Magazine issues » December 2011

ETFs: Eastern hurdles

HurdlesWith their tendency to trade mutual funds, Asian investors should be enthusiastic about ETFs. Yet, while demand exists, these products face substantial headwinds in the region. Mark McFee finds out what it will take for them to become part of the mainstream.

Would you have guessed that in the first seven months of 2011 South Korea’s stock exchange would see the third highest number of equity exchange-traded funds (ETFs) traded globally, exceeding total equivalent trades for the entire Europe, Middle East and Africa region?

Furthermore, figures from the World Federation of Exchanges show the bourses of mainland China (both Shanghai and Shenzhen), India and Hong Kong have all ranked in the top ten.

However, this provides a skewed image of the Asian ETF industry. Some may be voracious traders but take a look at total ETF turnover for the same period and Korea slips to tenth place, pipped by Hong Kong in ninth. In fact, excluding Japan and Australia, Asia only accounted for 2.6% of trading volumes, and these are mostly concentrated among a few large players.

Though small, the ETF industry appears to be growing healthily. Ex-Japan assets increased from $48.7 billion (€33.8 billion) at the end of the first half in 2010 to $62.5 billion at the end of July 2011, while listings rose from 286 to 386, according to data from BlackRock. But this is not the complete picture.

Marco Montanari, head of db X-trackers in Asia, points out that pan-industry data on Asian ETFs is missing two important factors. First, that assets of ETFs cross-listed into Asia are not included in order to avoid double counting. Second, that there is a huge amount of outbound investment from Asian investors into European or US-listed ETFs.

“According to our estimation, this is between $30 and $40 billion. That is why when you look at the assets of Asian ETFs only domiciled in Asia, it’s about 7% of the total assets around the world. But if you add the multi-listed ETFs and what is invested by Asian investors in Europe and the US, you go up to 15%.”

So, who is buying ETFs in Asia?

“It’s mostly institutions,” says Dr Hing S Tang, managing director and head of quantitative strategy business unit at BOCI-Prudential in Hong Kong, echoing the trend in other parts of the world. “Not just from Asia but from Europe as well. Institutions mean market makers, hedge funds, some traders. We do see some fund managers, but they are not common.”

Montanari confirms this, saying that db X-trackers’ estimate is 80% institutional (including private banking) and 20% retail.

However, Tang does not see institutional business as the only potential source of growth, nor a necessarily reliable one. “If you are a professional, you can easily access the US and European markets… So you see no reason to  buy Asia-listed ETFs. We need to educate the retail investors; they are the key to our growth in the future.”

Most providers would agree that the need for education on ETF usage is paramount. The flexibility provided to take short-term tactical positions sits well with the pro-trading mentality and a taste for arbitrage in some markets. But a major issue exists in the way in which these products are perceived.

“Many clients don’t want to buy ETFs that don’t record any daily volumes on exchange… What matters is the price you are paying is the correct one, while [in Asia] there is a large misconception about what the liquidity of the ETF really is and you have many investors considering ETFs as stocks,” says Montanari.

Some providers, both local and foreign, appear to dedicate considerable time and resources to promoting ETFs in Asia, no matter what type of client.

Nick Good, managing director and head of iShares Asia-Pacific, says: “We find that consistently, right across the spectrum, even in institutions, most of the investors are still relatively new to ETFs and this market is only just starting to take off.”

Indeed, informing investors of the functions and benefits of ETFs is absolutely necessary to overcome the hurdle of distribution.

Not entirely unlike how some developed markets, banks and insurance agents dominate distribution in Asia. And they are expensive.

Tang says: “Maybe they only make 25 basis points selling ETFs compared with 4-5% from selling mutual funds, so they won’t sell ETFs.”

With the nascent market for independent financial advice largely commission dependent, this channel also proves problematic.

Regulatory change, similar to what has been taking place in certain developed markets, may be necessary to bring about fundamental shifts in Asian distribution models, but the day when retail investors will be comfortably buying them over the internet seems to be some way off.

Good notes one more challenge that faces all groups operating in Asia. “You have substantial regulatory challenges and, unlike the US or even Europe, the region remains very fragmented; we treat each market individually,” he says.

Differing strategies
One of the distinguishing points about the Asian ETF market is the range of interpretations on how to tap into it. With sales generated by inbound foreign activity, outbound Asian activity and domestically, views diverge on where the market could be going.

Attitudes differ towards the large institutional flows into European and US-listed ETFs. Good, while accepting that some investors will prefer to invest in their local currency and under local regulations, is very positive about this trend. “You’re tapping into an existing market, it’s already trading, it’s already very liquid and that’s very attractive for an investor… But there is the potential for some customer segments to see real value in products that are listed locally and, particularly, where they are unique products.”

iShares has taken a mixed approach to offering products in Asia, cross-listing some from the US and setting others up from scratch on Asian exchanges. Good says that the firm has focused on key markets and clients with high levels of understanding of ETFs, while simultaneously driving forward investor education.

Although some foreign investors are liable to pay 30% tax on US dividend payments affecting equity ETFs, Good says they are aware of this and perfectly happy to continue investing in them for the liquidity on offer.

Db X-trackers’ Asian funds, on the other hand, are all either cross-listings or primary listings from its Luxembourg-domiciled ETF platform. Montanari feels that it is not advantageous for Asian investors to be buying into ETFs around the globe, particularly when underlying markets are closed, as the price transparency is not comparable with prices when they are open.

“In Europe, the growth you have is just from more people starting to buy ETFs or the people who already have them, buying more. In Asia, you’ve got another source of growth which is people who used to buy in the US and Europe starting to buy locally, because the range of products is getting larger.”

Running everything off a pre-existing platform results in economies of scale and lower fees for investors. With Hong Kong and Singapore recognising the Ucits brand, gaining approval to list locally is swifter too.

One thing that both groups have in common is a developing focus on products based on Asian underlyings. This could be particularly useful for foreign groups trying to attract Asian retail clients because of their preference for domestically-focused products.

In markets such as Hong Kong and Singapore, where foreign groups are particularly active, local groups can struggle to compete in terms of product range. But they are not without their own edge. Established brands and client relationships make for notably valuable assets.

Tang says: “Our advantage is that we do understand which products can sell better. But in terms of resources, global players have a lot more. They have deep pockets.”

The firm has focused on what it knows best, offering five ETFs with exposure either to mainland China or Hong Kong. Two have been cross-listed into Taiwan and one into Thailand. Tang confirms long-term plans for further launches.

If there is one thing that unites providers active in Asia, it is their belief that ETFs are simply better vehicles for investment than mutual funds. As more players enter the market, stock exchanges devote more time to supporting ETF development. As the background hum of the industry grows in volume, they could well capture the attention of more clients.

©2011 funds global

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