ETFs under the microscope : Where from? Where now? Where to? Global ETF industry : $1.5 trillion and growing

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1 ETFs under the microscope : Where from? Where now? Where to? David Patterson, Head of UK Wholesale Distribution IFP Scottish Conference Nov 2012 Simply buy the market Serviceleistungen / September 2011 Global ETF industry : $1.5 trillion and growing $ billion 1,600 1,400 1,200 1, ,000 2,500 2,000 1,500 1, Number of ETFs ** Asia Pacific ($) Europe ($) US ($) ,102.4 US, Europe & Asia Pacific ($) , , ,512.2 Europe ( ) Number of ETFs* ,115 1,483 1,803 2,254 2,718 2,986 0 *Number of ETPs at the end of the year is net of delistings for the period. ** As of last month Source:, Bloomberg 31/08/12 Past performance is not a reliable indicator of future results. 2 Global ETF industry : $1.5 trillion and growing US retail investors own some 50% of US listed ETFs Europe and Asia have a long way to catch up, but growth is strong ETF based asset allocation boutiques are slowly building a presence The new normal thematic/sector based investing is what ETFs are built for: low cost precision tools to keep your portfolio on track 3 1

2 ETFs: Why are they so popular with investors? Demand for surgical asset allocation and low costs, not negative alpha Relative Performance MSCI Emerging Markets Index vs XMEM vs Bloomberg Active Index for Funds 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% % % % % db x-trackers MSCI Emerging Markets TRN Index ETF BAIF UCITS OEF EMKT EQ Index The Bloomberg Active Index for Funds Emerging Markets Index (BAIF EM)* is made up of 121 actively managed EM funds and calculated by Bloomberg The BAIF EM Index has underperformed the MSCI EM Index by 13.68% compared to 3.01% for the db x-trackers MSCI Emerging Markets TRN Index ETF As of: 02 January 2012 Past performance is not a reliable indicator of future results. Source: MSCI, 4 Where from? Not from another planet Serviceleistungen / September 2011 The main key point is that LSE listed ETFs and most European ETFs are: UCITS!! Serviceleistungen / September

3 ETPs vs ETFs vs ETCs vs ETNs Clarify the three letter acronyms (a.k.a. TLAs) London Stock Exchange Secured Exchange Traded Products (ETPs) (Secured / Collateralised / Backed by assets) Other unsecured ETPs (Unsecured /backed b y issuer) ETFs Exchange Traded Funds ETCs Exchange Traded Commodities ETNs Exchange Traded Notes Diversified basket of securities UCITS regulated Secured/collateralised Retail Investment Product Single-commodity or diversified basket of commodities Futures or physically backed Secured /collateralised A highly liquid debt security Single asset or diversified basket of securities Unsecured/uncollateralized Issuer credit risk A debt security 7 2 platforms ETFs db-x ETC 8 ETFs Launched Jan 2007, now number 2 in Europe and number 4 globally* Over Euro 33 billion assets with multiple listings in Europe and Asia Over 200 ETFs covering a broad range of asset classes Equities developed and emerging markets, themes, short daily indices Fixed Income bonds, credit, money market Alternatives hedge fund, commodity, currency, multi-asset Supported by over 50 Market Makers and Authorised Participants First ETF provider to introduce fully collateralised ETFs in 2009 Full transparency on collateral and swap exposures since 2010 First Active ETF launched on LSE Feb 2012 All ETFs are compliant with UK Reporting Fund requirements Largest funds (in billion) DAX ETF 5.36GBP MSCI EMERGING MARKETS TRN INDEX ETF 2.22 GBP EONIA TOTAL RETURN INDEX ETF 1.66GBP Euro STOXX 50 ETF 1.63 GBP MSCI WORLDTRN INDEX ETF 1.46 GBP *Source: Deutsch Bank 12/09/

4 Summary Comparison of Exchange Traded Products Exchange Traded Funds (ETFs) Fund-based structures Exchange Traded Commodities (ETCs) Debt securities Exchange Traded Notes, uncollateralised (ETNs) Debt securities Tracking error can occur (physical replication) Exchange listed, liquid European based ETFs do not allow exposure to single or physical commodities Minimal credit risk: collateralised Available in multiple currencies No tracking error Exchange listed, liquid Permit exposure to single and physical commodities Minimal credit risk: collateralised (e.g. by equity gold, bonds, etc) or backed by the actual precious metal itself Available in several currencies No tracking error Typically OTC, but can be listed on exchanges Permit exposure to single commodity. No physical commodities. Credit risk: exposure to the risk of default of the issuer. No collateral provided Available in several currencies 10 ETP opportunities & risks : know what you are looking at Online portfolio services are coming, outsourced or DIY Managing your ETF portfolio via smartphone: instantly tl trade So what is wrong with this picture? 11 ETF Structure : What are ETFs? Index Funds UCITS/FSA Regulated Diversified Secured by assets Low Cost Shares Exchange traded Transparent pricing Liquid Easy settlement Exchange Traded Fund (ETF) ETFs are regulated and listed index funds that combine diversification and cost benefits of index funds with the tradability of securities, with no stamp duty. 12 4

5 ETFs simply buy the market, so know your index ETFs = Simply buy the market! Index Equities Developed Emerging Sectors Bonds Gilt Index Corporate Bonds Money Market Alternatives Commodities Private Equity Short/Leverage Short-term trading instruments eg day trading The returns of ETFs include both price movements and any income from the underlying index components 13 ETFs are listed mutual funds Structure I. Physical a. Full b. Sampling II. Synthetic a. Funded b. Unfunded Service Providers I. Adviser: Strategy II. Manager: Execution III. Administration: Pricing IV. Custodian: Safeguard Auditor: Accounts Strategy I. Passive index (β) Long II. Active (α) a. Long or short b. Leveraged Funds (ETFs and unlisted funds) Exposure I. Equity II. Fixed Income III. Commodities* (diversified indices) IV. Alternative Governing legislation I. Europe: UCITS IV II. US: 1940 s Company Act Source: * Europe only, including Swiss domiciled ETFs 14 Evolution of index replication techniques Simply buy the index Serviceleistungen / September

6 Evolution of Index Tracking UCITS 3 enables both physical and synthetic replication 1970s - Full or partial physical replication (Direct) Buy all / some underlying index components Evolution to swap based or synthetic replication (Indirect) Basket of securities plus index swap Performance linked to portfolio of assets held by fund Assets can be lent out to generate revenues to improve tracking performance Performance linked to returns of an index swap Swap counterparty exposure limited or eliminated through use of assets to act as security or collateral 16 What exactly is an index swap? An agreement between two parties to swap the exact performance of the index being tracked, before fees and replication costs, for cash or the performance of a pool of assets. A swap based ETF will enter into an arms length index swap agreement with a swap counterparty, typically an investment bank. European funds have been able to use index swaps as part of their investment policy since implementation of UCITS III in 2002, subject to a maximum of 10% of NAV Absolute return funds use exactly the same instruments. Use of swaps in ETFs is much simpler and more transparent 17 ETF liquidity construction Accessing the underlying market same for physical and synthetic Synthetic/swap based (indirect) replication ETF Full/partial Physical (direct) replication ETF Investor Cash Shares Collateral securities Index securities or ETF optimised sample Cash Shares Investor Index Return SWAP Counterparty Asset Return HEDGE SWAP (up to 10%) /\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/VVV\/ Securities lending (up to 100%) Securities Multiple Counterparties Collateral REPLICATE Asset Market of underlying Index (e.g. Bonds, Equities) 18 6

7 ETF Construction Full Physical, Partial/Optimised Physical, or Synthetic/Swap based? Each method has merits and high levels of transparency Full physical replication more straightforward to do on liquid, concentrated, single country or regional indices ( e.g FTSE 100, S&P 500) Partial physical replication using sampling or optimisation more common on broad market or emerging market indices with multiple components and/or countries: can produce higher tracking error (eg MSCI World, MSCI Emerging Markets) Optimisation = use of quadratic programming in algorithm based on a multi factor risk model and covariance matrix Synthetic replication provides perfect index tracking (before fees and index replication costs) regardless of the type of index, providing access to more markets and asset classes 19 Complete asset allocation tool box with ETFs Access to a wide range of markets and asset classes via ETFs Construct diversified portfolio based on investor risk-return-profile Active ETFs (of ETFs) : a low cost DFM alternative Equities Bonds Themes Commodities: ETFs & ETCs Alternative Money Market Investments Short and Leverage Countries Regions Sectors Developed Emerging Markets Sovereign bonds -, $, Inflation linked Corporate Emerging Markets Global Sovereign Direct / Physical Property Private Equity Infrastructure Shariah Fundamental Dividends Broad commodity indices Precious Metals Energy Soft Commodities SONIA ( ) Hedge Funds Equities EONIA ( ) Fed Funds Currency strategies Bonds Credit Effective Rate Commodities ($) Indirect / Swap based 20 Where now? Poised to become your new best friend Serviceleistungen / September

8 N A European ETF industry, replication analysis Number of ETFs AUM ( billion) Physical-AUM Synthetic-AUM Physical-funds Synthetic -funds Source:, Bloomberg, Reuters 22 ETF Transparency : no need for microscopes ETFs are already at the disclosure forefront of the fund management industry What needs to be improved is primarily consistency of information reported by various market participants The general mutual fund industry, and especially unlisted funds, could stand to become more secure by capitalising on the ETF experience 23 website collateral publication Daily publication of collateral for 120% haircut ETF 8

9 Key points (30 second guide to ETFs) In Europe, ETFs account for less than 3% of European UCITS mutual fund assets, so for you as UK advisors, all ETFs on the LSE are UCITS funds, so they use the same rules as every mutual fund ever recommended, so they are all secured with real, physical assets, so physical and synthetic are arguably the wrong labels, direct and indirect replication may be more helpful. 25 Key points (30 second guide to ETFs) ETFs have evolved to use an efficient delivery mechanism called a total return swap. Most ETFs are highly efficient and highly transparent Most track total return indices ETFs offer asset allocation precision and intra day trading flexibility There is no stamp duty on ETFs CGT on gains, income tax on income Most can be held in a SIPP or ISA Check the trading currency Also consider GBP hedged ETFs & ETCs 26 The main key point is that LSE listed ETFs and most European ETFs are: UCITS!! So what risks exist in listed and unlisted UCITS? Serviceleistungen / September

10 Fund industry indicative risk map Listed mutual funds Operations risk Counterparty risk TRS [max 10%] Securities lending Unlisted mutual funds Various derivatives [options, swaps, futures, forwards] Securities lending, borrowing, repurchase agreements CFDs, guaranteed products (for example equity/credit linked notes) Collateral diversification Operations risk Market risk Investment Strategy Tracking effectiveness Education & appropriate. Source:, No pan European regulatory guidelines for credit risk collateralization currently in place, best practice (CESR) guidelines on risk measurement plus self policing in some cases Independent administrator, custodian, collateral manager Audited financial statements Beta 96% Other 4% Negligible, industry av 30 bps Unavailable Insufficient data made available by fund managers and index providers Regulated by European level guidance as well as by additional specific regulation in each European country 28 Fund industry indicative risk map UCITS Funds Operations risk Listed mutual funds (ETFs) Unlisted mutual funds Counterparty risk Total Return Swap [max 10%] Securities lending Various derivatives [options, swaps, futures, forwards] Securities lending, borrowing, repurchase agreements CFDs, guaranteed products (for example equity/credit linked notes) Source:, 29 Where to? Eventual integration with most client portfolios Serviceleistungen / September

11 Accessing ETFs via platforms: Know your dealing costs Know your dealing point: once a day? Know your dealing options: NAV direct via EMX? Amalgamation of orders? Whole shares only 31 Other ETFs: In use by more than you may think Short/inverse daily ETFs* : are volatility and path dependent Leveraged & leveraged short daily ETFs* Enhanced/optimised Index ETFs : know the index methodology Active ETFs of ETFs : a low cost DFM solution? None to be feared, just understood * suitable only for sophisticated investors 32 Commodity ETFs & ETCs Don t just roll with it when it comes to commodities. Serviceleistungen / September

12 Commodity Futures the impact of rolling Development of major Oil indices since Crude Oil Spot db WTI Booster USD Index DJUBS Crude Oil Index S&P GSCI Crude Oil Index Indexed to 100 points as per 01 August 2005 Indexed to Aug. 05 Feb. 06 Aug. 06 Feb. 07 Aug. 07 Feb. 08 Aug. 08 Feb. 09 Aug. 09 Feb. 10 Aug. 10 Source: Bloomberg, May Past performance is not a reliable indicator of future results. Commodities: which product / wrapper to use? Exchange Traded Funds (ETF) Exchange Traded Commodities (ETC) Broadly diversified commodity indices (DBLCI OY, DJUBS, S&P GSCI, RICI) single commodities Oil, NatGas, Sectors Agriculture, Physically backed Gold, Silver, Platinum, 35 Final thoughts Simply buy the index Serviceleistungen / September

13 Thought one: After asset allocation, tracking difference is everything 37 Thought two: Headline low cost is good, but don t forget thought one After asset allocation, tracking difference is everything 38 Thought three: Did I mention that ETFs are UCITS? Don t treat ETFs any differently from the due diligence required for any investment 39 13

14 Summary The ETF industry is here to stay, has evolved, and leads on transparency Swap based ETFs offer highly efficient index tracking & access to a wider range of markets and asset classes than possible under direct replication Swap based ETFs have evolved beyond UCITS guidelines to limit or eliminate counterparty exposure. Key investor considerations for all ETFs and tracker funds Know your index. Check the tracking performance vs. index Check the costs of buying and selling ETFs are precision tools. Passive funds are tradable only once a day Know and understand the market and structure risks of all products: Investors should note that the ETFs are not capital protected or guaranteed and investors in each ETF should be prepared and able to sustain losses up to the total capital invested. (See section on full investment risks relating to ETFs ) 40 Summary of latest research and regulatory developments EDHEC-Risk Institute What are the Risks of European ETFs?, January 2012 ESMA Consultation Paper ESMA s guidelines on ETFs and other UCITS issues, 30 January 2012 FSA Fact Sheet for Investment Advisers Exchange Traded Products (ETPs), April 2012 Both physical and synthetic investment strategies can expose the ETP to a portfolio of unrelated assets. Both physical and synthetic strategies can expose investors to high levels of collateral. 41 Summary of latest research and regulatory developments Morningstar ETF Research Securities Lending in physical replication ETFs, August 2012 ESMA Final Report and Consultation Paper ESMA s guidelines on ETFs and other UCITS issues, 25 July 2012 The guidelines... increase the level and the quality of information provided by UCITS to their investors, clarify the criteria for the management of collateralised transactions such as securities lending, repo and reverse repos and OTC derivatives,. Steven Maijoor, ESMA Chair UCITS ETF providers must meet these requirements no later than the latter part of

15 Summary of latest research and regulatory developments ESMA Final Report and Consultation Paper The guidelines key provisions are: UCITS that fall under the definition of UCITS ETFs will have to carry the identifier UCITS ETF in their name; UCITS ETFs will have to ensure appropriate redemption conditions for secondary market investors by opening the fund for direct redemptions when the liquidity in the secondary market is not satisfactory; UCITS entering into efficient portfolio management techniques (EPM) like securities lending activities will have to inform investors clearly about these activities iti and the related risks. All revenues net of operating costs generated by these activities should be returned to the UCITS. When a UCITS enters into securities lending arrangements, it should be able at any time to recall any securities lent or terminate any agreement into which it has entered; UCITS receiving collateral to mitigate counterparty risk from OTC financial derivative transactions or EPM techniques should ensure that the collateral complies with very strict qualitative criteria and specific limits in relation to the diversification; and UCITS investing in financial indices will have to ensure that investors are provided with the full calculation methodology of financial indices. Also, UCITS should only invest in financial indices which respect strict criteria regarding, inter alia, the rebalancing frequency and their diversification. 43 ETFs under the microscope : the accompanying guides 44 Investment risks relating to ETFs (1) Investors should note that the ETFs are not capital protected or guaranteed and investors in each ETF should be prepared and able to sustain losses up to the total capital invested. Investment in ETFs involves numerous risks including among others, general market risks relating to the relevant index, credit risks on the provider of index swaps utilised in the db X- trackers ETFs, exchange rate risks, interest rate risks, inflationary risks, liquidity risks and legal and regulatory risks. The ETFs use as the counterparty for OTC derivative transactions. Although the ETFs fuly comply with the UCITS requirements in respect of counterparty exposure, in the event of a default under the terms of the OTC derivative transaction by Deutsche Bank, the ETFs could lose a portion of the NAV of the ETF. The NAV at the time of default also may be considerably less than the amount an investor originally invested depending on the performance of the relevant underlying index. You should therefore understand and evaluate the counterparty credit risk prior to making any investment. The value of an investment in a ETF may go down as well as up and past performance is not a guide to the future. Not all ETFs may be suitable for all investors so please consult your financial advisor before you invest in a ETF

16 Investment risks relating to ETFs (2) ETFs shares may be denominated in a currency different to that of the traded currency of the stock exchange on which the ETF is listed in which case exchange rate fluctuations may have a negative effect on the returns of the fund. Tax treatment of the ETFs depends on the individual circumstances of each investor. The levels and bases of, and any applicable relief from, taxation can change. may trade in limited markets. may be unable to replicate precisely the performance of an index. Investors' income is not fixed and may fluctuate. The value of any investment involving exposure to foreign currencies can be affected by exchange rate movements. For further information regarding risk factors, please refer to the risk factors section of the listing particulars or full prospectus. 46 Disclaimer 2011 AG This presentation contains a short summary description of the above mentioned ETFs and is for discussion purposes only. A complete description of the funds is in the respective and most recent prospectus of the above mentioned ETFs. This presentation is not for distribution to, or for the attention of, US or Canadian persons. Without limitation, this presentation does not constitute an offer or a recommendation to enter into any transaction. When making an investment decision, you should rely solely on the final documentation and any prospectus relating to the transaction and not this summary. Investment strategies involve numerous risks. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) the effect of any transaction they may enter into, including the possible risks and benefits of such transaction and should ensure that they fully understand the transaction and have made an independent assessment of the appropriateness of such transaction in the light of their own objectives and circumstances. In no way should be deemed to be holding itself out as a financial adviser or a fiduciary of the recipient hereof. may make a market or trade in instruments economically related to fund units or derivatives mentioned herein, and/or have investment banking or other relationships with issuers of the relevant securities. actively manages various risks, and on occasion may deal in securities mentioned in this document or in related instruments during the period between your receipt of this fact sheet and the award of any order. Whilst Deutsche Bank s trading or hedging activities are not intended to have any significant impact upon prices, its dealings could affect the prices you pay or receive for transactions in related securities or fund units., and its current and future subsidiaries, parents, affiliates, divisions, officers, directors, agents and/or employees, disclaim all liability with respect to this document and the information herein, and are not liable for any errors or omissions, or for any damages howsoever arising from any reliance placed thereon, save as required by applicable laws and regulations. A full description of the terms and conditions of all sub-funds are included in the prospectus of db x-trackers and db x- trackers II. You can get the full and the simplified prospectus of each sub-fund of db x-trackers and db x-trackers II at db x- trackers, 49, avenue J.F. Kennedy, L-1855 Luxembourg, R.C.S. Luxembourg D AG is authorised under German Banking Law (competent authority: BaFin Federal Financial Supervising Authority) and is regulated by the Financial Services Authority for the conduct of investment business in the United Kingdom. The registered address of AG, London Branch, is Winchester House, 1 Great Winchester Street, London EC2N 2DB. 47 UK, Ireland and Channel Islands Contacts: Hotline: Wholesale, Private Wealth, IFAs & Platforms David Patterson Nilesh Parmar david.patterson@db.com nilesh.parmar@db.com +44 (20) (121) (mobile) (mobile) 48 16