Deutsche Asset Management (Deutsche AM) is completing its transformation into one of Europe’s largest providers of physical replication ETF. The firm is currently engaged in converting from synthetic to physical replication a number of its ETFs including those offering euro-denominated corporate bond, US Treasury, and Eurozone government bond exposures, collectively accounting for approximately €3.6bn in assets under management (as of 30 September 2016).

Simon Klein, Deutsche AM’s Head of Passive Investment Sales for EMEA and Asia.

Physical ETFs, or direct replication ETFs, do not use swaps to achieve the reference index exposure. Instead, they physically hold underlying index constituents. In contrast, synthetic ETFs enter into swap agreements with a counterparty (usually a large financial institution) to receive the return on an underlying index in exchange for a stream of cash.

The main criticism of synthetic ETFs stem from the perceived exposure to counterparty risk – the possibility that the counterparty to the swap will not be able to meet its financial obligations. This risk is very low owing to collateralization and further minimized through practices such as netting payments between both parties. On the other hand, synthetic exposures may be more practicable for ETFs which are targeting less developed markets with higher associated trading costs and bid-ask spreads.

While the debate over which replication method is more effective continues to murmur on, there has been a clear shift towards physical replication in the European marketplace, with investors voting with their wallets. According to London-based ETF industry consultants ETFGI, there is now approximately $395.6bn committed to physical ETFs in Europe compared to $115.1bn in synthetic ETFs, as of July 2016.

Following the most recent switches, which took place in September on government bond ETFs, approximately 65% of db X-trackers ETFs, with approximately €26bn in AUM, now utilize a direct replication form.

Simon Klein, Deutsche AM’s Head of Passive Investment Sales for EMEA and Asia, commented: “The market has shown clearly that bond investors prefer physical replication, so we’ve adapted to meet that demand. This is good for the market as there is now another major ETF house in Europe providing a wide range of physical ETF products. That makes it easier for investors to diversify their portfolios to include other ETF providers.”

Recently converted db X-trackers fixed income ETFs:
db x-trackers II Eurozone Government Bond UCITS ETF
db x-trackers II Eurozone Government Bond 1-3 UCITS ETF
db x-trackers II Eurozone Government Bond 3-5 UCITS ETF
db x-trackers II iBoxx $ Treasuries UCITS ETF
db x-trackers II iBoxx $ Treasuries 1-3 UCITS ETF
db x-trackers II iBoxx $ Treasuries Inflation-Linked UCITS ETF

Upcoming conversions of db X-trackers fixed income ETFs:
db x-trackers II iBoxx EUR Liquid Corporate UCITS ETF
db x-trackers II iBoxx EUR Liquid Corporate Financials UCITS ETF
db x-trackers II iBoxx EUR Liquid Corporate Non-Financials UCITS ETF
db x-trackers II iBoxx Sovereigns Eurozone 5-7 UCITS ETF
db x-trackers II iBoxx Sovereigns Eurozone 7-10 UCITS ETF
db x-trackers II iBoxx Sovereigns Eurozone 10-15 UCITS ETF
db x-trackers II iBoxx Sovereigns Eurozone 15+ UCITS ETF
db x-trackers II iBoxx Sovereigns Eurozone 25+ UCITS ETF

Deutsche AM is not the only European ETF provider to be shifting towards greater adoption of the physically-replicating methodology.

Europe’s third largest provider of ETFs Lyxor Asset Management has also been active to moving towards greater physically backed ETFs, setting a goal of a minimum of 50% physical ETF assets. The firm has not renounced synthetic approaches, however, explaining in an interview with ETF Strategy that they are still used to access select markets.

Another issuer, London-based ETF Securities, also recently converted one of its equity ETFs, the ROBO Global Robotics and Automation GO UCITS ETF (LSE: ROBO), into a physically backed ETF, subsequently lowering the fund’s total expense ratio from 0.95% to 0.80% through savings on the underlying swap fee.