Part 1 of this three-part product briefing on exchange-traded funds (ETFs) looks at the basic features, structures, benefits and risks of this increasingly-popular investment tool – as well as at how the market has evolved and some of the opportunities and challenges for ETFs going forward.
Date: Apr 2010
Tags: Fees, Transparency, Diversification, Index, Equities, Commodities, Asset classes, Fixed income, Mutual funds, Tracking error, Liquidity, Benchmark, Risk
The family of exchange-traded products
When talking about exchange-traded products, Mark Wightman, vice president, Asia Pacific at SuperDerivatives, said this generally refers to a family of different structures.
Probably the most common are exchange-traded funds (ETFs), but it also includes exchange-traded commodities (ETCs) and exchange-traded notes (ETNs).
Wightman said these products arose from the natural evolution of passive trackers, which allow both retail and institutional investors access to a pool of assets on an exchange-traded basis – and often assets which the investors would otherwise not easily be able to get access to directly.
It is important to first understand the key characteristics of each structure. According to Chin-Ping Chia, executive director and head of research for MSCI Barra in Asia Pacific, ETFs are open-end tracking mutual funds which trade like a stock, enabling investors to buy and sell them throughout the day. Plus, since they act like stocks, Chia said it is possible to do things like short them or lend them out. Further, he added, ETFs track an underlying index.
For example, said Steve Davies, chief executive officer of Javelin Wealth Management, it is possible to have an ETF which tracks the Straits Times Index (STI) in Singapore, or one which tracks the MSCI worldwide equity index.
Since ETFs are structured to match the constituents of the particular index they track, they therefore generally match its performance, explained Davies.
When it comes to ETCs, Wightman at SuperDerivatives said the only difference is that the underlying is a commodity-based structure, which could be a single commodity.
For example, he said, some ETC structures allow investors to invest directly in crude oil, but also in more esoteric assets such as sugar, cocoa, or heating oil.
ETNs, meanwhile, refer to products in note format, said Wightman. In turn, he warned investors and advisers to be aware of the counterparty risk in terms of the entity which is creating the note in the first place.
Basic ETF structures and types
According to Sutat Chew, executive vice president and head of market development at Singapore Exchange Limited (SGX), ETFs started as simple instruments to give investors what they wanted for what they saw.
This meant benchmarking to a particular index with the aim of tracking it in terms of its returns, he explained.
So with the traditional ETFs which first came out in the US, the investment managers which created them used a technique called full replication.
Chew explained that this meant the investment managers bought a series of stocks to replicate the relevant index, enabling, for example, investors to buy an ETF on the SPDR (run by State Street Global Advisors) and so get exposure to the entire S&P index in one go
To create an ETF product, Chia at MSCI Barra said ETF providers typically assemble an investment team to look into replicating the position of stocks in a portfolio and tracking an index.
The providers also need market players and intermediaries to help them develop the market, for example through market dealers to ensure liquidity in the process of creating an ETF.
When looking at the building blocks of ETFs, Chia said the most important thing is to understand the underlying index which the product tracks – in terms of the objectives of the index, how the index is constructed, its methodology and coverage, and how it is maintained.
For equity products, Davies at Javelin Wealth Management said it comes down to buying the number of individual equities which compose the particular index, and then reweighting the index on a daily basis to adjust for movements in the value of the underlying stocks.
The same applies for ETCs, he explained, although they tend to buy physical assets. For example, he added, apart from central banks, the StreetTracks Gold ETF is the world’s biggest buyer of physical gold.
Currency ETFs are another common type, added Joseph Ho, managing director and head of ETF sales & marketing for Société Générale in Asia.
While banks in Hong Kong might offer customers the option to have their accounts in multiple currencies, banks in the US generally only allow customers to hold money in US dollars. Currency ETFs, which are benchmarked on exchange rates, therefore allow investors to play the exchange market, he said.
There are also fixed income ETFs, which Davies said invest in baskets of different fixed income products, for instance bonds, high-yield debt, or treasuries.
The benefits of ETFs versus mutual funds
According to Chew at SGX, ETFs have several key advantages: they are efficient, given that they are easily accessible by investors as well as being lower cost than traditional mutual funds; they are transparent in terms of pricing; and they are flexible, because investors can buy and sell them throughout the trading day. By contrast, he said investors can only buy and sell mutual funds at their net asset value (NAV) on a forward basis.
In Chia’s view, this is one of the key differences between ETFs and mutual funds – relating to the arbitrage mechanism arising from the in-kind creation and redemption process.
Authorised participants can create shares of ETFs by turning a pre-defined basket of stocks in exchange for the equivalent value of ETF shares, and vice versa, he explained. This process allows underlying ETFs to be priced close to the NAV of underlying portfolios, allowing ETF to trade continuously throughout the day with a price.
In terms of the cost benefits of ETFs, Davies explained that mutual funds and unit trusts typically have front-end loads or wide bid-offer spreads attached to the funds when investors buy them – which can be as much as 5%.
In addition, he said there are annual management changes of anything from 0.75% to 1.5%. Over a five-year period, for example, such charges might on their own take 7% to 9% cumulatively off the performance of the fund, said Davies, adding that this is a significant shortfall for a fund to make up.
Chia said ETFs also offer investors tax advantages compared with mutual funds – which is especially relevant for investors in markets where capital gains tax is imposed. In the context of mutual funds, any gains which investors make when they sell their shares from a portfolio are taxable. With ETFs, however, he said that since this is an in-kind redemption, there is no physical selling of securities, meaning no tax to pay.
From a performance perspective, Davies said that when reviewing historical patterns, on average about two-thirds of actively-managed mutual funds or unit trusts underperform their benchmarks – meaning that investors are paying for that underperformance.
As a result, if investors can only predict that one-third of actively-managed mutual funds or unit trusts will outperform the index, Davies said it is probably better to buy the index via an ETF.
Market development and evolution
According to Davies, ETFs were originally created by investment management company Vanguard, which felt that the fees being charged by many active managers were not justified by the performance of the mutual funds which they managed.
Vanguard’s thinking was to replicate a specific index to give its clients market performance at a low cost, he explained, given there were no requirements for any active management.
The first ETF, which was on the S&P 500, listed in the US in 1991, said Chew, although it then took about seven years before the ETF market in the US really developed.
The US market didn’t really get going until the QQQ ETF was launched, added Chia. That development in turn led to the first ETF being launched in Europe around the year 2000.
Over the last five years, the number and size of ETFs offered on a worldwide basis has exploded, said Davies.
It has now become a very significant individual product class, covering everything from equities to fixed income to commodities to currencies. In fact, he added, an ETF can be created on almost anything on which an index exists.
In Asia, Chew said that despite the rapid growth of ETFs, it is still a nascent market, although he said Asia is coming towards the end of a seven-year cycle.
As part of this process, Chia explained that many stock exchanges in the region are starting to place increasing importance on developing their ETF markets.
Exchanges in Singapore, Hong Kong, Korea and Japan, for example, all have ETFs listed on them.
The financial crisis has also had a positive impact on the ETF market.
Before the crisis, a lot of investment activity was driven by the selling process, explained Peter Hu, managing director and head of investor solutions for Barclays Capital in non-Japan Asia. However, as the market went into crisis mode, Hu said there was a hunt by investors for simpler exposures to different opportunities – with exchange-traded products providing such exposures in a transparent, liquid and expedient manner.
Key risks of ETFs
In addition to knowing the benefits of ETFs, there are also various risks for advisers and clients to be aware.
First is market risk, said Ho at Société Générale, explaining that investors need to look at the underlying index which their ETF is tracking to determine the investment risk being taken. For example, when investors buy an ETF on the MSCI Korea Index, he explained that they are getting the risk of the Korean market (as well as the currency risk in that case).
In comparison, added Ho, the structure of mutual funds tends to give investors a lot of protection because assets are held separately from the manager via a trustee.
It is also important to remember that not all ETFs are created equal, said Davies.
While the bigger ETFs are very good because they are liquid and everyone makes a market in them – in turn enabling investors to buy and sell them very easily – some of the smaller ETFs have much greater liquidity risk, he explained.
It might therefore be more difficult to buy and sell them on a daily basis, leading to pricing anomalies.
Another key risk of ETFs – which was seen during the financial crisis – is that a lot of these products are backed by a particular underlying entity. This means that if that entity defaults, then based on the capital structure, the recovery value will be determined by the recovery value of the underlying bond, plus the NAV of the particular exposure, said Hu at Barclays Capital.
For people concerned about counterparty risk, Wightman said advisers and investors must make sure they understand what is sitting behind the ETF and who the counterpart is.
For Davies, when assessing ETFs, he said that in addition to looking for quality issuers and the liquidity of the ETF, he also looks to see if the ETF provides adequate representation of the underlying index – and therefore whether tracking error is significant or relatively nominal.
According to Chia, that tends to boil down to the manufacturing techniques which ETF providers use, with different techniques potentially producing different amounts of tracking error.
Some of them use full replication, he explained, to essentially replicate all components of the securities of the index – which typically results in low tracking error. Others, however, will use sampling, or an optimised approach, to track an index. In these cases, Chia said there will likely be more tracking error.
Davies said that tracking error which is relatively small, for example less than 0.5%, is acceptable.
But if it is more than that, investors and advisers need to ask why.
Chew at SGX said there are also risks relating to the use of derivatives and swaps in ETF structures.
In the last two to three years, he said that a lot of attention has been focused on single-product ETFs, such as commodities, which involve derivatives.
Yet while single commodity ETFs are a great way for investors to get access to a precious metal or agricultural product, Chew explained that being based on a single derivative makes these products riskier than ETFs which involve a series of total return swaps spread across different investment banks with different concentration risks with collateral behind them.
Market outlook and challenges
In terms of the outlook for ETFs in Asia, Chia said that if the market continues to develop as it has been, then the next stage will be more sophisticated forms of product innovation to capture different types of investment strategy and asset classes.
Wightman said the natural evolution over time is likely to involve international ETF providers offering more local currency products. He said he sees no reason why more “Asian-ised” products won’t be developed, based on various thematic or asset-based stories relevant to the region.
However, cautioned Ho, a big obstacle to the further development and growth of the ETF market in Asia arises from trying to encourage brokers to sell the product.
Because traditional mutual funds pay a fee to the distributor, there is a clear incentive for brokers to try to sell the product, he explained. But with ETFs, providers cannot rely on brokers pushing the product, given the brokers’ commission-led incentives to encourage clients to trade in and out of (more volatile) individual stocks or mutual funds. In contrast, ETFs by their nature are diverse baskets of stocks so are less volatile than single stocks and therefore less likely to be traded as frequently.
For certain ETF products, for example A-Share ETFs, Ho said brokers will sell them to clients as they cannot sell individual A-Share stocks – and are not therefore compromising any potential commissions. But in general, he said ETF providers need to help end-investors understand the value of ETFs so that they demand them from their brokers.
The key hurdle, he explained, is that accessing and educating end-investors directly are time-consuming and costly processes.
Further, added Chia, passive investment strategies are not things that many retail investors are used to. Understanding the role of ETFs in their portfolio and asset allocation is therefore a critical aspect which needs a lot of education.
