The DAX is a total-return index (dividends are reinvested into the index) made up of the 30 largest and most liquid German companies listed on the Frankfurt Stock Exchange. They represent 80% of the aggregated Prime Standard segment capitalisation. Individual stocks are weighted on a free-float market-capitalisation basis with a cap of 10% to avoid single-name concentration.
Consumer cyclical, basic materials, and financial services are the index's biggest sectors--both with 15%-20% weightings, followed by healthcare, industrials, and technology (all 10%-15%). Despite a relatively high concentration in the top three sectors, the index's overall exposure is well-diversified, given the almost-even allocations of the remaining sectors and the 10% cap on individual stocks.
Among the companies with higher weightings are chemical company Linde (8%-10%), software company SAP (8%-10%), and insurer Allianz (8%-10%).
The index weightings and constituents are reviewed and rebalanced on a quarterly basis.
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With an ongoing charge of 0.09%, this fund is the second-cheapest DAX ETF on offer. However, its tracking difference (fund return less index return) has been one of the tightest. Investors should also consider trading costs, including bid-ask spreads and brokerage fees, when buying and selling the ETF.
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The fund uses full physical replication to replicate the performance of the DAX Gross Total Return Index, thus purchasing all securities in the same weightings. The fund uses futures for dividend management purposes. This is a standard practice and helps limit tracking error. It is worth noting that this ETF switched from synthetic to physical replication in February 2014.
The ETF engages in securities lending to improve the fund's tracking performance. Deutsche Bank Agency Securities Lending acts as the lending agent. The fund may lend out a maximum of 50% of its portfolio, although in practice the average percentage lent out tends to be below this limit. In the 12 months ended July 18, 2019, the fund lent 2% of its assets under management on average with a maximum of 6% and received a net revenue of 0.01%. Gross lending revenue is split 70/30 between the ETF and the lending agent, respectively. All transactions are overcollateralized, and the securities taken as collateral tend to be top-rated government bonds and blue-chip stocks.
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We acknowledge the advantages of a passive approach to German equities.
Given its meaningful cost advantage, we think Xtrackers DAX ETF has a fair chance of outperforming its average peer in the Germany large-cap equity Morningstar Category in the long run on a risk-adjusted basis.
At face value, the DAX is not what one would call an ideal index in terms of construction. It encompasses a small number of companies (30), which results in high (up to 10%) exposure to single stocks. Besides, like many single-country indexes in Europe, the DAX is fairly concentrated in large and giant caps, with virtually zero exposure to mid- and small caps. This makeup puts the fund at a structural disadvantage relative to actively managed funds in the category. Active managers enjoy the flexibility of venturing down the market-cap ladder to opportunistically dabble in mid- and small-cap names.
That said, the DAX is well-diversified from a sector perspective. And despite its structural disadvantage, the fund has beaten most active managers in the category, especially after adjusting for survivorship bias. The fund has delivered above-average risk-adjusted performance during the trailing 10-year period.
With an ongoing charge of 0.09% the fund benefits from a considerable advantage, an edge that compounds over time. Its fee is well within the bottom quintile of all European single-country strategies. Additionally, while it is not the cheapest DAX exchange-traded fund, it is one of the best-performing in terms of tracking difference. The fund has tracked its benchmark very closely.
Despite its large-cap focus and lack of depth, this fund has done well versus its category peers over time. It is also inexpensive. For these reasons, the fund retains a Morningstar Analyst Rating of Bronze.
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Most DAX-tracking ETFs have a significant cost advantage versus their active peers. Their average fee is 0.13%, significantly lower compared with other European single-country strategies.
Second, despite the low number of stocks it holds, the DAX is well-diversified from a sector perspective. Over the past 15 years, its sector weightings in any single sector have remained under 20% most of the time, except for financials, which peaked at 26% in the runup to the financial crisis. As of this writing, the DAX's largest sector exposures are consumer cyclicals and financial services (both 16%).
The combination of price advantage and sector diversification is thus key; not least considering that irrespective of size, German companies are strongly driven by export performance. This poses the interesting question of whether moving down the cap spectrum in an equity market like Germany may provide fewer opportunities to add value relative to markets where large, mid-, and small caps respond to a heterogeneous set of economic drivers. But highly skilled active managers may exploit the opportunities that do exist.
As we write, measured against its category peers, the DAX's level of risk has been average over the past 10 years and slightly above-average over the past three and five years. We attribute this to the higher allocation to cyclical stocks relative to the average peer. This can cause DAX-tracking funds to experience higher levels of volatility when things get shaky, but it helps boost returns during bull markets.
All things considered, we conclude that a low-cost DAX-tracking fund has a fair chance of delivering returns in excess of its category average over the long term on a risk-adjusted basis. However, we also acknowledge that there is scope for highly skilled active managers to add alpha in this market.
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The cheapest direct alternatives are the synthetically replicated ComStage DAX ETF (ongoing charge: 0.08%) and the physically replicated Vanguard DAX ETF (ongoing charge: 0.10%). The ComStage ETF is domiciled in Luxembourg, while the Vanguard ETF is domiciled in Ireland. The dividends paid by German companies are subject to the same (15%) level of taxation in both jurisdictions.
Aside from DAX ETFs, investors don't have much choice, as few funds that track alternative market-cap-weighted benchmarks are currently available. ComStage FAZ ETF (ongoing charge: 0.15%) offers exposure to Germany's 100 largest companies, while Amundi MSCI Germany (ongoing charge: 0.25%) is made up of around 55-60 companies. Both funds provide slightly broader and more-diversified exposure to the German equity market.
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