William Chow, who runs the ETF business for Hong Kong-based Value Partners, talks to Hubbis about his view and outlook on ETFs in Asia, especially given the current stage of the market’s development, and some of the frustrations that many issuers are now facing.

Date: Nov 2011

Tags: ETFs, Transparency, Fees, Portfolio construction

There has been a lot of growth in this space in Asia, and in the last few years many fund houses have jumped into the market to try to grab a share of the pie. However, only five or six of the 20-plus players in the Asian markets are serious players, and Value Partners is certainly one of them.

The process of educating retail investors about ETFs will be a long one. Asian investors tend to be stock-pickers in nature, which is different from what happens in the US, for example, where they often express their investment opinions through ETFs. So this characteristic of Asian investors really drives the liquidity of the products.

Also, the regulators have been taking a conservative stance in terms of product development in Asia over the last couple of years. This is understandable given that the regulator is focused on protecting the retail investor. Market players are working closely with the regulators to understand how to enhance risk disclosure, and provide a lot more information about products to increase their comfort levels as much as possible.

As a result, there has been growing frustration with the market from many providers. Some of them were a bit over-optimistic initially. Issuers will therefore need to be patient.

How can you differentiate what you offer in the market?

For example, our gold ETF is unique given that all the gold is stored in Hong Kong, at the airport. After launching initially in November 2010 with US$25 million assets under management (AUM), roughly a year later we have about US$150 million AUM.

I see a lot of investors, whether locally, from China or elsewhere, diversifying their portfolio not only with the Gold ETF, but also in terms of where the gold is stored.

Also, our first ETF was focused on the China market. For this we created our own investment methodology in partnership with FTSE, to develop a more active ETF which does stock-picking via a systematic approach. To identify the 25 value stocks, we look at various factors, including: valuations, the quality of the stock, dividend yields, operating profit margins, and contrarian factors.

In choppy markets, what types of ETF innovation might be possible?

In volatile markets where inflation is also high, ETF providers have an opportunity to provide yield-enhancement type products.

There is also space for commodities underlyings to develop, and potentially RMB ETFs in the years to come.

Do you expect to see any consolidation in the Asian ETF market?

Year-to-date, there have been some redemptions from product providers in Asia. At the same time, a lot of ETFs have not really taken off.

These challenges lead the providers to question whether they should continue to invest in their businesses in what is already a crowded marketplace.

What types of reforms would help the market develop further?

Enhancing transparency is important, although this is more difficult with ETF products which are more focused on generating alpha, compared with the more passive ETFs.

There also has to be a sharper regulatory spotlight on stock lending, given that this has become a concern for authorities around the world.

Ultimately, the more transparency there is and the more risk disclosure in the market, the better it is for investors.

Do investors understand ETFs enough to the extent to which they look at certain criteria to influence their investment decisions?

When it comes to more straightforward products, these are easier for investors to understand, and they are seen as safe, so investors buy into these without too much hesitation.

For more innovative products, it takes time and a track record to encourage investors to buy into these and show that the ETFs work in the way they say they do.

What can retail investors learn from the way in which institutional investors use ETFs?

They need to take a longer-term approach to their financial planning, and by looking at their risk appetite and investment objective, they need to see where ETFs fit into their portfolio.

How should investors view ETFs as part of their portfolio construction process?

Investors in ETFs should take a core-satellite approach to their portfolio.

They should focus on their investment objectives and what they want to achieve, combined with their risk appetite, to determine how they can use ETFs as a part of the construction of their portfolio.

How should wealth managers discuss ETFs with their clients in terms of how and where they fit in client portfolios?

The cost-effectiveness of ETFs, certainly compared with mutual funds, is one of the things which makes them attractive. At the same time, the product generally offers a lot of transparency, with providers often showing all the holdings on a daily basis and how much cash and stocks the ETFs hold, and also the dividend payout, in a very systematic way.

Also, an important point which most investors don’t think about, is that they can be traded at any time during the day. By comparison, mutual funds can be traded less frequently.

How can providers help to overcome the resistance from wealth managers to selling ETFs, based on the fact that they get paid less commission for these products?

This is the source of the frustration for product providers. Another part of the reason for the somewhat slower take-up of ETFs in Asia than many issuers would have hoped is the lower incentive from distributors to recommend these products to investors.

There is also a lack of distributions for ETFs in Asia compared with in the US, Europe or even Australia, where fee-based models via a larger IFA community exists, where these advisers get paid on AUM instead of transaction-led commission.

My best guess is to see the IFA distribution channel develop in Asia over the next two to three years. Also, I think brokerage arm can be a media for ETF distribution channel going forward, and I can see this happening right now.

Therefore, there is a question-mark over the extent to which some providers can build up the AUM of their new products.

From which types of investors do you expect to see growth in ETFs coming from?

One group is family offices, which pose a lot of potential to buy ETFs for portfolio construction as part of a core-satellite strategy.