Ahead of the product curve

Paul Burgin looks at the nature of the German ETF market and how it is at the helm of product development

The German ETF market was the first to emerge in Europe and remains the largest by assets and listings. It is maturing fast as the hunt for new asset classes pushes ETF design to its limits.

Ten years ago, the first ETFs in Europe were launched on the Deutsche Boerse. The iShares Eurostoxx 50 and Stoxx 50 have since become staples across Europe, listed on multiple exchanges, with many imitator funds subsequently springing up. The Deutsche Boerse’s Xetra platform dominates both the local and European market.

BlackRock’s last quarterly industry review showed 363 primary listings for the whole country, with 1,038 total listings from nine providers. With assets under management (AUM) of €85.3bn, the German market is well ahead of France and the UK, with just under €50bn apiece.

Deutsche Boerse’s latest statistics show monthly turnover regularly topping €14bn, lead by the iShares DAX fund based on local large cap stocks with 13% of the market, followed by the db x-trackers DAX, iShares Eurostoxx 50, and db x-trackers short DAX and Stoxx 50 vehicles. Fixed income products are dominated by Eonia and German government bund trackers. 

Although there are seven stock exchanges across Germany, only Boerse Stuttgart has challenged the supremacy of the Frankfurt-based Deutsche Boerse. Last year, the Stuttgart exchange launched a new ETF segment with a clear regulatory framework setting binding spreads for minimum quote volumes on over 300 products. Commerzbank’s ComStage ETFs and Deutsche Bank’s db x-trackers products were the first to list. Transaction fees were set at 0.119% of order volumes, capped at €12.18 plus sales tax.

Retail activity on the Stuttgart exchange is picking up. Nevertheless, average daily volumes remain less than 2% of those recorded by the Frankfurt exchange, according to BlackRock data. Private investors still need further convincing that ETFs and exchange-traded commodities (ETCs) are right for them.

A cautious approach

Collectively, German retail investors tend to be cautious, and with good reason. Many have been caught out by scams, failures and bubbles in the past. From the 1950s onwards, millions were lost in a Ponzi scheme run by Investors Overseas Services. The incident prompted the banning of dachfonds or funds of funds until the 1990s. Even today, many investors are suspicious of such vehicles and their double charges.

Monies were lost too as investors rushed to the dotcom-fuelled Neuer Markt in the late 1990s, only to see their tech bubble dreams burst when the market shut down in 2002. Speculation on individual stocks can also get out of hand. German buyers ramped up the price of Bank Bali’s shares in overnight trading in Indonesia before the bubble burst in 1999.

Not surprisingly, investors now need convincing when faced with the relatively new merits of ETFs and ETCs. In retail, exchange-traded products (ETPs) also face heavy competition from low cost index-zertifikat perpetual certificates issued by large banks. Ben Johnson, European ETF strategist at Morningstar, said: “Many of these certificates have the same advantages as ETFs, with low spreads and on-exchange trading and visibility.”

The retail market is not helped by the poor sales reputation of many of the largest financial product retailers. A spate of surveys in recent years have shown just how poor branch advice can be. One, by the Verbrancherzentrale Bundesverband, a group of consumer organisations, showed 24 of 25 bank advisers gave unsuitable advice on mutual funds.

Banks did not take kindly to the criticism and neither did the regulator BaFin. New advisory protocols, or beratungsprotokoll, came into force at the beginning of this year. Banks must now log advice and sales contacts, noting investments discussed and customer concerns.

Unfortunately, many distributors have followed the letter rather than the spirit of the law. The regulator sampled over 1,000 of the new logs and found the majority of them lacking. Poor template design did not allow for enough permutations and differing client needs.

Just as retail investors need convincing that ditching their certificates for ETFs is a good idea, so institutional investors were initially cautious about investing in the new ETPs.

Although ETF Securities’ physical gold products are now the biggest in the market by AUM, achieving status was a hard slog. One might have assumed that Germany’s cautious institutional investors would have rushed to such products that had real, tangible assets behind them. That assumption would be wrong, said Tim Harvey, co-head of European Sales at ETF Securities.

He said: “Traditionally, fund and pension managers would have looked at mining stocks or processors for exposure to any precious metal sector due to the non-existence of suitable exchange-traded products.”

When Harvey and his colleagues began telling German institutions about the benefits of commodity ETCs and physical backed products, they received a warm but hesitant greeting. Institutional investors had previously avoided direct access to commodity asset classes, including bank-issued delta one certificates, due to concerns over their transferable securities status under Ucits (Undertakings for collective investments in transferable securities) legislation.

Harvey said: “They wanted confirmation that they could invest in these new vehicles. When BaFin gave their clarification and approval concerning commodities as an asset class, everything changed and a whole new asset class opened up for fund managers.”

Confirmation came from BaFin in 2007, giving the go-ahead for investment in physically backed ETCs providing they had no embedded derivatives. Where Harvey once had to beg for an audience, suddenly investors came to him. Concerns about counterparty risk inherent in bank-issued certificates also helped win investors round to the ETF cause as the financial crisis struck.

ETFS Gold Bullion Securities and ETFS Physical Gold are now the biggest ETPs in Germany by fund size, according to Morningstar data. Both are bigger than more mainstream iBoxx, Eurostoxx and DAX products, by several hundred million euros.

Refocusing on ETFs

German institutions are now looking to ETFs to provide access and liquidity to a diverse range of asset classes at a price that suits them best.

Morningstar’s Ben Johnson said: “The German ETF market is now the furthest along the evolutionary curve. Not only is it the biggest market with the largest share of on-exchange volume, it has moved into exotic categories from a product design perspective.”

Johnson highlighted the db x-trackers hedge fund ETF as the most extreme example of how far and how quickly the German market has moved. He said the product is one of only a few available in Europe at present. “It is at the outer fringes of the ETF structure. The basket of multi strategies is suitable for sophisticated investors willing to understand how it works. A complex strategy needs superior liquidity, an issue that is top of mind with institutional investors. The index should be far more liquid than the many hedge funds that were stuck over recent years.”

Distribution power is concentrated in Germany as it is in other EU markets. The big banks and largest Sparkassen can sell in-house products by the bucket load and be effective gatekeepers against products manufactured by other firms. The large number of private banks and independent advisers tend to work from a list of preferred products rather than a ‘whole of market’ approach. Where a parent bank manufactures a suitable product, it is often selected over competitor offerings.

Deutsche Bank’s db x-trackers has gained a significant portion of the market from within its own sales network, boosting its market share to roughly 17%. Commerzbank’s ComStage ETF arm has leveraged less growth and assets from its own distribution base. 

iShares was the first company to launch ETFs in Germany. It consolidated its lead position in listings and AUM through Barclays’ purchase of Indexchange from Bayerische Hypo-und Vereinsbank in late 2006. At the time, Indexchange was the country’s biggest ETF provider with AUM of €15.2bn.

Although there is room for smaller independents such as ETFlab and hedge fund specialist Marshall Wace, the big players have a natural advantage when it comes to market making, pricing and distribution.

Simon Klein, head of ETF & ETC sales for Europe at Deutsche Bank, said: “Clients are active users. They will pull money out if they need to. They use ETFs for passive and tactical purposes.”

Heavy trading and rotation requires significant liquidity, which Germany’s biggest mainstream ETFs have in abundance. As investors look further afield to exotic asset classes, they also want to be able to get in and out of indices without worry or delay. Klein said: “Cost of the product is just one point of concern. More important is the trading cost, but liquidity is even more important than the management fee.”

He said bigger players have the advantage when they have capabilities in market making, enhancing product performance and providing additional research for investors.

The liquidity issue has come to the fore as Germany’s institutions discover the delights of emerging markets. Klein said there have been heavy inflows recently into developing markets equities as they will more likely profit from the crisis than those in the Western world. Global and emerging market dividend funds have also been a popular overweight position.

Demand for emerging market and precious metal indices has pushed recent product development away from traditional cash-based to synthetic replication. Klein said a cash-based emerging market product could have a 6% tracking error, far too large for any German institution. Under a synthetic structure, the error can be reduced to just a few basis points.