Spring 2011

INSIDE VIEW: Chinese eyes target ETF growth

DumplingsThe ETF market in Asia is growing and David Ngan, of Hang Sang, and Ken Sue, of HSBC, expect more Chinese providers to set up operations in Hong Kong. Asia is often associated with fast growth, dynamic markets and innovation. And in the exchange-traded funds (ETFs) space, Asia certainly merits these labels.
ETFs have become increasingly popular in many markets around the world as a convenient way to track index performance. Asia, and Hong Kong in particular, is no exception; the development of ETF market in this region has been phenomenal.
Since the first ETF was launched in Hong Kong in 1999, 72 ETFs have been listed on the local stock exchange with assets under management (AuM) nearing the US$30bn (€21.6bn) mark. Among them, synthetic ETFs with derivatives as underlying assets have grown more rapidly in recent years, compared with traditional physical ETFs, but the simpler physical ETFs are among the biggest in the market, with the majority of AuM.
Local ETFs provide exposures across different asset classes, such as equities, bonds and commodities, as well as different countries and regions. Interest in various sector ETFs has also grown, especially in the Chinese market, which have a broad sector base.
There are currently twelve ETF providers in Hong Kong. Some of which have been in Hong Kong for quite some time, such as State Street, BlackRock and HSBC/Hang Seng, whose operations are based locally. Other big European or US players are extending their business to Hong Kong by cross-listing their products or adding local products to their range. Fund management companies in other Asian countries have also recently chosen to set up ETF operations in Hong Kong. The choice of Hong Kong as their starting point is presumably due to the regulatory framework and local investor base. Given this activity, it is likely that more Asian fund houses will participate in the Hong Kong ETF market, especially Chinese fund companies.
In terms of underlying investment options, the “China growth story” is the most popular theme for ETFs. Although investors are keen to gain local Chinese market exposure, only qualified institutional investors can access the China A-share market directly through the Qualified Foreign Institutional Investors (QFII) scheme, which requires approval from Chinese regulators.
By creating derivative-based ETFs backed by institutions with the required QFII quota, Hong Kong can use Low Exercise Price Options (LEPOs) to gain access to China A-shares.  The indices used to offer local China exposure include not only the well-known large cap indices such as Xinhua/FTSE A50 China Index or the CSI300 Index, but also sector indices such as Chinese Financial and Consumer, which are mainly subsets of the broader CSI300. Chinese sector index ETFs seem to be the fastest growing segment in recent months.
Despite the demand from investors for local Chinese exposure, a shortage of QFII quotas means that the supply of A-share ETFs has not been able to meet the huge demand from investors. The premium of A-share ETFs over their net asset value has widened significantly since 2010, partly due to the expectation of Chinese currency appreciation. The most liquid A-share ETF in Hong Kong, iShares FTSE/Xinhua A50 Index ETF, has traded at an average premium of 6.62% in 2010 compared to a 0.53% premium in 2009. The premium has increased by even more so far this year, averaging 11.16% in January and February 2011. The premium has become a barometer of investors’ confidence in China’s A-share market.
For investors who are not comfortable with such a high and volatile premium, it is possible to gain China exposure through China-related stocks traded in Hong Kong, such as the so-called H-shares and Red-chips. These companies are either registered in mainland China or their revenues are mostly generated from the mainland. The Hang Seng H-share Index and FTSE/Xinhua China 25 Index are two widely used indices for tracking these Chinese stocks. The Hang Seng H-share Index has larger exposure to the Chinese banking and insurance sector with a 50% plus weighting whereas the FTSE/Xinhua China 25 Index is more evenly weighted across sectors and has more exposure to the telecom and energy sectors.
In terms of investor demand, retail investors have an enormous interest in trading A-share ETFs due to their natural home bias. We also see more institutional investors in Hong Kong using ETFs as an asset allocation tool.
One important development comes from the Mandatory Provident Fund system (MPF), the retirement investment scheme in Hong Kong. Many MPF funds have ETFs as constituent funds for members’ selection, attracted by ETFs’ low management fees and small tracking errors. Mutual funds in Hong Kong are also using ETFs to gain exposure to China for example. In addition, hedge funds are also active in trading ETFs, as evidenced by short positions in some ETFs at times.
As China’s market capitalisation becomes larger in t­andem with strong economic growth, we expect more China-related ETFs to be listed on the Hong Kong market. However, the limitation of QFII quota is a hurdle for product development, which will create high premiums and extra counter-party risks.
More broadly, the growth of wealth management across Asia, coupled with greater focus on delivering good performance at the overall portfolio level should see more and more use of ETFs as good value, simple, transparent building blocks for retail and private wealth portfolios, This has been the source of strong growth in ETFs in the US and European market and may well prove to be one of the engines for sustained growth in Asia in the coming decade. 
• David Ngan is head of asset management, Hang Seng and Ken Sue is head of wealth management sales and ETFs, Asia Pacific, HSBC­­­ ©2011 funds global

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