Institutions in Asia may be preferring index funds over exchange-traded funds for longer-term investments, to keep costs down and avoid risks from synthetic replication techniques.

Alvin Tay, who heads Cambridge Associates’ Singapore office, observes that many of the firm’s clients have passive index exposure within their equities allocation. “This reflects a policy intention to control expenses as well as active risk exposures within the portfolio,” he says.

“Reflecting the desire to control expenses, our clients have largely opted to implement their passive exposures via funds rather than ETFs, which typically have meaningfully higher total expense ratios than their regular fund equivalents.”

Over the past year, Asia’s pension funds, sovereign funds and endowments have been using exchange-traded funds more often than previously, particularly during portfolio transitions.

A larger proportion of institutions in Asia use ETFs than in the US. A survey by Greenwich Associates found that about a third of Asian institutions employ ETFs, but only 14% of US institutions invest via ETFs, although institutional assets account for about half of ETF assets in the US.

Catherine Barker, head of iShares in Southeast Asia, estimates that ETFs’ asset growth in Asia may be about 80% from institutions and 20% from retail investors; in the US, the split is closer to 50-50. She suggests that Asian institutions use ETFs mainly for transitioning portfolios, cash equitisation, tactical allocations, or portfolio rebalancing.

ETFs provide intra-day liquidity and the ability to swiftly implement or reduce exposures, but these attributes are not of primary importance to many of Cambridge’s clients because they seek long-term core exposure to equities via passive index investing, he adds. But Tay says some clients found ETFs’ flexibility to be useful in specific situations, “including as a tool to maintain a stable exposure to an asset class when transitioning between two active managers.”

Institutions’ use of the core-satellite approach is another often cited reason for the increased use of ETFs worldwide. But in Asia, core-satellite is novel. Christine Huang, vice president of Lyxor ETF Asia-Pacific ex-Japan, thinks it may take another three years before Asia’s institutions adopt core-satellite to the extent where ETFs are used to a similar level as in the US.

“When more institutional investors in Asia adopt the core-satellite approach with a separation between alpha and beta strategies, ETFs can play an increasingly important role in core portions of the portfolio. But it will take time to evolve because the region’s pension funds and sovereign funds have been employing external managers for the past 10 to 20 years,” she says.

Huang suggests that some public or pension funds might consider using ETFs instead of external, active managers. It may indeed become a possibility in the future, as Asia’s larger institutional investors continue to increase their capacity to manage assets internally.

Various studies, including those by Greenwich Associates and Cerulli Associates, point to a continued trend of enhanced internal management. In a June 2010 report, Greenwich found that 30% of Asian institutions are revising long-term plans in favour of internal management, and nearly two-thirds plan to “significantly increase” their internal management capability in the coming year.

But the day when ETFs form a substantial portion of institutional portfolios in Asia may be distant. Several hurdles are in the way. First, ETFs have an identity predicament. Are ETFs passive or active investments? Are they mutual funds, stocks, bonds or futures contracts? These classifications can make a difference when regulators set limits on active and passive assets allowed in a fund.

From a CIO’s perspective, ETFs present the issue of risk parameter and risk budgeting. Consider that the majority of ETFs listed in Asia are synthetic, which means that they do not own underlying assets, and many use derivatives to replicate an index’s returns. The CIO of a family office remarked that he was wary of ETFs because of this and because some ETFs go short. But Huang explains that synthetic ETFs may not all be as risky as they sound: UCITS-compliant ETFs have a 10% limit on derivatives exposure.

Second, the range of ETFs in Asia simply isn’t vast enough yet. According to BlackRock, there were only 15 fixed income ETFs out of a total 249 in Asia Pacific as of end April 2010. Consider that fixed income continues to constitute 60% to 80% of most Asian institutions’ portfolios. Institutions also tend to invest for regional or global exposure. But of the Asia Pacific’s 217 equity ETFs, 207 were single-country exposures.

Of these, 62 ETFs were focused on Japan, 43 on South Korea and 42 on China. Only 10 equity ETFs offered broad exposures to the Asia Pacific, emerging markets, Europe, global, global ex-US and Latin America. Some providers are attempting to expand the range. Lyxor for example, has recently launched an Asia ex-Japan real estate ETF in Singapore.

Third, institutions worldwide are still largely unfamiliar with ETFs. For example, Barker of iShares observes that institutional investors are sometimes unaware that ETFs provide both primary and secondary liquidity. Institutions can get primary liquidity by accumulating sufficient shares of an ETF to exchange them for the underlying assets. This trade in kind is one of ETFs’ success factors in the US because it circumvents taxes, but there is no equivalent tax implication in Asia under most circumstances. Investors can get primary liquidity by trading shares of an ETF.