Increased security

Peter Guy looks at the attractions of ETFs, or exchange traded funds

PUBLISHED : Monday, 30 April, 2012, 12:00am
UPDATED : Monday, 30 April, 2012, 12:00am


Exchange traded funds - ETFs - are gradually finding their way into the world of Asia's retail and corporate investors, who are discovering their unique portfolio characteristics and relatively lower costs.

ETFs are securities that track an index, a commodity or a basket of assets, like an index fund, but that trade like a stock on an exchange. Their fans say they give the diversification of an index fund with the ability to sell short, buy on margin and buy as little as one share.

Despite some recent ETF withdrawals from the Hong Kong market, indicators for ETF acceptance and growth in Hong Kong are still buoyant.

The major benefits of ETFs for investors - liquidity, transparency, trading flexibility and diversification - are still the key benefits and standards that ETFs must achieve in order to drive the more important trends in the local investment scene.

Globally, the Exchange Traded Products (ETP) industry has continued to grow in 2012, despite market turbulence in Europe. It attracted US$18.4 billion in net new assets during February, according to BlackRock. Global assets held in ETPs reached US$1.72 trillion at the end of February, an increase of 12.8 per cent year to date, with combined inflows for January and February standing 111 per cent higher than recorded in the first two months of 2011.

Emerging market equity ETPs saw significant inflows as a result of a positive global trend by gathering US$7.9 billion of new assets in February and US$14.5billion year to date. This represented the strongest-ever start to a year for this product category and reversed the outflows experienced in the second half of 2011. Currently there are 89 ETFs listed on the Hong Kong Stock Exchange, representing about US$26 billion in assets under management.

However, in March Lyxor International Asset Management (a wholly owned subsidiary of Societe Generale ) applied for the deauthorisation and delisting of 12 of its ETFs on the Hong Kong stock exchange. The most likely reason, according to market participants, was probably a lack of trading volume and turnover.

The key to a successful ETF is the popularity and liquidity of the underlying asset that is being traded. According to Marco Montanari, head of Deutsche Bank ETFs and db-X funds, Asia: 'The key to meeting investors' needs is to create ETFs with genuine demand. This not only means a useful investment theme, but strong underlying assets and ETF liquidity that allows active and accurate buying and selling.' Indeed not all ETFs are equally popular, as a large majority of global ETF assets sit at about 100 of the more than 1400 ETFs in the US.

The low interest rate environment that is expected to continue since the US Federal Reserve announced low rate policies has ignited the rise of dividend-focused emerging market ETFs. Emerging markets have not traditionally been the place to look for dividend yield, but the relatively stronger balance sheets and financial health of Asian corporates has created an opportunity.

Keith Chan, head of listed product sales for HSBC, says: 'Low interest rates and the ability to design an ETF that is based on balance sheets rather than market capitalisation allow originators to serve this demand.' ETFs for emerging markets have enjoyed a strong start this year, with record combined inflows for the first two months of US$14.5 billion for January and February according to BlackRock.

For example, Wisdom Tree manages a fund called DEM Emerging Markets Equity ETF, which has attracted inflows of US$820 million in 2012, making it the ninth fastest growing US ETF this year. DEM is the first emerging markets dividend ETF: launched in 2007, it has accumulated assets of more than US$3.3 billion. Between 2008 and 2011 investors could have made better returns by investing in the MSCI emerging markets index than from the US stock market. At the end of 2011, DEM was offering a dividend yield of 6.4 per cent, which is substantially better than the 3 per cent yield on the MSCI emerging markets index and 2.2 per cent on the S&P 500.

With such results, emerging markets are now an important area for investors looking for both dividend yield and potential dividend growth. Other large ETF sponsors launched emerging markets dividend index funds, such as BlackRock's iShares Emerging Markets Dividend Index Fund, which was launched on the NYSE in February 2012. This fund tracks the performance of the Dow Jones Emerging Markets Select Dividend Index.

Active ETF strategies were given validation when Pimco launched the ETF version of its huge Total Return Fund in March. This ETF will reflect the performance of Pimco's Total Return Fund, which is the world's largest bond mutual fund with nearly US$245 billion in assets.

It is an important development space because it is a version of a well-known fund run by a famous manager, Bill Gross. Previously, active ETFs were only a small part of the ETF universe. According to Deutsche Bank, there are only about 40 actively managed ETFs in the international markets, representing just 0.5 per cent of the total ETF market, so this means they have struggled to attract sizeable assets and trading volumes. Pimco's new ETF is setting a new standard for the ETF space. Montanari says: 'The local market may not be ready for active ETFs, as 90 per cent of ETF volume in Hong Kong is linked to Hong Kong or China indices.'

Increased collateralisation requirements for Hong Kong-originated and listed synthetic ETFs were announced in August 2011 by the Securities and Futures Commission. New rules improved the level of the collateral and transparency of domestic synthetic ETFs in an effort to strengthen protection for investors. ETF managers who administer locally originated, synthetic ETFs will be required to increase collateralisation to ensure there is no uncollateralised counterparty risk exposure.

Synthetic ETF managers will also be required to increase collateral to 120 per cent of the related gross counterparty risk exposure in the event that the collateral is represented by equity securities. Perhaps memories of the Lehman mini-bond collapse still represent a hurdle that both local regulators and ETF managers must confront, even though the issues concerning collateral between local ETFs and mini-bonds are completely different.

Most market professionals believe that additional assurance of security for investors will be good for the local development of ETFs. Montanari says: 'Deutsche Bank already collateralises its ETFs by 100 per cent for counterparty risk.' Montanari says that even though Asia only represents 5 per cent of the world's ETF market, it could equal Europe's size in five to 10 years.

Hong Kong-originated ETFs are now supported with 100 per cent to 120 per cent collateral assets that are held by an independent custodian. Even before the Securities and Futures Commission imposed new measures, collateralisation was 80 per cent. However, the Lehman mini-bonds were not collateralised. Instead they were backed by a guarantee by Lehman Brothers, which failed investors when the bank itself was forced into bankruptcy.

One of the most useful features of ETFs is their ability to track and emulate a group of stocks or sectors in countries or areas that would be too expensive or difficult to assemble for your average investor. Their ability to access restricted markets or replicate sectoral investment themes at a low cost is attractive to investors looking to execute specific strategies.

For example, BlackRock's iShares CSI A-Share Consumer Discretionary Index ETF uses derivative instruments linked to China A shares, which emulates the performance of 300 mainland consumer stocks. It covers sectors such as household durables, cars, speciality retail, car components, hotels, restaurants and multiline retail, among others. Sandra Lee, managing director of BlackRock, says: 'Investors who want to specifically follow the Chinese retail sector and an industrial group that is not as heavily influenced by government policies as others will find this to be an ideal access tool.'

Contrast this ETF with China Construction Bank International's China Policy Driven Fund, launched on January 2009 and currently with assets of US$315 million. Its investment objective is to invest in a diversified group of equities that can benefit from the policies of the mainland. Without a reference benchmark, this mutual fund executes a total return strategy based on political, economic and sectoral analysis. Timing, sector concentration, switching and tactical re-allocation between mutual funds and ETFs are adding more choices to the diversity and conflict of investment viewpoints.

Asian fixed income ETFs are also a new and popular product area because they provide investors a chance to access returns from a diversified portfolio of Asian bonds at a generally lower cost than investors could realise by trading or assembling their own portfolio. In December 2011, BlackRock (Singapore) added two more Asian fixed income exchange traded funds to its Singapore-listed fixed income ETF line. The iShares Barclays Capital USD Asia High Yield Bond Index ETF is the world's first ETF to provide access to the Asian high-yield credit market. The iShares Barclays Capital Asia Local Currency 1-3 Year Bond Index ETF provides access to Asia's local currency bond markets with less sensitivity to interest rate movements than existing products due to its shorter duration.

These instruments effectively trade like listed securities, but provide an investor with exposure to the bond market, tracking the performance of fixed income indices and investing in a basket of bonds, all without requiring the investor to actually buy bonds. Investors are beginning to see more choices in ways to invest in Asian bond markets at varying levels of risk adjusted return that suit their investment requirements. Sandra Lee of Blackrock says: 'Historically, Asian investors haven't considered using the fixed income sector because it was expensive or cumbersome to invest in. ETFs brought accurate tracking, practical access and cost efficiency to Asian bonds.'

All of these developments in the global and Asian ETF markets point to trends providing greater choice, lower costs and better efficiency for local investors.