Asia comes of age

While the exchange-traded fund (ETF) market in Asia is much smaller and more immature than the European and the US markets, it has been rapidly expanding throughout the global economic crisis. Assets under management (AUM) for iShares ETFs in the Asia ex-Japan region, for example, reached $4.3 billion by end of 2008, a 43.7% increase in AUM over the previous year. On a global basis, iShares, a leading provider of ETFs, reported net inflows of $89 billion in new ETF assets for 2008, compared with $70 billion the previous year.

Joseph Ho, head of ETF sales and marketing for Asia at Lyxor, says ETFs are recognised for their transparency, flexibility and cost-effectiveness. Moreover, as index trackers, ETFs have no active risks relating to stock pickings: "ETFs have continued to pick up assets [in 2008 and 2009] because of their transparency and liquidity. When you have volatile markets, it is not the time to be making stock picks. We are still in a stage where macro views drive the market and individual stock risks remain high. Also, the benefit of using an ETF over an index future is that there are more ETFs than futures to choose from; and there are no [quarterly] roll risks and costs and you actually have got the physical asset."

Moreover, as credit conditions have eased and risk appetite resurfaced since March this year, the demand for ETFs has not dwindled. According to Barclays Global Investors' ETF Landscape Industry Review, published in July 2009, the total AUM for ETFs in Asia (ex-Japan) stood at $31.08 billion at the end of July 2009. Globally, it expects assets in ETFs to reach $1 trillion in 2009 and $2 trillion in 2011.

The majority of ETFs in Asia are based on blue-chip indexes and still limited by country. Ken Hon, head of Asia Pacific derivatives trading at Citi and based in Hong Kong, says: "Asia has seen rapid growth in the ETF market especially in the past couple years. At the moment, ETFs in Asia are focused on regional or country exposure, though in the future we will eventually see more sector and thematic ETFs."

However, some unique developments are taking place in Asia. For example, economies comprising greater China are starting to co-operate more closely in the area of EFTs. Hang Seng Index ETF and Hang Seng H-Share Index ETF became the first Hong Kong ETFs to cross-list in Taiwan following a co-operative deal signed between the Securities and Futures Commission (SFC) and the Taiwan Financial Supervisory Commission (FSC) in May 2009. The move is seen as a big step forward in terms of regulatory co-operation and increases Hong Kong's position as a preferred ETF platform as it can now channel investment flows from Taiwan into the mainland, linking up these markets with Hong Kong as the gateway. Local investors will also be able to engage in overseas investments and consequently facilitate liquidity flows into Taiwan.

"We are seeing greater China connection being built and this will enhance capital flow among the three markets," says Jane Leung, senior director of product, Asia ex-Japan at iShares in Hong Kong. "The cross-listing also signals the awareness of the benefits of ETFs and this is likely to fuel the ETF market development in greater China in the long run. Cross-listing usually allows an ETF to buy access to investors which could result in greater liquidity of the fund."

The Hang Seng Index ETF and the Hang Seng H-Share Index ETF will be traded in the new Taiwan dollars, but will share a minimum board lot size of 100 and 200 units respectively. The key difference between them and other stocks in Taiwan is they are lower than the minimum board lot size of 1,000 units and have had the daily limit of 7% on stock price movements removed. The listing of these ETFs was followed on August 17 by BOCI-Prudential Asset Management's Wise - CSI 300 China Trackers which trades through Polaris International Securities Investment Trust's Wise Polaris CSI 300 Securities Investment Trust Fund. And then the first Taiwan ETF to be offered in Hong Kong, the Polaris Taiwan Top 50 Tracker, was offered on 19 August.

Marco Montanari, head of ETFs for Asia at Deutsche Bank in Hong Kong, says the deal paves the way for investors to gain exposure to other markets in the region and is very encouraging for the future of ETFs. "Cross-listing ETFs potentially enable issuers to reduce costs and generate benefits in terms of economies of scale that can be reflected in lower costs for the final investors," says Montanari.

Sumeet Nihalani, senior director of sales, Asia Pacific and the Middle East, at Dow Jones Indexes, based in Singapore, also interprets the cross-listings in Hong Kong and Taiwan as an important step towards a more flexible and active cross-border ETF business within greater China. Nihalani expects new listings of ETFs based on international indexes in the near future as investors might seek further opportunities to diversify outside the region. "Cross-listing ETFs is a cost-efficient way in reaching a wider and more international investor audience."

The advantages of using ETFs to mitigate risk have also been recognised in other parts of Asia. For example, New York-based Van Eck Global unveiled its Market Vectors Vietnam ETF on August 14 to become the first US-listed ETF tracking the Vietnamese market. The index represents 28 companies in eight sectors. Around 70% of the index comprises securities of companies domiciled and primarily listed on an exchange in Vietnam, which also generate at least 50% of their revenues from the country. The remaining 30% is made up of offshore companies which generate at least 50% of their revenues from Vietnam, or show a significant or dominant position in the Vietnamese market.

And it is not just equity-linked structures that are gaining traction. Deutsche Bank launched what may be Asia's first money market ETF on August 28, with the listing of its US Dollar Money Market ETF in Hong Kong. The ETF provides investors with access to the overnight dollar money market by tracking the Fed Funds Effective Rate Total Return Index, which is intended to reflect the performance of a daily rolled deposit earning the US federal funds effective rate.

Many market participants believe the potential appetite for ETFs in Asia for both tactical and strategic asset allocation is high. Montanari says even without considering the growth due to the underlying markets, the Asian ETF market has the potential to increase by more than 20% per year in the coming years. "The ETF market in Asia [including Japan] represents only around $50 billion against around $150 billion in Europe and more than $500 billion in the US," he says.

However, development in Asia does face challenges, notably due to its fragmented markets. Statistics by Dow Jones Indexes show Japan is the largest market in the region with 67 listed ETFs and AUM of $25.5 billion in July 2009, followed by South Korea in terms of total listings with currently 38 ETFs and Hong Kong in terms of AUM size of $17.1 billion. But growth is expected across the board.

"Singapore is picking up in terms of ETF listings and assets under management in ETFs," says Nihalani. "A Dow Jones Eurostoxx 50 index-based ETF was listed at the Singapore Stock Exchange a few weeks ago, giving access to the 50 largest companies in the eurozone. Taiwan and Malaysia have seen some more ETF activity recently; the latter mainly in the Islamic finance space." The first ever Islamic ETF in Asia was launched in January 2008 based on the Dow Jones Islamic Market Malaysia Titans 25 Index, comprising the 25 largest sharia-compliant companies in Malaysia.

Assets under management in ETFs in India have also beengrowing significantly, which suggests there could be further developments in the domestic ETF market there in the next few years. "The next big country market in Asia is likely to be India," says Christopher Lee, head of risk management products intermediary sales at UBS in Hong Kong. "Country-based ETFs are more successful in Asia than in Europe and the US - especially the ones that look at China - but this is because the Asian market is not as sophisticated as these other two markets."

However, diversification into more sophisticated sectors brings increased risk. As the Asian ETF market catches up with Europe and the US, there are hopes it can avoid some of the problems encountered during the development of those markets. Some of the more sophisticated leveraged and inverse ETFs, for example, drew fire in the US in the second half of 2008 for a lack of transparency as they did not track the indexes and benchmarks as closely as they might be expected to, which may be confusing for less sophisticated investors.

But in terms of risk and ETFs, the main debate centres on the large growth of leveraged and synthetic structures, where an over-the-counter (OTC) index swap seeks to offer competitive advantage from not having to own the underlying equities. This means investors get the performance of the reference assets, but the costs and risks associated with an ETF based on equities and measured against a total return benchmark and are then passed onto the provider of the OTC swap. In practice the total return swap (TRS) provider hedges their risk on the TRS against the underlying asset by buying the portfolio themselves. To mitigate credit risk they can call for additional margin from investors if the value of the portfolio drops. The provider's only regulatory capital requirement comes from the credit risk and therefore the spread charged on the TRS offers a decent rate of return for them.

The problems for the investor come when the portfolio becomes illiquid and drops in value. This can lead to investors being forced to post more margin until they can no longer afford to do so and are forced to liquidate positions in illiquid markets. There is also a problem with the counterparty risk angle whereby should the counterparty default the investment objectives may not be achieved.

Leung notes some ETF providers, who without the experience and capability to perform the fiduciary duties of an asset manager, are using swaps to mimic index returns. "These products tend to have minimal transparency so investors don't really know what they have invested," she said. "Usually these swap-based ETFs can only create or redeem with a single counterparty, representing a certain degree of counterparty exposure for investors."

iShares, by contrast, offers cash-based ETFs using participation on P-notes to access restricted markets such as China. "And we use a multi-dealer model to reduce bid/ask spreads," says Leung. "We have placed strong emphasis on transparency - our counterparty exposure is disclosed daily on our website."

However, in general she does not think investors are returning to leverage under current market conditions. She says the growing interest in ETFs is actually a testimony that people are going back to basics - investing in simple products they think they understand. l