Exchange Traded Funds – more markets, greater choice
Exchange Traded Funds are experiencing a growth in popularity that looks likely to boost trading volumes across the region’s stock exchanges. Asia’s ETFs market really began in 2000 but and then came to a halt in 2004 once each of the main markets had all launched domestic market focused ETFs. There has been a steady stream of new listings since, but it is only now that momentum is building that will drive ETF issuers to bring more and various new products to market.
Recent study shows that trading volume increased by 85% from year end 2007 to year end 2008, on all exchange products in Asia, ex Japan. Asia will still only represent around 5% of global market (inc Japan maybe 7%). An increase in trading volumes reflects the fact that both institutional and retail investors are getting used to trading ETFs.
So why have ETFs become the flavour of the moment in Asia? As Joseph Ho, Head of ETFs at Lyxor says, “You can clearly see the shift from traditional mutual funds to ETFs that happened in 2008. Every time you have difficult markets, there is a move from active to passive fund management. As an investor, you don’t want to pay high fees and if you can find an investment that provides perhaps better diversification as well as being cheaper, then you will go for that.”
ETFs are traded by fund managers as well as by traditional buy-side investors, because they offer competitive pricing, especially on those products which have an active market and they have a variety of liquidity management uses. ETFs can be purchased on margin and they are lendable. In the US, there is a thriving securities lending business using ETFs. Many of the new ETFs coming to Asia are cross-listings from European or American exchanges. In the case of Europe, the issuers are taking advantage of the mutual recognition afforded UCITS authorized funds in Hong Kong and Singapore.
Although most ETFs in Asia use swaps to replicate the characteristics of a given index, they are not in themselves derivatives. They trade and settle like individual shares. Swap-based ETFs depend on index replication through the use of swap agreements between an ETF issuer and an investment bank. The ETF typically holds a basket of securities prescribed by the swap counterparty. The basket is not a perfect reflection of the relevant index, but is designed to be a representative sample. The swap provides the replication of the index performance. If the value of the basket increases by, say 5%, and the total return of the index via the swap is 7%, the resulting payments between the ETF basket and the swap are netted off, with the ETF enjoying an increased in value of 7%. The swap counterparty is responsible for paying the 2% difference. This is typically generated by investing in securities or derivatives which track the index performance, and by hedging any open positions for the swap.
Although swap based ETFs are the norm outside of the US, the post-Lehman environment has resulted in a degree of caution towards anything involving swaps. However, for funds authorized under UCITS III legislation, the counterparty risk is limited at any time to 10% of the net assets of each ETF in which these instruments are used.
Deutsche Bank is a relatively recent entrant to the global ETF arena, making its debut last year. The bank has ambitious plans for growth in Asia. By the end of 2010, Deutsche estimates Asia could have increased its ETF market volume by around one third, to US$85bn. Global head of db x-trackers at Deutsche, Thorsten Michalik says, “It took seven or eight years for ETFs to become really popular in Europe and the US. It has nothing to do with the sophistication of the investors, since 90% of turnover comes from institutions. You just need to come up with the product palette and give the choice.”
Institutional investors in Europe and the US have a much wider choice of ETFs than is currently the case in Asia, so it is useful to look at how those investors now use ETFs as the building blocks of active portfolios. A pension fund or other institution in the US, for example, will typically use ETFs on broad indices to serve as a diversified core holding, while style, thematic and sector ETFs can be used to implement tactical asset allocation models. The can be used, for example, in rebalancing and bias adjustment, for long/short selling strategies, trading strategies and cash management in an equity portfolio. They also provide an efficient means of gaining international diversification, commodity and fixed income exposure.
The challenge then is to broaden the market. In April 2009 there were 175 ETFs listed in Asia in 12 countries and across 15 exchanges. But Michalik says “The product cannot be successful unless there are two to three hundred ETFs listed on Asian exchanges. The range of different asset classes also needs to expand. Currently there are hardly any bond, commodity or currency ETFs available and that is what the market needs. So we expect the numbers will grow steadily and with 18 months there will probably be 300 ETFs.”
All investors want low management fees and ample liquidity. The argument for using ETFs becomes more compelling when they can be used as an integral part of the portfolio construction process. It has become clear that institutions can use ETFs for asset allocation purposes, where for example, they have to fill an emerging market lag in a portfolio. In Europe, they are also used for cash substitution and for simple trading purposes, for moving in and out of the market quickly. Michalik says, “This will come to Asia too, as soon as we have ETFs available in multiple markets. This will happen within the next few months.”
He also stresses the importance of tradeable market: “Liquidity is a valuable characteristic of ETFs, but more important is the tradability created by a market maker. On Asian stock exchanges trading volume is typically much lower than in Europe. But you have to differentiate between the level of on-exchange trading volume, and the level of potential for trading in ETFs. That’s where a market maker comes into play. For ETFs it’s a more enhanced function compared to say a standard market maker for equities.”
Lyxor’s Joseph Ho says, “A key point for investors thinking of using ETFs is that normally, if you want to implement a core-satellite approach, you need a large amount of money. But with ETFs you can do it relatively cheaply, so you don’t need to be a huge fund to adopt such an approach. At the same time, if a large institution can use ETFs efficiently in an asset allocation framework, I think they will want to do that. It’s an efficient tool for a global investor.”
State Street Global Advisers (SSgA) has been at the forefront of developments in Asia’s ETF market, and not just with the Tracker Fund in Hong Kong. They launched the first ETF in Australia linked to the ASX 200, introduced the first STI ETF to Singapore in 2002 and were also licensed to operate in Japan. Also in 2002, they went into Korea, working with sub-adviser LG Investments (now Woori Asset Management) and worked closely with the local regulators in Korea to help develop the market. In 2003, they did the same in Taiwan, working with Polaris to introduce the Taiwan Top Fifty ETF. In 2005, working with China Asset Management, SSgA introduced the China 50 A Share ETF and soon after that they launched the Pan Asian Bond Fund. Launched originally on the New York Stock Exchange in 2004, the SPDR Gold Trust has subsequently cross-listed in Singapore, Japan and last year in Hong Kong. It is now worth over US$30 billion, making it the second largest ETF by assets in the world
SSgA’s head of ETFs for Asia Pacific, Sammy Yip, says “Globally, the markets have moved away from large cap equity. Fixed income, commodities and foreign exchange generates more interest in the product. If we have all styles of the platform, then investors can really use ETFs as the basis for a diversified portfolio. For a risk-optimised allocation, an ideal approach is to have a core portfolio with low costs but at the same time producing a more stable return. It gives you the scope to run an alpha portfolio as a complement with single managers. Products like the gold ETF can provide that satellite application as well. I think as time goes on we will see a much greater choice allowing investors to use ETFs as part of their asset allocation processes.
“We have seen more passive beta products since 2008. It’s not hard to see why. It’s a bear market but an institution will want to bet back to a fully invested position, and that’s where ETFs become a useful alternative.”
Deutsche’s Michalik says development of the db x-tracker ETF products will happen in Japan, Korea, Hong Kong, Singapore and Taiwan, but he rules out the idea of working with partners in these countries. “Right now, the strategy is to do everything on our own. We have the asset management capability and also the skills in structuring, trading and investment banking.”
The first batch of ETFs is listed on the Singapore Exchange. This batch includes Asia’s first inverse ETF, the S&P 500 Short ETF. Investors who expect the S&P 500 Index to fall can buy this product. “A short ETF, especially in today’s volatile environment, can help investors better manage their investment risk and at the same time making it possible to generate positive returns, without having to use derivatives,” says Michalik.
The other funds are linked to the MSCI Taiwan TRN Index, the FTSE/Xinhua China 25 and the
S&P CNX Nifty 50 Indian index. The newest addition is linked to the FTSE Vietnam Index. Deutsche plans to launch as many as 20 ETFS in Asia by the end of 2009. One such could be the first ETF based on actual hedge funds, linked to a proprietary Deutsche Bank index that captures core hedge fund strategies (equity hedge, market neutral, credit and convertible, systematic macro and event driven) in a liquid and transparent format. Each strategy is reflected by a sub-index which is represented in the main index according to recognised industry asset weightings.
Each sub-index is linked to the performance of its constituent hedge funds sourced from Deutsche Bank’s leading hedge fund managed accounts platform. The platform is a risk controlled, liquid and transparent investment platform representing a broad spectrum of hedge fund strategies. The funds on the platform are run by Deutsche Bank entities with external third party hedge fund managers appointed to manage each underlying portfolio.
SSgA’s Sammy Yip is optimistic for developments in Asia. “When we look at the way the market has developed in the US and Europe, with a lot of new product ideas coming through, Asian is following that trend. We will see more diverse offerings - fixed income ETFs, fund focused on specific sectors, emerging markets. The question is simply, what gaps do you want to fill first?
Lyxor began introducing ETFs to Singapore in 2006 and now has 13 products listed there and a further 12 in Hong Kong. Head of ETFs, Joseph Ho says the plan is to launch a further five in May, with a view to having at least 20 ETF listings in Singapore by the end of the year. Further listings in Hong Kong will follow. The product offerings are slightly different in each place, with MSCI World, MSCI Emerging and Nasdaq ETFs available in Hong Kong and a purely Asian range, plus two commodity funds available in Singapore.
The Lyxor strategy is based on cross-listing its European UCITS compliant funds as the most cost effective way of building a meaningful range of products that will trade in Asia. “The region is fairly fragmented and the natural inclination of investors is to buy local, so this next phase of development for Asia is building out the range of products that will encourage investors to use ETFs as more than just access products.”
Cross listing allows us to bring product that has a certain size, so that as an issuer you are not too concerned about break-even. It’s a low cost option for us as well. Once the market has sufficient breadth, we can encourage local investors to look outside their home market. And eventually we can talk to them about mixing and matching ETFs within an asset allocation framework.
It’s not just about the product, it’s how you support it. Having the market making support for a growing range of products is vitally important.
In the last couple of years trading volumes have increased, but still the pace is much slower than in the US and Europe. At the moment, issuers in Asia have a hard time arguing for ETFs to be used as the building blocks for portfolio construction. But that is what is happening now in the US.
Of course, other groups are too and it is the intensifying competition that is another fascinating aspect of the ETF market development in Asia right now. Barclays have been a dominant and high profile player through the iShares brand. Now that brand has changed hands, it remains to be seen what the new owners CVC will do. Deutsche has signaled its aggressive intentions. Lyxor intends to be a significant player and others of the European banks, such as Credit Agricole, can also be expected to make more of a play for business in Asia.
Hong Kong remains the largest base for ETF assets, with around 60% of the AUM in the region, ex Japan. It also dominates trading volume, so it will remain the key market until perhaps China makes more of a play for listing of ETFs. Singapore is also keen to compete for ETF listings, as does Bursa Malaysia, which is encouraging for the ETF market as a whole. Yip says, “Although we see Asia as a region, it is multiple markets with distinct distribution and regulatory characteristics. We need to be able to develop products that will be able to have multiple listings, and if the local approval process becomes easier, the success of the ETF market becomes more likely.
In Hong Kong, the first local ETF was the Tracker Fund of Hong Kong, launched in 1999. In 2001, Barclays Global Investors launched the iShares MSCI China Tracker. In June 2005, the Securities & Futures Commission authorised the first bond index-tracking ETFs in Asia and the first ETF to offer non-mainland investors access to the China A shares market. It has also authorised a commodity ETF, tracking the CRB Index.
In Singapore, ETFs were introduced in 2001 when the SGX, in partnership with The American Stock Exchange, launched trading in ETFs such as the SPDRs, Diamonds and iShares. DBS Asset Management became the first domestic issuer of a domestic equity ETF in March. The DBS Singapore STI is tied to the benchmark Straits Times 30 stock index. DBS had introduced a fixed income ETF two years prior to this. Now, DBS is working closely with the SGX on other ideas. Director of Equities Chan Kum Kong says DBS want to use their ETF marketing as a platform to move into advising clients more closely on their asset allocation. “The ETF structure allows us to go to an insurance company and offer them the return capability. We are solution based and ETFs provide the building blocks for the development of other products. There are good prospects for this solutions based approach.”
Kong believes the exchange platform offers both transparency and security: “Investors have been exposed to counterparty risk, but the exchange platform has not been challenged in this crisis - so the time is right for us to tap into that market.”
DBS is responding to a trend for investors to choose lower fee options. “So it does become a cookie cutter approach, where you develop low cost, high volume options and respond quickly to short term trends and opportunities, especially in the retirement space in places like Singapore and Hong Kong.”
This January, the Malaysian government launched Asia’s first Shariah-compliant ETF, as part of its bid to establish the country as a regional hub for Islamic funds. Called the MyETF Dow Jones Islamic Market Malaysia Titans 25, the fund is owned by state fund manager Valuecap. It is Malaysia’s first national ETF. Investors in the fund will gain exposure to 25 Shariah-compliant companies listed on the Malaysian stock exchange.
The Korean stock exchange started its ETF listing program in 2002 with four broad-based index trackers. The exchange now offers around 40 different products and the exchange reports daily trading volumes have risen steadily, even after the credit crisis. More than half the activity is from domestic institutions, with 32% made up by foreign investors. Of the total transactions, 88% of ETF trading on the KRX is focused on the KOSPI 200 index.
According to KRX chairman and CEO Lee Jung-Hwan, the weakness of the Won, the ban on short selling and particularly the lifting of trading fees between September and December last year boosted ETF activity. He explains, “There is no security transaction tax on Korean ETFs, so the trading cost is low compared to other investments.” The reclassification of Korea from advanced emerging to developed status for the FTSE Global Equity Index Series, which comes into effect in September this year, is likely to impact this as well. The KRX is also working with Standard & Poor’s to develop a global index comprising companies listed on the Korean and other Asian markets. S&P’s Seiichiro Uchi says, “The deregulation in Korea has made foreign-asset based ETFs possible. We have an active plan with Samsung Asset Management for an ETF launch in the first half of the year.”
In Japan, ETF sponsors continue to launch products this year, despite some delays because of poor sentiment in the market, and a few projects have been cancelled. Seiichrio Uchi, head of marketing at Standard & Poor’s, observes, “The transparency and easy-to-understand is catching investors’ attention. As well as the global providers, we are now seeing domestic Japanese providers competing in the ETF space, where they have the in-built advantage of local distribution channels. The activities of the likes of Nomura Asset Management and newer players such as Mitsubishi UFJ Asset Management have made the market more dynamic in Japan.”
In Australia, despite the difficult financial market conditions Exchange Traded Funds are continuing to gain market traction. According to Jonathan Morgan, Business Development Manager for the Australian Stock Exchange, ASX sourced ETF assets have grown more than eight per cent over the last year from $1.4 billion to just over $1.6 billion with total turnover of $5.115 billion over the last 12 months.
“The growth in ETF trading has been particularly impressive given market conditions. The key attractions of SDPR ETFs continue to be their liquidity and transparency, the cost-efficient exposure to a broad range of assets, and tax-efficiency,” he said.
Rob Goodlad, managing director of State Street Global Advisors in Australia, said “During a year of significant equity market volatility SPDR ETF trading volumes have increased substantially as investors show a preference for low-cost diversified equity investments. Over the longer term we expect the ETF growth rate in Australia will continue to mirror that of other developed countries such as the US, where ETFs now make up more than half a trillion US dollars in assets,” Goodlad said.