Ever since index funds were first created in the US in the 1970s, interest has grown steadily. In 1996, Warren Buffett gave the funds a substantial boost when he singled them out for mention in Berkshire Hathaway’s annual report. He wrote: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

An index fund replicates the movements of an index of a specific financial market and enables investors to indirectly match that index. The main advantage of index funds is their lower management fees, on the basis that they require little or no active management. An average index fund’s expense ratio is likely to be around 0.2%, compared with 1.5% for an actively managed fund.

Growth in index funds during the past few years has come mainly from exchange traded funds (ETFs), which track stock and bonds indexes, or individual sectors. ETFs are open-ended investment funds listed and traded intra-day. By contrast, index funds cannot be bought and sold during the day. “ETFs are attracting a great deal of interest in Asia,” says Paul Hoff, Managing Director of FTSE Asia Pacific. “Governments are keen to attract such products to their own markets, because they are simple to understand and easy to access.”

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. 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.

Hoff says Islamic investment has been building momentum in Asia and is very important in countries with large Muslim communities, such as Malaysia and Indonesia. “Now that Middle East investors are looking for more diversification, we are seeing a lot of products being put together to cover the Asian markets, that can be sold to these investors.” FTSE and other index providers have been working with the exchanges across the region to meet the need for Shariah products.

While ETFs have grabbed all the recent headlines, index funds, which are well established in the US and European markets, are also catching on in Asia and, says Hoff, across the entire region there is a growing appetite for index products. “Investors are looking seriously at creating linked products, using different sets of products we have made available through our own network in the commercial market or the partnership indexes we have developed globally and for the region.”

Chris O’Brien, vice-president, global head of business development at Standard & Poor’s says Asian investors have recently become more open to trends in investment such as index products. “Traditionally, there has been a home bias with Asian investors generally holding domestic instruments. But during the past few years there has been liberalisation of domestic markets in Asia, and investors here are investing internationally and moving into new markets, with new capital,” he says.

The major trends in investment in the region are globalisation, emerging markets and sub-equity classes such as listed property. Index funds are reflecting this, with investment flowing into themes such as listed companies in the infrastructure, clean water, forestry and timber market sectors. “These themes are extremely important to Asia,” says O’Brien. Another new sub-equity class to which investors are keen to gain exposure via index funds are frontier markets, which include countries such as Vietnam.

The use of index products is being driven across Asia by increasing liberalisation of financial markets. The Chinese Government’s qualified domestic institutional investor scheme (QDII) enables Chinese citizens to invest in foreign equities markets, through qualified institutional investors. “Japan has liberalised the use of foreign investments and cross-listing of ETFs,” says O’Brien. “Korea and India are liberalising international products and raising the foreign investment ceiling for institutional investors.”

Deborah Yang, executive director at MSCI Barra in Hong Kong, says there are a number of advantages of index products for investors in the Asia Pacific region. MSCI’s indices were designed with multiple purposes in mind, she says. “The products can be used for research on the performance of markets, for asset allocation, benchmarking, performance analysis, and can be used as a basis of a tradable product such as exchange traded funds, futures, options or for structured products.”

Yang says index innovation is increasing at a rapid pace. “Nearly 40 years ago, we created our World index, the first global index; 20 years ago, our Emerging Market Index was born. Last year, we launched Islamic Indices, Frontier Markets, and the Asia Apex 50 - a tradable proxy for MSCI Asia ex-Japan, one of the most widely referenced indices for the region,” she says. 

Just recently, the firm has launched MSCI Strategy and Thematic Indices - including infrastructure, short, leveraged and equal weighted indices. “Strategy indices, based on an investment theme, as well as customised indices, have grabbed the attention of investors in Asia,” says Yang.

Russell Investments has been expanding its global index offering in the past year. The group is a market leader in the US, where indices such as the Russell 2000 small cap index are well know. In early 2007, Russell launched a family of global stock indices, covering small cap, large cap in developed and emerging markets. In April 2008, the group is launching a new Global Style Index (see ‘Around Asia’ in this edition). For Asian investors, companies based in China and Taiwan with shares available for foreign investors are reflected in the Russell Emerging Markets Index and the Russell Emerging Asia Index. Those in Hong Kong and Japan are reflected in the Russell Developed Index and the Russell Developed Pacific Basin Index, as well as the Russell Asia Pacific Index.

Asian institutions differ from other international investors in their approach to index products, says S&P’s O’Brien. “In North America and Europe, investors tend to view index products as equities and divide them into large cap, small cap, developed and emerging markets. In Asia, product sets are more likely to be regional, hence the driving interest in thematics such as listed real estate. When investing in themes, people are looking at the traditional comfort zones in the Asian economy,” he says.

“There is new capital coming into the markets and it is being invested by much more savvy and comfortable investors,” says O’Brien. “In many cases, local investors will look at what is available on a global basis and ask us to develop a pan-Asian version. Because of the somewhat parochial asset allocation in Asia, we have seen huge growth in the number of indices being grouped together for different themes or geographic slices.”

FTSE’s Paul Hoff says in investing outside their own markets, domestic or regional Asian institutional investors are using “some very broad benchmarks” for their global mandates. As for international investors looking to invest in Asia, Hoff says in established markets they will look to benchmark against FTSE Japan or FTSE Asia Pacific ex-Japan. To get to other markets in the region where liquidity is low, however, they will use participatory notes (P notes). P notes are issued by registered financial institutions to overseas investors that wish to invest in stock markets without registering themselves with the local regulator.

Yang says in Asia there is an increasing appetite for more transparent and more accurate information, especially in volatile markets. “Investors also want good data with consistently constructed benchmarks, setting a common language in the investment community to understand investment themes and explain performance,” she says.  

Before moving to Asia Yang specialised in working with asset owners, such as pension funds, government funds and endowments, in the US. “Generally Asian investors are eager to learn about global best practices in using indices. Asset owners care about having a fair benchmark that accurately reflects the investment process of managers. A benchmark should be replicable, such that it is both a fair representation of a market and can be used for passive replication. For asset allocation, investors want an index that has limited overlaps - reducing ‘benchmark misfit’ when gaps and overlaps are created as different index families are combined. Importantly, investors want an index to be efficient with lower turnover, and thus reducing the cost to manage.”

Hoff says for investors in markets where there is already a substantial amount of passive investment by major institutional investors (such as Japan and Australia), index products that offer a different approach are becoming popular. FTSE and Global Wealth Allocation (GWA) have developed a series of indices for the global equity market that break with the traditional price-weighted design. The FTSE GWA indices capture a company’s wealth creation in the form of its net income, cash flow and book value. Another product, the FTSE Rafi series (created with Research Affiliates) are non-market cap weighted indices, using four fundamental factors, rather than market capitalisation. The factors are total cash dividends, free cash flow, total sales and book equity value.

“FTSE GWA and FTSE Rafi are being used by many institutional investors to diversify their core portfolios,” says Hoff.

Index products are increasingly sophisticated and diverse. For example, climate change and the associated socially responsible investing has not yet led to the creation of index products, but Hoff says it is a likely direction and says that there may well be a rating on climate change in the future, for which index providers will create an index.

“The main advantage of index funds is very simple - they are cost effective. But they are also transparent and give the investor a very well defined asset class. Because it is easy to make an index, there are a lot of index funds being developed.”

Yang says as companies create new indices, it is easier for investors to identify the beta of new segments of the market and contrast this with the sources of alpha. “This is true for composite regions, countries, size, value/growth styles, industries and also for investment themes such as infrastructure. While innovative indices steal a good deal of attention, they represent a small, but growing portion of our business.”