Despite the dramatic growth in exchange-traded funds (ETFs) to date in Asia, investors still have a long way to go to fully understand the real value and use of these products as investment tools if ETFs are to gain further traction across the region and start to form a larger proportion of portfolios.
Date: July 2010
Tags: ETFs, Liquidity, Asset allocation, Portfolio construction, Fees, Transparency, Index, Derivatives
Despite the dramatic growth in exchange-traded funds (ETFs) to date in Asia, investors still have a long way to go to fully understand the real value and use of these products as investment tools if ETFs are to gain further traction across the region and start to form a larger proportion of portfolios.
And while ETFs seem to tick the boxes of simplicity, liquidity and transparency – increasingly sought-after product characteristics in the wake of the financial crisis – further education is needed to determine precisely how versatile and liquid they are, and to help advisers to be able to incorporate them effectively for their clients.
To discuss and debate these issues, some of the region’s leading practitioners in the ETF space came together for a panel discussion hosted by Thomson Reuters in Singapore in early July.
Market development
On a global basis, ETFs have been a phenomenon over the last decade or so – starting in the US, and then followed by Europe – in terms of volume as well as the allocation of funds by both institutional and private clients.
In Asia, ETFs are still developing, said Sutat Chew, head of the securities business at Singapore Exchange (SGX), with slow and steady growth. “But the product set is gradually depending and widening across markets and stock exchanges,” he said.
After the initial equity products were launched in Hong Kong and Singapore in the late 1990s and early 2000s, more issuers are increasingly coming to market with new products, explained Chew. “Commodity ETFs have gathered momentum in the region in recent years, and the last 12 months or so has seen the arrival of fixed income ETFs.”
This enables private clients to access a range of asset classes in real time in a cheap and efficient way, he said.
At the same time, there is also increasing success in Asia in terms of cross-listings, added Hon Cheung, regional director, official institutions group, for State Street Global Advisors in Asia.
According to Marco Montanari, head of db x-trackers ETFs for Deutsche Bank in Asia, there are certain similarities between the way that Europe’s ETF market developed and the way the market in Asia is evolving.
“For example,” he said, “Europe is also composed of a lot of separate markets, plus Asia has been very receptive to European structures – with the majority of ETFs listed in Singapore and Hong Kong being UCITS III-compliant.”
What is missing in Asia, however, is the ability to sell an ETF in any country once it is approved in one market. Some agreements are being discussed in North Asia, but this is yet to happen, said Montanari. As a result, some Asian investors are buying ETFs listed in the US or Europe.
Looking outside of Asia, Christopher Johnson, senior manager in the ETF product management group at Vanguard, said there is a lot of overlap of products in the US and Europe – with almost all types of products already represented.
In terms of newer developments, he pointed to Canada, where active ETFs are coming to market quite aggressively. There is also only a monthly disclosure requirement, creating less of a hurdle for these products than, for example, exists in the US, where daily disclosure is required, said Johnson.
Using ETFs as investment tools
At Singapore-based AL Wealth Partners, chief investment officer Leo Drago said the firm is virtually 100% invested in ETFs for its equities exposure. “The reason for this is because we believe that stock-picking equates to taking an implicit view that those stocks are going to outperform that ETF sector or the overall market. However, most fund managers underperform,” said Drago.
As a result, he said it is easier to use ETFs to express specific views in a diversified portfolio.
Interestingly, a lot of US-based hedge funds are using more and more ETFs, said Drago, explaining that if they are bullish on the banking sector, they increasingly prefer to buy the ETF on this sector rather than the individual banking stocks.
For investors in Asia to do this, however, they need to take into account various things, he said. “For example, there is some tracking error with some ETFs as a result of certain markets being closed or having restricted currencies.”
According to Cheung, the usual checklist for investors to determine which ETFs to buy includes the liquidity, cost and also the size of the ETF.
“Softer measures such as the focus of the manager and ETF business, and transparency and simplicity, are also increasingly important for a lot of buyers,” he added.
Many Asian investors also seem to have various misconceptions when it comes to ETFs.
For example, explained Montanari, they often decide which ETFs to buy based on the volumes they can see on the exchange. “The investors give priority to what they perceive as more liquid ETFs, yet they misunderstand the real meaning of liquidity with ETFs,” he said.
Rather than acting like stocks, Montanari said ETFs are instruments which buy stocks, so the liquidity of the ETF depends on the liquidity of these underlyings.
“So ETFs which don’t trade might still be liquid, and investors can call up any market maker to get a price and bid-offer spreads in line with the underlying market,” he said.
However, while the number of ETFs is not pre-defined, and ETFs can be created any time, investors should be aware of situations when the ETF trades more frequently than the underlyings, warned Montanari. “If that happens, then market makers cannot hedge themselves and the price can rise more than the value of the underlying index.”
This has been the case with the China A-Share ETF, he explained, given that access to the underlying is restricted, so the ETF trades at a premium to the underlying index.
In terms of tradability and liquidity, Gerard Ayodeji, managing director of Flow Traders in Singapore, emphasised that it is important to bridge the gap in knowledge about liquidity in the underlying and liquidity in the ETF.
“In the Asia Pacific region, many people still look at the traded volume as an indication of the liquidity of an ETF. This is wrong,” he said. “Market makers such as Flow Traders can create and redeem ETFs, which allows them to bring the liquidity in the underlying into the ETF. We regularly provide liquidity by pricing large trades based on the underlying market. As a result of this, ETF trades which are very large when compared to the average daily turnover are possible without much market impact.”
It is also important for investors to understand that not all ETFs are equal, said Chew.
“Some ETFs are created by full replication, and are therefore investing directly in the underlying stocks,” he explained. “On the other hand, ETFs can be created by synthetic replication through the use of some derivatives. Many issuers in Asia use some of these tools and the complex use of some derivatives can eat into the costs of the product.”
In general in Asia, Chew said that ETF research is lacking at the moment: “There is not enough information about different types of ETF products, for example tracking them to different cost structures and whether they perform to their benchmarks, to ensure what investors see is what they actually get.”
Further, said Ayodeji, it is important for investors to be clear on the reasons why they are buying an ETF in the first place.
If investors have a strategic longer term view and plan to hold onto ETFs for two to three years, then a bit of market impact should not make too much difference, he explained. This would then influence what type of ETF is most appropriate.
On the other hand, said Ayodeji, short-term tactical traders need to be aware of which ETFs they can buy quickly, efficiently and in sufficient size. “They also need to be sure that they will be able to get an exit price when they need it. This is important to give these investors the confidence to trade it in the size, and as aggressively and quickly, as they need to.”
Time zone and tax issues
For investors looking to buy ETFs linked to Asian underlyings, Montanari said it is better to buy them in Asia, and therefore in the local time zone, because it is easier to check the price of the underlyings and the price of the ETF.
If investors buy an ETF in the US or Europe which is linked to the Korean or Taiwanese indexes, for example, he said investors will have to trade while the underlying market is closed/. “This means the price will be based on expectations.”
The same concept is true for investors looking to buy ETFs linked to European or US indexes, added Montanari. “It is better to buy them in their home markets rather than in Asia.”
Asian investors should also be aware of taxes they might be subject to on their dividends, he said, depending on where the ETF is listed.
For example, if an investor buys an ETF listed outside of Asia, for instance in the US, they might be subject to 30% tax on their dividends. So the economic benefits will be negated.
All-ETF portfolios
As the universe of different types of ETFs expands to cover a wide range of asset classes, it is realistic to create portfolios made up entirely of ETFs – if using global products and not just confining portfolios to what is available in Asia.
According to Cheung, the one aspect of finance theory which has been proven to work consistently over time is diversification. So, he asked, why shouldn’t investors look to use a passive strategy via ETFs to achieve this?
In Asia, however, Drago said that many retail investors think they can pick stocks which will outperform ETFs. Yet most of them underperform.
“The fact that many clients in Asia like to have control over their investments and speculate on single stocks is a key barrier to ETFs being adopted in a much bigger way,” said Drago.
In line with the idea of constructing portfolios using ETFs, Chew said it is important to dispel two key myths. First, he said, is private investors’ notion that it is easy to outperform ETFs in Asia.
“In the US,” explained Chew, “maybe 5% to 10% of managers might outperform the S&P500, so going for cheap beta through buying an S&P500 ETF product is a good way to access the market. In Asia, the assumption is that managers can generate more alpha because of there being a number of inefficient markets. Yet even in inefficient markets like India and China, there are still only 50% of managers – at most – which outperform the market. So investors are still taking a large bet.”
The second myth relates to the limited number of Asian products available. However, said Chew, with more and more products coming to the region’s exchanges, it is possible to construct a portfolio in this time zone using various building blocks to give global coverage across asset classes.
With ETFs, Cheung said wealth managers can also take a more active role in advising their clients and managing the overall risk in the portfolio. “And in a way which is consistent with doing the best job for their clients,” he added. “This is making ETFs look more attractive from a business perspective,”
In Europe in 2008, for example, active funds saw outflows of around US$350 billion while ETFs saw inflows of around US$50 billion. As a result, Montanari said that no financial advisers could continue to ignore whether they should offer ETFs to their clients.
“Advisers also had to regain the trust of clients, meaning they had to be more open to more efficient products,” he explained.
Chew said that with the costs of front- and back-end loads and wider bid-offer spreads, how often can advisers really churn mutual funds in a client’s portfolio and actually make money on a regular basis?
While ETFs might not earn advisers anywhere near as much in fees as they get from structured products, Chew said it is hard to explain to clients the rationale for having in their portfolios expensive products which might be losing value on a compounded basis as a result of giving away management fees.
ETF wish list for Asia
Looking forward, market participants have various items on their wish-lists of how they would like to see the Asian ETF market develop.
Montanari said he would like to see investors start to buy locally-listed ETFs, rather than offshore ETFs – because of the tax advantages as well as the variety of ETFs which now exist across Asia. “There is also now sufficient disclosure to give investors the required comfort,” he said.
According to Montanari, if the US$30 billion currently invested by Asian investors in ETFs listed in the US and Europe comes back to Asia ex-Japan over the next few years, then the region’s ETF market will double in size.
Cheung said he would like to see regulators take steps to improve access to their markets by Asian domiciled products. “One of the reasons for the prevalence of UCITS III-compliant ETFs is because they are the easiest type to structure that can be offered across Asia.” In contrast, he explained it was not always easy or possible to offer an Asian-domiciled ETF in other Asian markets.
While there are an increasing number of ETF issuers coming to Asia, Ayodeji said it would be good to see the investor base develop a greater understanding of what ETFs can really do for their portfolios, and therefore how and when they can use them appropriately. “This would lead to a lot more ETF trading,” he said.
One of the most desirable developments from Johnson’s perspective would be a move towards fee-based advisory services. “Without this, ETFs will continue to be held back,” he said.
For Chew, more knowledge generally among financial professionals in Asia about ETFs is vital. “If that happens, I cannot see any reason why there won’t be growth in assets for managers and growth in volumes for the exchanges,” he said.
Meanwhile, Drago said he would like to see more ETF providers offering different types of products targeting specific sectors – including pan-Asian products – to enable asset managers to have more choice and investors to make bets in their portfolios more easily. “The market doesn’t need more issuers copying each others’ products,” he said.
