Physical ETFs are cheaper and more transparent

New ETFs offer a simpler, cheaper and more transparent way to trade mainland equities, and they have no lurking back-tax issues, says Jasper Moiseiwitsch

PUBLISHED : Monday, 17 September, 2012, 12:00am
UPDATED : Monday, 17 September, 2012, 3:33am

This is a story about exchange traded funds (ETFs). But before you flee the Money pages, fearing a jargon-filled article that knocks you out with technicalities, please hang on and consider a few facts.

First, at some point you have probably thought about A-shares, which are yuan-denominated, mainland-listed equities. That might be less the case these days - the market is dreadful - but at some point you would have considered the shares, which are the best way to invest in China's growth story, the biggest economic boom in contemporary times.

If you have thought about A-shares, then you have surely looked at ETFs, as the instrument is effectively the only way that Hongkongers can get into this market.

The A-share ETF market is large. There are about HK$175 billion of such funds listed in Hong Kong, with most of that money in A-shares. The iShares FTSE A50 China Index, the biggest Hong Kong ETF, trades at more than twice the volume of Cheung Kong shares in terms of dollar amount, just for reference.

And here we come to our point. In recent months three mainland asset managers have launched a new kind of ETF that offers cheaper access to A-shares. How much cheaper? About 2 per cent to 3 per cent in terms of annuals costs, which is significant. Any fund manager would be proud to offer an immediate 3 per cent annual gain.

There are two types of ETFs that invest in A-shares. The new funds invest directly into the shares - they physically own the securities and are therefore called "physical" ETFs. The second type replicates A-share returns with derivatives. These funds are called "synthetic".

The new, physical, funds are simpler and more transparent than the synthetic ETFs. They are also free of back-tax risk.

This bears explaining. Most synthetic ETFs invested in A-shares have not set aside any money for a much discussed, and long expected, capital gains tax on investments held by foreign funds. The reasoning is that, because mainland investors pay tax on their investment gains, so should the foreign funds.

But, somewhat inexplicably, in the years since the Chinese government let qualified foreign investors buy mainland stocks and bonds (in 2003) it has never clarified whether it wants foreigners to pay tax on capital gains. It has just left the issue twisting in the wind.

There is a possibility that fund managers may wake up one morning with an edict from Beijing to pay nine years of back taxes on their investment gains (at an expected rate of 10 per cent).

Synthetic ETFs as such carry tax risk - specifically, that a hefty back-tax bill may suddenly fall out of the sky. Unfairly, any new investor coming into the fund would bear the brunt of this bill. He effectively would be paying the back taxes on behalf of investors who traded in and out of the fund in the years previous, and who are long gone.

ETF providers disclose the capital gains tax risk in clear language. Deutsche Bank's db x-trackers CSI 300 ETF, for example, states in its prospectus that: "Tax provisions are not made at the ETF level and therefore any retrospective enforcement may result in a substantial loss to the ETF." Other funds use similar language.

The new funds don't involve this risk, simply because they are new. There is no tax to claim back from previous years. They also fully provide for a possible capital gains tax - they withhold 10 per cent of gains in a reserve account.

So the new ETFs are cheaper and take a different approach to taxes. But are they actually better than the synthetic funds? To get to that point, a little background is in order. In July-August, E Fund Management, China Asset Management and CSOP Asset Management launched Hong Kong's first three physical ETFs.

This was a breakthrough. All previous A-share ETFs were prohibited by regulation from owning A-shares. Prior to July Hongkongers could only invest in A-shares through synthetic funds.

The synthetic ETF providers sign a contract with a qualified institution that can legally own A-shares, and which holds the shares on behalf of the ETF.

In this arrangement, the ETF providers rely on third parties to make good on a promise to pay out on economic gains of the shares. There is a risk that the third party will renege on its commitments.

To protect against this, the third parties have to post collateral against 100 per cent of their commitments. Because the third parties do not like to tie up a lot of collateral in these schemes, they charge the ETF provider a fee for the service.

This fee is passed to ETF investors in the form of a 1 per cent to 2 per cent collateral charge. Synthetic ETFs are more complicated to manage than physical ones, and so generally have higher costs. This is reflected in another ratio, called total expenses. E Fund's physical A-share ETF, called the CSI 100, has an expense ratio of 0.99 per cent

Ping An of China CSI RAFI A-Share 50, a synthetic fund, involves total expenses of 1.91 per cent. Bear in mind this does not include collateral costs, which add roughly another 2 per cent in annual costs to the typical synthetic fund.

"We are just one third of the cost [of the synthetic funds]," says Nathan Lin, managing director of E Fund, with reference to the collateral charges and other expenses.

Cost is one matter; transparency is another. Most ETF providers do not clearly describe the collateral expense to investors in offer documents. For example, iShares does not disclose collateral costs. It does say in a footnote in the A50 ETF prospectus that, "estimated total expense ratio does not … include variable items such as collateral costs (which may be significant)".

Most investors would not even be aware that collateral costs are a key cost of the fund. They are not charged directly, and do not appear on a statement. They are simply deducted from the fund, depleting the net asset value. Individual investors who want to get a sense of an ETF's collateral costs would have to look at a fund's historical net asset value in relation to the index that it tracks - not an easy estimate.

All synthetic ETFs, no matter how fairly and efficiently managed, suffer from transparency problems. That is because it is impossible for the ETF provider to easily explain its many derivative contracts and counterparty arrangements.

"Synthetic ETF providers might use derivatives with multiple counterparties. Each counterparty has different requirements and uses different derivatives, different interest rates and different embedded fees. It's impossible to generalise or describe. It's often a black box," says Robert Jones, head of FCL Advisory.

If synthetic ETFs are black boxes, it's not because they are trying to hide something. They are just complicated by nature of their derivative structure, which means investors must take a lot on faith.

Hong Kong's big synthetic ETF providers, in fact, do a good job with their instruments. They efficiently replicate the indices they are tasked to track. They have multi-year track records and trade in large volume without problem.

But the point is physical ETFs bypass all these issues because they directly own shares they track. It's straightforward. There's no complexity, no counterparty risk, no hidden collateral costs, no back-tax time bomb.

So one might think it would be a good idea to sell the synthetic A-share ETFs and buy physical ones.

Marco Montanari, Deutsche Bank's Asia head of ETFs and db-X funds, Asia, says synthetic ETFs have different characteristics over the physical newcomers. The first is history - the big synthetic funds have been around for some time, they are well known and can point to a track record of performance.

The second is trading volume. The big synthetic funds trade more heavily than the new physical ETFs.

The three physical ETFs are all denominated in yuan, which can be inconvenient for people who may want to trade in Hong Kong dollars (the final currency exposure is yuan for both type of ETFs).

The synthetic funds also typically follow a set of European Union standards known as Undertakings for Collective Investment in Transferable Securities, which gives comfort to many investors.

Finally, while Montanari acknowledges that the fees and expenses of the physical ETFs are lower than the synthetic funds, he says this does not tell the whole story. Ultimately investors will have also to consider the ability of all the ETFs to faithfully track an underlying index.

"If you buy the ETF with a low cost, and at the end of the year the fund has a tracking error of 2 per cent, the fees don't give the full picture," says Montanari.

Jones of FCL Advisory agrees, saying investors should give the physical funds some time to settle in to see how well they do in terms of trading volumes and managing tracking error.

The bottom line is this: the physical funds have yet to establish themselves. But they are very promising and any investor interested in A-shares should take a look at the instrument.


What is an ETF

Exchange traded funds are those that trade publicly on a stock exchange. You can buy and sell the fund with the same ease and the same low fees that you buy shares, and they typically have lower fees than regular mutual funds.

For example, a bank will typically get a commission of 5 per cent when it sells a mutual fund, which comes out of the investor's pocket. ETFs do not have any selling commissions.

Because they are bought and sold like a stock, banks can only charge a brokerage commission on their sale, typically around 0.25 per cent.

The fund's low costs and the fact that they are well regulated public instruments make them an excellent alternative to unlisted mutual funds.