investment products, discusses current key themes and trends in the exchange traded fund (ETF) market.

ETF Report UK: We all know that assets invested in ETFs are growing substantially, but what are the major investment themes we're likely to see ETF investors interested in over the rest of 2015?

Roger Bootz: An important theme this year will be currency hedged ETFs. Recent volatility in the US dollar, Japanese yen, euro and Swiss franc has reminded investors of the potential risks associated with exposure to foreign currencies. For example, between July 2012 and December 2013 the Japanese yen fell from 96.12 against the euro to 144.82, a near 34% loss for euro based holders of yen. 

We're spending a lot of time explaining to investors the currency risk element inherent to investing in international equities and bonds, and then showing how this can be mitigated with a currency hedged ETF. Many of our ETFs have currency hedged share classes. Our db x-trackers Japan Index UCITS ETF (DR) for example has US dollar, euro and GBP hedged share classes.

Another important theme is what investments are popular given the continuing low interest rate environment. Here we find investors interested in higher yield bond ETFs, such as the db x-trackers iBoxx EUR High Yield Bond UCITS ETF and db x-trackers iBoxx EUR High Yield Bond 1-3 UCITS ETF, both of which launched in January and provide exposure to euro denominated high yield corporate debt. Assets under management in bond ETFs listed in Europe grew by just over 40% in 2014, so the fixed income ETF market is really growing.

ETF Report UK: What trends do you see in the 'smart beta' space?

Bootz: What's commonly called 'smart beta' we refer to as 'strategic beta,' which is alternative ways to take beta exposure— i.e. tracking indices that are not market capitalisation weighted. 

To this end we have a range of equity factor ETFs providing exposure to value, quality, momentum and low beta. These can be used as building blocks for factor-weighted portfolios. 

Although it's not common practice at the moment, we expect in the future financial advisers will increasingly build factor based model portfolios for their clients. This is an area where advisers can really add value through their expertise, so it is worth learning what factor based investing is and how it can be implemented using ETFs. 

We also offer some very straightforward alternatively weighted ETFs, such as an ETF tracking an equally weighted version of the S&P 500, which is popular, and dividend weighted ETFs. 

I expect we'll see more fixed income strategic beta ETFs come to market this year, providing exposure to fundamentally weighted fixed income indices.

ETF Report UK: What distribution challenges do you face in the European market?

Bootz: Unlike the US ETF market, the European market is split across multiple exchanges, with differences also in distribution across countries. It's important therefore to be a large ETF provider operating on all the major European exchanges, and with good connections to advisers and platforms in different countries. 

One challenge for all ETF providers is to work with the major platforms to ensure ETFs are available to investors via platforms. It's also important for us to support the adviser community through education and general engagement. That's part of the distribution mission.

ETF Report UK: Where are we with the impact of RDR and equivalents?

Bootz: There was talk of the UK's retail distribution review and its European equivalents being overnight game changers. We never thought that would be the case. Creating that level playing field is of course important, but that's just the start of a process of putting ETFs on a par with other investments, such as regular mutual funds. There is still a lot of education required and effort to make retail investors in particular aware of the benefits of using ETFs. 

MiFID II [Markets in Financial Instruments Directive] is also an important development in terms of creating that level playing field. The benefits of these changes will come through in stages in the coming years.

ETF Report UK: Are asset managers using ETFs more as access tools?

Bootz: They are. More asset managers are now using ETFs for asset allocation purposes, both for short term tactical positioning and also for long term strategic, buy and hold investing. We introduced a range of Core ETFs last year providing exposure to major equity market benchmarks with annual all-in fees starting at 0.07% per annum. These are proving popular for the core, strategic investments. 

We also find asset managers using our ETFs for access to markets that are traditionally difficult to reach. Our London-listed db x-trackers Harvest CSI300 Index UCITS ETF (DR) for instance provides exposure to China's domestic A shares equity market. That's used by asset managers who see it as an easy to use access tool for an important market that's not traditionally been readily accessible to international investors.

ETF Report UK: What will it take to get European retail investors as interested in ETFs as those in the US?

Bootz: Retail investors are estimated to account for around 15% of European ETF assets under management. In the US the market is far more retail oriented, with around 50% or more of assets under management in ETFs held by retail investors. On one level that means the scope for retail growth in Europe is tremendous, but it also means we have to work out why retail investors in Europe aren't as engaged with the ETF market as their US equivalents. 

That means putting effort and investment into education and engagement so investors can see the benefits that ETFs can potentially bring in terms of efficient market exposure, transparent and straightforward products and so on. One direct way to increase engagement is to offer ETFs as part of regular savings plans. In Germany we've engaged with brokers to ensure that ETFs are available in this respect.

It is clear though that not only is the European ETF market set to grow substantially in coming years but that more retail investors will start to use ETFs either directly or indirectly via the services provided by their advisers. 

An important trend that's more prevalent in the US but is being adopted in Europe, and that we and the adviser community here in Europe need to recognise, is the rise of the so-called robo adviser—computer driven automated systems that create portfolios for investors often using ETFs as building blocks. I saw some research recently that estimates that by the end of this year global assets under management of robo adviser services will reach $20 billion, globally, while it's estimated that assets under management of robo advisers could grow to $450 billion by 2020. Europe's robo adviser market is maybe two years behind the US in terms of development, but it's also going to grow fast. The European market is currently estimated at around $3 billion but is predicted to grow to over $100 billion by 2020. 

Clearly, that's potentially a big game changer for advisers in Europe.

ETF Report UK: What makes an ETF provider successful?

Bootz: First you need to have a good range of products that are competitive in terms of all-in fees and trading costs. We have an extensive range of ETFs covering all asset classes. 

When investors think of ETFs they tend to think of equity index products, but ETFs are a good way to get fixed income and broad commodity exposure too. And for single commodities like gold or oil we have a range of exchange traded commodities. Other ways to stand out are making your products as transparent as possible. db x-trackers ETF details, like underlying portfolio holdings and weightings etc., are all updated daily online and are free for anyone to see.

ETF Report UK: What products has Deutsche AWM launched recently that IFAs might be especially interested in?

Bootz: We've launched a number of interesting new ETFs over the last 12 months. In April we launched an ETF tracking the JPX-Nikkei 400 Index of Japanese stocks. That's a popular index as it's not simply capitalisation weighted but selects stocks based on quantitative and qualitative screening. It's listed on the LSE as a GBP hedged share class. In February meanwhile we launched Europe's first ETF to provide exposure to Gulf Cooperation Council country equity markets, including Saudi Arabia. That's an important addition to the emerging market space. An interesting new launch from last year is our ETF offering exposure to Germany's Mittelstand and Midcap sector, which is listed on the LSE.

Roger Bootz is head of public distribution for passive investment products at Deutsche Asset & Wealth Management. The views expressed here are his and do not reflect the views of Deutsche Asset & Wealth Management or Deutsche Bank AG.