Look into Hong Kong’s financial newspapers or street bus stands, and one crop of advertisements keeps popping up: exchange-traded funds (ETFs).
The scope of locally created and focused funds are expanding, while well-recognised international funds continue to re-list in either Hong Kong or Singapore, seeking to draw regional investor money into their coffers.
With the world’s stock markets looking as if they have turned a corner, but uncertainty remaining over the outlook for the world’s economy, this level of marketing is only likely to grow.
At their most basic, ETFs are funds that list on a stock exchange and use the money raised from doing so to invest in an exposure of underlying financial instruments that constitute a set benchmark.
The better an ETF, the closer it matches the performance of the products in its benchmark. The managers take a small fee – typically 9-15 basis points (bp) for equity ETFs or 20bp-25bp for bond or commodity ETFs – for managing the portfolio. In return investors get exposure to an asset class without having to actively manage such exposures themselves, and the ability to easily withdraw their money from liquid products.
Larger and more established ETFs in particular are very liquid, with many post net asset value estimates that are updated every 15 minutes, giving investors a very good idea of how they are trading and minimising the arbitrage of the fund and underlying instruments.
For Asia’s investor base, which is increasingly wealthy but lacking expertise in many areas, particularly global fund management, ETFs fill a hole. They offer diversification and ease of investment.
This region is particularly attractive to ETF providers because of its growth potential. The reason there are so many adverts for ETFs in places such as Hong Kong is that the market is far less developed than in Europe and the US. Investors in the region are less familiar with the concept, and they tend to buy a narrower array of funds.
For the leading ETF providers, that offers an opportunity.
“ETFs in Asia are a hugely fast-growing space for wealth services and the asset management industry,” says Frank Henze, head of Standard & Poor’s deparitary receipts (SPDR) ETFs, Asia Pacific, for State Street Global Advisors (SSgA), the second-largest provider of ETFs in the world. “Many institutions use ETFs as temporary investments or for settlement and cash management purposes, given their liquidity.”
Sandra Lee, managing director and head of iShares for Asia at BlackRock, adds that demand into ETFs has already been strong in 2012. “Net new assets [into iShares funds] have doubled year-on-year from HK$25.2 billion to HK$52 billion (US$3.23 billion to US$6.67 billion),” she notes.
The ETF market in Asia ex-Japan is already sizeable. At the end of December 2011 there were 396 ETFs and exchange-traded products in the region (most of which were equity tracker funds), managing around US$91.5 billion in assets.
This has since grown further. Henze estimates that ETFs now manage around US$100 billion, but take out Japan and this is closer to US$54 billion, says Lee. Both agree that the industry is growing fast, with Lee estimating ETF assets under management in the region to be growing at 35%-40% per annum for Asia ex-Japan.
If there’s any downside to the instruments it is the fact that investors have to rely heavily on the competence of the providers and their counterparties.
Added into that, some ETFs are synthetic, which means that they use derivatives to approximate underlying positions rather than buying the assets themselves.
The ability to monitor the growth of ETFs, and ensure that minimum standards of the instruments are maintained is vital to ensure the market’s healthy progression.
The appeal of ETFs in Asia began following the Asia financial crisis of 1997-1998. Their principal appeal was their liquidity.
“Investors wanted more control over their investments by way of having access to liquid tools in addition to stock picking,” says BlackRock’s Lee. “Following the crisis more people wanted liquidity reasons in particular. And given last year’s tsunami in Japan, and then the US downgrade [from ‘AAA’ to ‘AA+’ by Standard & Poor’s in August 2011] it’s been shown that stock and bond markets can be very volatile. As a result more investors are using ETFs as an intraday means to enter and exit markets.”
This demand has since grown. But markets in the region tend to have different product preferences. Unlike the US, which is one country with one financial market and currency, or the Eurozone, which may consist of many countries but has one currency and set of rules, Asia is filled with countries with either middle-sized economies or a pronounced home bias in their investments.
That has produced a varying set of preferences when it comes to ETFs.
“Each country has a slightly different dynamic depending on the maturity of their financial services industry, the focus of that industry, and the growth of that particular country,” says Henze of SSgA. “For example in China ETFs are most typically used by QDIIs [qualified domestic institutional investors, or funds approved to invest in overseas assets] because ETFs offer them an easy way to gain exposure to investment themes without having to build in-house expertise.
“Singapore is very different; it is driven heavily by the wealth industry. ETFs are a core component of wealth and private wealth portfolios. The demand for ETFs in South Korea meanwhile is heavily driven by retail clients, and as a result there is a lot of small tickets and high turnover of ETF stocks on the exchange.”
Hong Kong is one of the largest hubs for ETFs in Asia, and it’s also the market with the most eclectic factors supporting its growth. The city comprises elements of high net worth and retail demand – with the latter being promulgated by advertisements of various ETFs across the city. Institutional investor support is strong too, with emphasis being placed on ETFs that can be used as part of the local populace’s Mandatory Provident Fund allocations, or their required monthly pension contributions.
“Pension funds have more of a home bias,” adds Lee, “but more institutional investors in Asia generally are valuing overseas investments and are dipping their toes into new markets.”
This has been made easier by the fact that established international ETFs regularly re-list on local exchanges, in hopes of finding regional demand for large, liquid instruments that offer regional investors easy access to international products.
Such products have some appeal in Asia. “It can be difficult to sell US products into Europe but it’s generally easier here, due to the natural desire to tap liquidity. The aspect of ETFs as a trading tool resonates stronger with many Asian investors than as an asset allocation tool.”
This means that major international ETFs like the SPDR S&P 500, the first ever US ETF that was set up in 1993, or the Hang Seng Tracker Fund, get a lot of Asian investor interest.
Such ETFs also offer markets that are constrained in their ability to get indirect exposure to areas into which they are either constrained from investing, or have little understanding. Chinese QDIIs use ETFs for this very purpose.
Another thing ETFs can be used for is taking a more defensive bet on the market.
Overall equity ETFs still dominate in Asia, which is a region well known for its heavy investor interest in stocks. Developed country Asian ETFs still account for over half the assets under management in the region, and emerging Asia ETFs are the recipients of another sizeable percentage of funds.
But this is beginning to change slowly. ETF providers note in particular that bond ETFs are gaining traction in Asia. Again, their relative liquidity appeals.
“Fixed income ETFs are fast-growing; investors like them due to their liquidity and transparency, and you can access bonds onshore versus [having to trade the bonds in the over-the-counter market] offshore,” says Lee. “Investors like to use such ETFs. It keeps them nimble.”
She notes that emerging market and high yield bonds and equity ETFs in particular have been gaining appeal, as investors gamble that the world’s economy is improving and that it is time to become more adventurous in their investments in the hope of getting better returns.
Commodity ETFs are also gaining traction.
“ETFs offer investors the ability to get access to instruments like that they may have had trouble doing so before,” says Henze.
This is certainly the case with bonds, which are typically very expensive on a unitary basis, with an individual bond often costing US$10,000 or even US$100,000, and the bonds generally being distributed to institutional investors via bank syndicates. Retail bonds exist too but they are far less liquid or common, particularly in Asia.
Commodities offer their own difficulties, in particular the need to buy and physically hold the underlying asset or participate in futures markets, the navigation of which might well not be the primary strength of the investor.
One popular ETF in Asia outside of the equities space has been State Street’s SPDR Gold Trust.
“It is the most liquid commodities fund in the world and it’s got tremendous appeal in Asia as people can buy or sell it in sizeable volumes,” says Henze. “And the location of the transactions doesn’t matter much because it has had a lot of appeal across the world, especially where people are looking at easily executable products and easy liquidity. It’s strongly used in the wealth space and in gold portfolios, and many Asians are comfortable investing into gold.”
However the ETF has not had a sterling time of late, with its performance having trailed off as investors have in general abandoned gold in the hopes of benefiting from the sustained rally of equity prices during the first half of 2012.
The fund’s equity valuation dropped from US$165.65 at the beginning of March to US$162.12 on March 31.
“On the one hand people think it’s a readjustment, but on the other hand inflation is a real issue, even if it’s not quite as pressing as last year and gold is a counter-cyclical investment to rising inflation,” says Henze.
Talk to market luminaries SSgA and BlackRock, and it’s little surprise that they extol the virtues of investing into ETFs with larger providers.
“Investors here show a marked preference for investing with larger providers because they have local and international products, in terms of underlying product as well as listing, and recognised execution capabilities,” says Henze. “A lot of ETFs live or die by their infrastructure.”
Instruments like ETFs rely on their ability to accurately monitor and reflect the performance of underlying instruments. That depends on possessing strong execution, trading and settlement capabilities.
Large ETF providers like BlackRock and SSgA tend to conduct ETFs based on physical assets to ensure this. Employing synthetics to mimic an underlying basket’s performance generates an entirely difference set of exposures, both in terms of the financial markets – i.e. relying on the direction of futures – and the counterparties that offer such derivatives.
However the need for such sophistication can also make ETFs somewhat esoteric. Buying into them is easy enough, but engagement with the providers of the ETFs can be a challenge.
Added to this there is the complexity of knowing exactly what counterparty risk investors are exposing themselves to when they buy into an ETF.
These are all points that Kha Loon Lee, head of the standards and financial market integrity division, Asia Pacific, of the CFA Institute says he would like to see looked at.
“In the REIT space you see more analyst research coverage but this hasn’t happened yet in the ETF space, as far as I can tell, so there is a lack of third-party coverage. The information on ETFs is not easy to get, and there are no company account filings, so a lot of the information on ETFs depends on what the provider wants to give.”
He feels that setting up a system whereby such information is accessible, and ideally having third-party analysts to assess ETFs would benefit their clarity and minimise the chances of providers misstating facts or the composition and performance of their ETFs.
He also advises that ETFs have a standard level of disclosure that they are required to meet, such as offering complete counterparty disclosure. That is particularly important in Asia, where the sector is growing so quickly.
Henze agrees that more can and should be done to improve understanding and clarity about the industry.
“Education, transparency and clarity are all important. This debate has been rolling on for the last year or so, with various regulatory forays and conclusions drawn from across the world,” he says. “The conclusions have all strengthened the product. In Hong Kong for example there is now a trading symbol where someone is obviously trading a non-physical ETF, while in Australia such products need to be called synthetic.”
Another important development has been that ETFs’ collateral requirements have increasingly been made more stringent. Henze notes that Hong Kong’s Securities and Futures Commission for example has increased the collateral requirement of ETFs for synthetic funds to levels of over 100% fund’s exposure.
There have also been moves to ensure that less risky assets are included as part of this collateral, to reduce the structural risks of such ETFs.
“Fundamentally we want to avoid an event in those products, and the quality of the products ought to be comparable,” says Henze. “There is particularly an ongoing focus on synthetic products, and ensuring that they have lower degrees of risk.”
Investor education will be a key tool to keep investors happy with buying into new types of ETF. Again, this is an area where larger providers feel they have an advantage as they have the personnel and resources to talk to investors.
“Investor education takes time but is essential for new ETFs,” says Lee. It’s important to be able to display a fund’s liquidity and tracking success, but mutual fund managers in particular tend to wait and see before entering new products, so having success over a sustained period is important.”
The hope among all ETF providers for Asia is that as the region’s institutional funds and retail investments rise, ETFs will enjoy more than their fair share of growth.
Some of this will be inevitable; ETFs most likely will grow inevitably simply because the pool of investible money in Asia is doing so. SSgA’s Henze estimates that the amount of Asian money invested into ETFs could grow from around US$100 billion to the level of Europe’s investment of US$400 billion over the next five to six years.
“More clients will come to the market, understand how ETFs work, and see how they trade, while more ETFs will branch into new assets and products that attract yet other investors,” predicts Henze.
The growth of regional pension pots is likely to facilitate that too, which will be another advantage to larger ETF providers as they confer a greater identity of endurance and reliability, while the ETFs that they run tend to be more liquid, an important factor for institutional investors.
China-related ETFs are a good bet. Several already exist – iShares has nine ETFs covering China alone – but it’s likely that these will rise as the country liberalises its currency convertibility and capital account, and as the offshore renminbi grows.
This could however also mean more synthetic funds, at least in the short-term, given the inability of foreign funds to access onshore China shares or bonds. In this instance at least some offshore Chinese asset managers may have an advantage too, via RQFII, or the licences some of them have recently received to invest into mainland bonds.
Potentially these funds could eventually parlay this access into creating China bond ETFs. It’s unlikely to happen soon however; the asset managers have highly circumscribed levels of access, which would likely have to rise a lot before they could easily offer such ETFs.
Another prospect would be for offshore renminbi-denominated bond ETFs in the not-too distant future. The secondary market for dim sum bonds remains fairly illiquid for now, but as it grow and more names enter this will change, and there will no doubt be ETF providers seeking to take advantage of this, either physically or through synthetics.
Be prepared to see many new ads about ETF products; their spread into Asia looks unlikely to slacken any time soon.