The active ingredient in markets and passive s growth

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1 The Allocator September 1, 2017 The active ingredient in markets and passive s growth David Bianco Chief Investment Strategist, Americas Deutsche Asset Management Active and Passive asset management will coexist, live long and prosper We expect passive funds to continue to take share from active. U.S. funds and ETFs are 37% passively managed, up from 3% in U.S. equity funds and ETFs are 46% passive. Active equity hasn t had a calendar year of net inflows since Absent a recession, we expect passive to be 5 of U.S. funds and 6 of equity in about 5 years. But active equity funds will not vanish. A rising market should keep US active equity fund assets stable until passive share plateaus. We think passive funds, used as tools, helps the market be properly priced, liquid and on an uptrend. Active promotes efficient markets and productive economies Active investors help to correctly set the price of supply-side factors like risk capital and allocate such capital to high return uses. When done well, it maximizes longterm return on capital and minimizes volatility. Active investing is not a zero sum gain to society or to investors in aggregate. Attempts to beat the market, while zero sum, raise the return for all investors (passive and even lagging active) from what it otherwise would be. The market is a thinking machine that affects corporate actions. Active management of passive products is on the rise Part of passive s recent growth spurt is from its rising use by professional investors and advisors. The passive industry has created many new products that facilitate active positioning in portfolios. Passive began by replicating broad market indices, facilitating low cost construction of diversified portfolios. Since, its offerings have exploded across asset classes and into many equity market sub-segments, which include region, sector, industry, style, factor and multi-factor ETFs. These more targeted passive products provide active investors instruments to express nuanced active views. Today s ETFs give investors the ability to question market prices by key layers and segments. Single stocks are the basic building blocks bottom layer, middle layers are industries/sectors and key segments of styles and factors. Ability to easily act upon the market by layers and segments aids efficiency in our view. Lower management fees suggest higher equity valuations than history We don t think the growth of passive funds, so far, has caused less broad equity market efficiency or liquidity than history. But the cost of a diversified equity portfolio is clearly lower with or without active management. The more return investors keep for themselves, the more valuable the underlying asset should be. We encourage investors to consider their triple-net total return: after fees, taxes and inflation. On this basis, prospective equity returns look more attractive than history despite PEs above history. We think low interest rates and passive s growth justifies higher PEs. What is the value of active mutual funds? Outperformance after fees The value of active funds is professional investment management. A rigorous investment process implemented by dedicated and experienced managers. The active fund industry provides individuals and their advisors a menu of choices to fit where they choose to be active in their portfolios with various active strategies and managers. The abundance of choice, competition and specialization of skills and strategies that active funds offer, should boost an investor s confidence to invest in the more complicated segments of the market, like growth stocks and small caps, through the ups and downs, but it must lead to alpha after fees to add value. See our August 4th Allocator, Eye on the Prize. While specialization by size, style and industry are important, significant alpha potential also exists from sector and style tilts and tactical asset allocation. Thus, managers with an ability to evaluate and act upon opportunities across a broader investment universe could add further value. Contributor - Ju Wang, Investment Strategist & Portfolio Analyst S&P 500 Outlook S&P Dividend Yield 2.1% 2.1% S&P total return 9.4% 6.4% Next 5%+ price move (Up / Balanced Risk / Down) Risk of near-term correction (Low / Moderate / High) Down Low S&P EPS $119 $131 $140 PE on trailing EPS DPS $49 $53 Allocations for taxable / USD capital as of September 1, 2017 Deutsche AM View Current Long-term Fixed Income 35% 35% Equities 6 55% U.S. Equities 35% 4 S&P % 35% Small Caps (R2) 0-1 Foreign DM Equities 15% Foreign EM 5% 0-1 Alternatives 5% 1 Risk & Duration: Preference shaded Low Risk β Stocks Down Gold TIPS Cash Treasury Bonds Short Duration IG Bonds Muni Long Duration Bond Substitutes Cyclical Stocks Value Stocks Growth Stocks Defensive Stocks Oil /Copper Stocks Up Source: Deutsche AM. All opinions and claims are based upon data on 9/1/2017 and may not come to pass. This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. For illustrative purposes only. * Generally Accepted Accounting Principles (GAAP) Yields Up Yields Down HY Bonds High Risk β For institutional client and registered representative use only. Not for public viewing or distribution.

2 What s the nature of passive investing? Pure passive investing, e.g. market cap weighted index replication, assumes that the crowd or the wisdom of the market is right. Usually, the crowd or the market is right and it s cheap and easy to follow the crowd/market. But sometimes the crowd is wrong. Many enhanced passive ( smart beta ) strategies exist, such as weighting index constituents equally or weighting constituents by earnings or dividends or risk metrics like volatility, etc. These are ways to question market efficiency by weighting stocks by a characteristic different from market cap. Market cap is determined by the market observed share price and shares outstanding. What s the nature of active investing? Active investing assumes that market prices are not always correct and that opportunities exist to earn superior risk-adjusted returns by building a portfolio that differs from the market. We think active investing promotes market efficiency. This assumes most active investors choose what to buy and sell based upon a fundamental process of evaluating all future probable earnings and a fair valuation or fair internal rate of return based on the expected earnings or free cash flow. We think such intrinsic value based active strategies aid market efficiency. Active strategies based on technical or solely on price momentum or purely on empirical methods without conceptually sound underlying fundamental reasons aren t necessarily promoting market efficiency. We think active managers should embrace an efficiency maker role, as improving efficiency earns outperformance over time. The self-interested involvement of fundamental active investors in a market, attempting to identify and act upon mispriced securities, helps to keep securities rationally and reasonably priced. The market is an imperfect price mechanism, but superior to all others. Rational pricing of securities helps to set the price of risk capital and allocate risk capital to its highest return uses. Accurate price signals are crucial for a well-functioning economy. This is generally well understood with prices of goods/services or demand-side price signals. But price signals for the means of production like labor, commodities and risk capital are crucially important supply-side signals. Correctly valued stocks gives managers a signal as to the opportunity cost of capital employed. The valuation of stocks signals the market s view on a company s incremental use of capital. Valuations will influence whether a company returns capital to investors or expands its capital usage by reinvesting profits or issuing more securities. This dynamic behavior of companies responding to a well-functioning market promotes capital deployment to its highest return opportunities. This is why we think active investing helps to raise the aggregate return earned by all investors. Active investing is not a zero sum gain to society or to all investors in aggregate. Attempts to beat the market, while zero sum, raise the return for all investors (passive and also lagging active) from what it otherwise would be. Albeit passive can free ride well-functioning efficient markets. What s the reward for active investing? The reward for active investing is potential outperformance. For actively managed capital to outperform some other actively managed capital must underperform. Outperforming requires outthinking other active investors. This is a very competitive endeavor. The gain from active management comes from taking correct views on uncertain or controversial issues. If capital management in either the real economy or financial markets were easy then there would be little need for active investors. Most of the controversies that active managers face relate to future outlooks. Forecasting remains one of the greatest challenges to businesses. Markets bring together all the abilities of man and machine to attempt to provide useful signals about the future. If active investors always made the right decisions then stock prices would be very stable, likely rising by an undisputed cost of equity less the dividend yield. But there must be some volatility, which signals uncertainty, for active managers to profit and be useful. Thus, active management requires controversies to exist and an engaged debate with something to gain for being right. Active with the right methods in the right places at the right price can add value We will save it for other notes to defend active management and explain how we think it can add value by employing the right methods in the right places at the right fees. But here we point out that falling fees for active management should help improve its value to investors. Active managers who cover fees with outperformance and offer service and consultation along the way should be a desired partner to any investor looking to navigate what will inevitably be markets with controversy and uncertainty. Average Fee & Expense Ratios of Equity Mutual Funds (bps) Total fee and expense ratio (load fee not included since 2011) Triple-net Equity Return: Our Outlook vs. Historical Norm Historical norm since 1960: Outlook: Nominal gross return 10. Nominal gross return 7. less fees (~1.5%) 8.5% less fees (~0.5%) 6.5% less tax (~25%) 6.4% less tax () 5.2% less inflation (4%) 2.4% less inflation (2%) 3.2% Triple net equity return Investment fees ~1.5% Investment fees ~0.5% Tax rate on equity returns ~25% Tax rate on equity returns Inflation 4. Inflation 2. Source: ICI, IRS, Tax Policy Center, Deutsche AM as of Past performance may not be indicative of future Deutsche Bank AG. All rights reserved. R (9/17) No public viewing or distribution. The active ingredient in markets and passive s growth

3 Total US MF & ETF AUM Active vs. Passive ($bn) $18,000 $16,000 $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 Sep-95 May-96 Jan-97 Sep-97 May-98 Jan-99 May-00 Jan-01 Sep-01 May-02 Jan-03 Sep-03 Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 May-14 Jan-15 Sep-15 May-16 Jan-17 45% 4 35% 25% 15% 1 5% Active Passive % Passive Total Equity MF & ETF AUM Active vs. Passive ($bn) $12,000 5 $10,000 4 $8,000 $6,000 $4,000 $2,000 1 Sep-95 May-96 Jan-97 Sep-97 May-98 Jan-99 May-00 Jan-01 Sep-01 May-02 Jan-03 Sep-03 Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 May-14 Jan-15 Sep-15 May-16 Jan-17 Active Passive % Passive Includes Morningstar US Equity, International Equity and Sector Equity subcategories For institutional client and registered representative use only. Not for public viewing or distribution.the active ingredient in markets and passive s growth 3

4 Total Fixed Income MF & ETF AUM Active vs. Passive ($bn) $5,000 $4,000 25% $3,000 15% $2,000 1 $1,000 5% Sep-95 May-96 Jan-97 Sep-97 May-98 Jan-99 May-00 Jan-01 Sep-01 May-02 Jan-03 Sep-03 Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 May-14 Jan-15 Sep-15 May-16 Jan-17 Includes Morningstar Municipal Bond and Taxable Bond categories Active Passive % Passive % Passive of Total AUM Equity, Hybrid, Fixed Income Aug-95 Mar-96 Oct-96 May-97 Dec-97 Jul-98 Feb-99 Apr-00 Nov-00 Jun-01 Jan-02 Aug-02 Mar-03 Oct-03 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Aug-09 Mar-10 Oct-10 May-11 Dec-11 Jul-12 Feb-13 Apr-14 Nov-14 Jun-15 Jan-16 Aug-16 Mar-17 Allocation Alternative Commodities International Equity Municipal Bond Sector Equity Taxable Bond US Equity For institutional client and registered representative use only. Not for public viewing or distribution.the active ingredient in markets and passive s growth 4

5 Active vs. Passive flows ($bn) 2017 YTD* $400 -$300 -$200 -$100 $100 $200 $300 $400 $500 $600 Passive Active Source: Morningstar Direct. YTD as of May 30, 2017 Active U.S. Equity Fund Flows ($bn) -$50 -$100 -$150 -$200 -$250 -$ YTD* Source: Morningstar Direct. YTD as of May 30, 2017 For institutional client and registered representative use only. Not for public viewing or distribution.the active ingredient in markets and passive s growth 5

6 Key Investment Forecasts Economic forecasts E Interest rates E Equities E 2018E Global GDP 3.1% 3.5% 2yr Treasury* % S&P U.S. GDP 1.6% 2.1% 10yr Treasury* 2.45% 2.6 price return 7.2% 4.2% Capex 0.2% 3-5% 10yr TIPS* % dividend yield 2.1% 2.1% S&P total return estimate 9.4% 6.4% Fed Funds rate LT IG Muni* 3.35% ~3. DXY Next 5%+ price move: Down Euro* IG Corp* 3.39% 3.6 Oil/bbl (WTI)* HY Corp* 6.46% 6.4 Risk of near-term correction: Low Source: Deutsche AM as of 9/1//2017. *Forecasts for June 2018 Allocations for taxable/u.s. dollar capital as of Sept. 1, 2017 Deutsche AM View Current Long-term Considerations Fixed Income 35% 35% Expected return/risk Treasury/Agency seek neg. correlation Municipals 1 > return, < liquid Corp. Credit 5% selective HY > IG Equities 6 55% Expected return/risk U.S. Equities 35% 4 S&P % 35% S&P is global + Tech Small Caps (R2) 0-1 Beyond beta booster? Foreign DM Equities 15% Unique? Valuation? Financials 5% 3% OW Foreign Banks Non-Financials 15% 12% OW DM Industrials Foreign EM 5% 0-1 Alternatives 5% 1 Is it truly uncorrelated? Commodities /Re/PE FX/Vol/ alpha Tactical adjustments (<6mos): -1 from equity, +1 treasury = Down Suggested allocations for taxable / USD capital S&P 500 Outlook Dare to ask: 2017 end target: 2400 Why not 2800 S&P cycle-high? 2800 = 18x 2019E EPS of ~$ end target: 2500 S&P 500 to reach 2800 by 2019 end on a long expansionary cycle of moderate growth. 2016A 2017E 2018E S&P avg. trailing 4qtr PE S&P EPS $119 $131 $ PE on trailing EPS DPS $46 $49 $ DPS/EPS 38% 37% 38% "S&P PE stands on the shoulders of bonds" S&P Quarterly EPS: Most favored sectors: 1Q16 $ Q17 $31.25 Healthcare, Tech, Financials 2Q16 $ Q17E $ Q16 $ Q17E $33.00 Least favored sectors: 4Q16 $ Q17E $34.00 Energy, Industrials Source: Deutsche AM as of 9/1/2017 Source: Deutsche AM as of 9/1/2017 For institutional client and registered representative use only. Not for public viewing or distribution.the active ingredient in markets and passive s growth 6

7 Contact Information David Bianco Ju Wang , , Want to start to receive The Allocator and other materials from our thought leaders directly in your inbox? Go to the Subscription Center on deutscheam.com: And sign up and request the types of thought leadership materials you would like to receive by topic (The World, The Markets, and Asset Class Perspectives) or exclusively by one or more of our experts. For purposes of ERISA and the Department of Labor s fiduciary rule, we are relying on the sophisticated fiduciary exception in marketing our services and products through intermediary institutions, and nothing herein is intended as fiduciary or impartial investment advice. Deutsche Bank does not render legal or tax advice, and the information contained in this communication should not be regarded as such. The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that we believe to be reliable. We do not guarantee their accuracy. This material is for informational purposes only and sets forth our views as of this date. The underlying assumptions and these views are subject to change without notice. Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. Investments come with risk. The value of an investment can fall as well as rise and your capital may be at risk. You might not get back the amount originally invested at any point in time. Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its Deutsche Bank AG. All rights reserved. R (9/17) Not for public viewing or distribution. The active ingredient in markets and passive s growth 7