Articles

Creating non-equity ETFs in Asia

Marco Montanari of Deutsche Bank looks at the potential for non-equity ETFs in Asia, discussing the challenges to overcome and risks to address in the process.

Date: Oct 2011

Tags: ETFs, Liquidity, Regulation, Suitability

  • More than 90% of the assets in Asia for ETFs have equity underlyings, compared with around 70% in the US and Europe
  • The challenges in creating non-equity products include regulatory restrictions, whether a recognised benchmark exists, and liquidity and market access
  • Most of the work in relation to suitability goes into describing the structure, collateral and transparency
  • The main risks with ETFs include market risk, currency risk, liquidity risk and counterparty risk

According to Marco Montanari in an interview, there are many ETF-related opportunities in Asia in the non-equity space.

More than 90% of the assets in Asia for ETFs have equity underlyings, he explained, compared with around 70% in the US and Europe.

Possibly because of the difficulties in building products linked to Asian underlyings, such as the lack of liquidity and lack of benchmarks, he said the future is in creating more fixed income and commodity exposure with an Asian flavour.

Considerations when creating non-equity products

Montanari said there are various challenges in creating non-equity products, the first of which regulatory related.

For example, when the firm creates an ETF, its create funds in compliance with the UCITS regulations, under which it is possible to create ETFs linked 100% to equity markets outside of OECD countries. However, with an ETF linked to bonds, it has to be linked to bonds of OECD countries.

As a result of this, Montanari said it isn’t possible to create an ETF at the moment under UCITS regulations which is linked to Indonesian bonds, despite this being an attractive market.

The second challenge, he said, comes from the market itself and whether a recognised benchmark exists. This requires discussions with an index provider to then build an index.

A third challenge relates to liquidity and market access, and the extent to which it is possible to efficiently trade the market in order to provide a good product for investors. For example, the product needs to trade intra-day with limited tracking error, said Montanari.

Meeting suitability requirements

When new products are created, these are designed to fit the relevant regulatory frameworks to sell them to the relevant investor base, said Montanari.

Ultimately, ETFs have the simple objective of tracking a market one-to-one, he said, so there is no long/short or other strategy. As a result, an investor who buys an ETF linked to Indonesia knows that they will make or lose money depending on whether the Indonesian market goes up or down respectively. As a result the risk of confusion is limited.

Most of the work has to go into describing the structure, collateral and transparency, which is where there is most focus and attention from the regulator to ensure this is clear for investors.
 
Worst-case scenarios

According to Montanari, there are different risks with ETFs. For example, there is market risk depending on whether a market falls by a certain amount.

Currency movements present another risk, he added, so when investors buy an ETF, they are exposed to the currency underlying the market they are investing in.

Another risk is liquidity, said Montanari. If the underlying market stops trading, for example, or it isn’t possible anymore for the market-maker to hedge itself, then the client would not be able to trade the ETF anymore.

These risks are similar to those for all types of investment products.

For ETFs, there is also counterparty risk, he explained, so with synthetic ETFs, if the counterparty of the derivative defaults, then they will need to sell the collateral in order to get reimbursed.

At the same time, if an investor buys an ETF that does securities lending, in case of default of the borrower, again there will only be access to the collateral, but not the original securities.

 

 
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