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ETF Strategy for Mega-Trends

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Some of the major investment themes that began last year are still unfolding. The collapse in oil prices, the depreciating euro and surging bond prices are among this group. But other opportunities will arise.

Which segments of the global equity market offer value? How can advisors hedge against volatile currency fluctuations? Where do alternative beta strategies fit in?

Dodd Kittsley, head of ETF strategy at Deutsche Asset & Wealth Management shared his thoughts with Research.

As you look at the months ahead in 2015, which investing trends do you think we’ll see playing out?

More dollars were invested in ETFs in 2014 than ever before. We expect this growth to continue and accelerate in the coming year, driven by increased investor adoption and product innovation. While indexing has been employed by institutional investors for nearly five decades, many advisors and individual investors are just becoming aware of the benefits that these strategies can deliver. Indexing delivers broad diversification to thousands of individual markets and exposures and allows investors to take advantage of broad macro trends in an efficient way.

ETFs offer a low cost, tax efficient and easily tradable way to build portfolios that are transparent, risk controlled and diversified. They also allow investors to capitalize, in a single trade, on compelling themes and strategies. In 2015, we expect to see continued demand for investors to control risk in their bond portfolios through duration management. We also believe that investments in stocks outside the US are particularly attractive, when controlled for a stronger US dollar. Currency hedged ETFs saw massive growth in 2014 and assets in those funds now exceed $20 billion. We believe this growth is just the beginning as investors now have the ability to invest internationally, in a variety of different markets and countries, while eliminating the impact of currency fluctuations.

The S&P 500 has recorded five consecutive yearly gains but a market correction is inevitable. What should advisors being doing right now to prepare their clients?

At Deutsche Asset & Wealth Management, we believe that corporate profits could see a new high in 2015, leading to further appreciation for the S&P 500 and other U.S. stocks further down the market cap spectrum. Due to the prolonged bull market, stock valuations have become rich and will likely react more strongly to economic and company data. Nevertheless, in our view, the environment for stocks remains positive overall in 2015. The low interest rate environment is causing capital inflows into stock markets. We expect a moderate acceleration in global economic growth and inflation to remain low. While the Fed will likely raise rates, we expect them to do this modestly in the third quarter of 2015 at the earliest. That means we will keep the Goldilocks scenario for the markets in 2015. Slow and steady global economic growth will likely translate into positive returns for most equity markets in the coming year.

How do currency fluctuations impact equity performance and under what circumstances does it make sense to hedge currency positions?

Currency exposure can have a massive impact on the total return of international equities, which was a lesson learned by many U.S. investors with Japan in 2013 and, more broadly, with most international markets in 2014. The dollar strengthened against most major currencies over the course of the year, detracting significantly from equity returns. Many international indices, including the MSCI EAFE Index, have delivered positive returns year-to-date in local currency terms, but are in negative territory for un-hedged US investors, because of the magnitude of their currency losses.

We believe that investors with a neutral to positive outlook for the dollar should consider hedging their currency exposure. Dollar bulls will want to fully hedge and eliminate the impact of currency entirely. Those without a currency view should also consider a currency neutral position and fully hedge their currency exposure. Another approach, for those uncertain of currency movements in the coming year, would be to hedge half of one’s currency exposure.

The forces that drove the dollar higher in 2014, namely economic and central bank divergence between the U.S. and developed international markets, are likely to persist in 2015 and beyond. We think currency hedging is absolutely essential for investors who intend to participate in developed international equity markets in the years to come. Within emerging markets, we have seen increased volatility in currency movements relative to the U.S. dollar, which is likely to persist in 2015. Currency hedging to reduce volatility in emerging market positions is a strategy that has recently been embraced by investors and we believe will be effective in the years to come.

What regions of the global equity market do you believe offer good value?

We see 2015 as a more “normal” year, in which earnings growth and dividends will play a greater part in driving equity market returns. With that in mind, we see opportunities in many regions. Corporate profits in the U.S. will likely support equity markets here. We believe that the Japanese market has meaningful upside from improving corporate profits as well, and Bank of Japan and pension fund buying will provide support. We also see lots of reasons to like Europe, even with the sluggish growth picture. European Central Bank easing is expected early in the year, which will likely boost equities. There is also a great deal of room for improvement in earnings per share. Deutsche Asset & Wealth Management sees strong performance for European equities next year from higher corporate earnings and not multiple expansion. As earnings increase, we expect an uptick in capital expenditures, which have been low and a drag over the past year on headline GDP numbers. Additionally, shareholder friendly activity is expected to increase among European companies in the form of dividend increases and share buybacks.

There are concerns about reduced liquidity in the U.S. bond market. Should this worry advisors who use bond ETFs for fixed income exposure?

Fixed income ETFs have been one of the fastest growing segments of the ETF marketplace and now represent over $400 billion in assets, or nearly 14% of total industry assets. Their growth is reflective of investors’ increasing awareness of the enormous advantages ETFs offer when applied to fixed income, given their low costs, tax efficiency, transparency and liquidity. At a high level, ETFs transport bond trading from over the counter markets to equity exchanges, as ETFs trade on stock exchanges. Over the counter markets tend to be relatively opaque, negotiated and frequently have high trading costs, particularly for individual investors. In contrast, equity exchanges are transparent, highly competitive and generally offer much lower trading costs.

What we are seeing today has been a dramatic increase in fixed income ETF trading volume and a corresponding drop in available inventory and trading activity in individual bonds among financial advisors. Certain segments of the fixed income market have and will likely continue to be discontinuously liquid, meaning that much of the trading volume occurs at new issuance and then diminishes over time as many fixed income investors hold bonds until they mature. ETFs provide a solution to the lack of liquidity in fixed income markets and offer a way for market participants to trade bond markets throughout the day at market consensus prices. For less liquid bond markets, this may result in the appearance of premiums and discounts in ETFs relative to their underlying holdings. The less liquid the underlying bonds, the higher potential of a premium or discount to appear.

The important point for advisors to keep in mind is that premiums or discounts may not necessarily be mispricing, but rather the market’s estimate of the actionable price of acquiring those bonds. While this introduces uncertainty and higher care should be taken on what price to trade a fixed income ETF, it offers a means for investors to both buy and sell bond exposures that otherwise would be hard to trade, easily and efficiently.

Do you think the benefits of alternative beta have been overstated?

Alternative beta ETFs have and will continue to deliver a meaningful amount of value to investors. They have been a major driver of recent ETF growth and new issuance. While less than 20% of all equity ETF assets are invested in alternative beta funds, a much higher percentage of new money over the past two years has gone into these funds. Alternative beta goes by a host of other names—all generally meaning some variant of non-traditional indexing methods. For simplicity, we define alternative beta as any rules based index strategy that screens and weights stocks by something other than market capitalization. Examples include equal weighting, dividend weighting and volatility weighting. We view alternative beta indices as a diversified way to identify particular characteristics in the marketplace that investors desire, such as high dividend growth, attractive valuations and low volatility. In our view, a particularly interesting opportunity for investors exists in factor strategy indices. These attempt to quantitatively harness identified sources of risk premia, like momentum, low volatility, quality and value, which have historically been chalked up to alpha. In our view, there is tremendous room for innovation and investor adoption in this space.

The Chinese equity market has seen a lot of interest from foreign investors last year. How do you see this investment theme developing in 2015?

Foreign investor access to China is something that’s evolving dramatically. Due to foreign investment restrictions in China, multiple share classes of Chinese companies exist on various exchanges. Among some well-known share types are A-shares, B-shares, H-shares and red chips. However, China A-shares, those listed on the Shanghai and Shenzhen exchanges, have historically only been available for purchase by mainland citizens.

The A-share market represents roughly half of the total market capitalization of Chinese equities. U.S. investors are more familiar with other share classes because they are held in the larger Chinese exchange-traded funds—H-shares, red chips, P chips. Those are all listed outside of China. The A-share market previously hasn’t been accessible to investors. In fact, foreign ownership only accounts for 1.5% of the mainland China market. This is 1.5% of the roughly 50% of the overall market capitalization that China has to offer.

In addition, MSCI is considering adding A-shares to their widely used MSCI EM indices. Although this didn’t happen in 2014, MSCI will revisit this issue in 2015 and potentially include a portion of the A-share market. Full inclusion of A-shares in the MSCI Emerging Markets Index could mean inflows of $140 billion or more.

Today, most investors hold China ETFs that offer exposure to Hong Kong-listed Chinese equities. They don’t have access to the A-share market, or hadn’t until Deutsche Asset & Wealth Management launched Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR), the first ETF in the U.S. to provide exposure to that part of the market. ASHR is an ideal complement to the existing Chinese holdings that many investors may already hold. There’s no overlap—ASHR is purely A-shares.

For investors seeking core Chinese equity exposure, Deutsche X-trackers Harvest MSCI All China Equity ETF (CN) is an ideal single-ticket solution. CN is based on the MSCI All China Index, which holds all Chinese stocks regardless of where they’re listed, and offers the most comprehensive and diversified exposure to Chinese stocks available today.