Activity in the exchange traded funds market looks set increase even further this year, as the major promoters boost their product range in Asia. Although the market is still developing, with the level of marketing activity, ETFs have quickly become an integral part of the Asia-Pacific region’s financial landscape. The Asia-Pacific ETF market is ripe for further growth. Excluding Japan, ETF assets in the Asia-Pacific grew by an annual average of over 40 percent from 2003 to 2008, and by almost 50 percent in 2009. Sammy Yip - Vice President and Head of Exchange Traded Funds at State Street Global Advisors in Hong Kong believes they should grow at a similar pace in 2010. But he finds it more difficult to predict how Asia-based ETFs will evolve in terms of product offerings and key markets.

“While we can take some cues from Europe and the US, the investing culture in Asia differs from these more developed markets in ways which may affect the take-up of new ETF products by investors,” says Yip. “For example, in the last couple of years, fixed income ETFs grow in popularity in the US and Europe. In Asia however, investors are less accustomed to fixed-income instruments and may not feel comfortable with exposure to them, even through an ETF.

“That is not to say that they won’t find their comfort level eventually, just that it might take some time for such products to become widely accepted in this part of the world.”

Likewise, some ETF issuers in Europe are structuring products with derivatives as their base. Whether an ETF investor opts for exposure through a derivatives-based product or through one with a physical assets base, is entirely a matter of individual choice. But right now, that level of understanding has probably not been reached in Asia. Yip says, “I believe that exposure through a base in physical assets presents less counter-party risk and will therefore find more favor with Asian investors in the years ahead.”

So-called ‘Access ETFs’ might provide a good fit for institutions seeking broad exposure in Asian markets in 2010, he adds. “Access ETFs” are typically listed in one market, for example Hong Kong, with exposure in another market, say Korea - thus giving investors access to the stocks of a country which might otherwise be difficult for them to enter. As Asian ETF market evolves, this type of product could gain traction with investors due to the diversity and flexibility it can bring to a portfolio.

Institutional investors should begin to make better use of ETFs in Asia to implement asset allocation, assuming the ongoing development of a more diverse range of product offerings. ETFs can also be used by institutional investors to boost the efficiency of their cash management processes - a common feature of ETF investment in the US. ETFs give institutional investors somewhere to park their cash, thus ensuring market exposure is maintained. Moreover, these investors aren’t foregoing their liquidity needs in case they have to meet redemptions or cash outflows, because buying and selling an ETF is a simple process consisting of a single transaction.

As the various listing centres of Asia vie for the dominant role, Yip thinks Hong Kong is well-placed. “It already accounts for half the $37 billion in ETF assets under management in Asia. Hong Kong has been buoyed by the enthusiasm of stock market investors wanting to tap into the broader China story. Expected future inflows from QDII funds may support this trend, with Hong Kong-listed investment vehicles such as ETFs benefiting from the resulting enhanced liquidity.

Deutsche Banks’s director of ETFs and Structured Funds in Asia, Marco Montanari, is confident that Asia will develop a large and lively ETF listing market. But he is anxious to see it become more sophisticated in the short term. “The Asian market needs greater liquidity, more products and we need to educate investors about how to use ETFs. They are not sure what they are investing in or the implications if they do. I find it astounding that some investors in Asia would buy a US listed ETF, without understanding there is a 30% tax on dividends paid. Investors are obsessed with liquidity, so they will buy a US listed ETF because it is heavily traded, but they should be taking advantage of the fact that they can buy Asian ETFs in Asian trading hours.”

Other things that would help the development would be a greater integration of markets, allowing a single product to be sold in several countries. Taiwan and Korea are dominated by local ETF providers, while European domiciled funds can be bought in Hong Kong and Singapore. Montanari says, “The memorandum of understanding between Hong Kong and Taiwan is a first step in establishing a larger market. The creation of fund of funds and multi-manager strategies will be helpful too.”

Pension funds in places like Singapore, Thailand and Taiwan are doing their own passive management and are looking to get cheap exposure from a tactical perspective. This institutional interest will only develop with a broader range of product options. Montanari says, “We need to have more local flavour ETFs. Currently there are only a few local bond ETFs. If you want to have a successful market, you need the products. Of 300 ETFs in Asia, only 10 are focused on fixed income.” Deutsche is planning to introduce more in the first quarter. As well as its major market products that were so successful in 2009, including China and India, Deutsche is also providing access to Vietnam.

Ultimately, the market will only advance in line with investors growing understanding of where ETFs fit in their asset mix. “We saw the same thing happen in Europe. It takes time for people to become aware of the tax issues and to understand ETF tracking error. Investors need to understand the variance in tracking error amongst ETFs. The third largest ETF in the world had a 5% tracking error last year.”