Funds give investors a number of advantages

Once considered the 'new kids on the investment block', Exchange Traded Funds (ETFs) have come a long way since they were launched in Hong Kong in the late 1990s. Although the Hong Kong market is underdeveloped compared with the United States and Europe, the investment tools have grown from a handful a decade ago to 75 at the end of March.

Like their close relative mutual funds, the main objective of ETFs is to track the performance of an underlying index by investing in shares, bonds or other assets that make up the index. Although similar in characteristics, there are also fundamental differences between ETFs and mutual funds.

ETFs trade like equities, which means the price per share of an ETF changes continually throughout the day while the trading markets are open. On the other hand, mutuals only trade at the end of the trading day. Another key difference is the fee structure. Fees charged by mutual funds can vary from front-end loads, back-end loads, early redemption fees and active management fees. Because they are traded like stocks, ETFs incur transaction costs, such as trading costs and brokerage fees, which tend to be less.

Sandra Lee, managing director, BlackRock's iShares, Asia, excluding Japan, says ETFs can be used as effective building blocks that can be structured to meet the aims of an investment portfolio. They also allow investors to gain exposure to particular markets that may otherwise be difficult to access, for example, emerging markets, markets where investment by individual foreign investors is limited or investment themes including commodities, property and other investment products.

At present, most Asia ETFs focus on equity markets. However, Lee expects commodities and fixed income ETFs to play a bigger role as demand for ETF investment products continues to expand and develop. 'ETFs offer investors several advantages, which include market access, transparency, cost effectiveness and liquidity, allowing investors to move in and out of particular markets quickly and effectively,' Lee says.

According to investment management house BlackRock, ETF assets in the Asia region grew by more than 40 per cent year-on-year to about US$54 billion last year, compared with nearly US$39 billion at the end of 2009. At present, the Asia-Pacific, excluding Japan, ETF sector has 217 ETFs, 324 exchange listings, from 62 providers on 13 exchanges.

Reid Steadman, global head of S&P ETF Licensing, says he would not be surprised to see the number of ETFs in Asia expand by between 50 and 100 per cent over the next 12 to 18 months. 'Because they are listed on recognised exchanges and operate with transparency, retail and institutional investors in Asia are increasingly aware that ETFs are a useful way to diversify their portfolios and access a wide range of asset classes,' Steadman says.

Frank Henze, State Street Global Advisors Asia-Pacific head of ETFs, says the Asian ETF market is growing as an increasing number of retail investors are electing to make their own investment decisions. 'The reason ETFs have become popular and will continue to gain popularity is because they are flexible and enable investors to enter and exit markets efficiently and at low cost,' Henze says. He says using ETFs, investors are able to combine market features in line with investment goals.

'Because ETFs are passive and track an index, investors are able to make macro decisions instead of micro decisions and, therefore, reduce the risk involved with making individual stock selections,' Henze says.

Like any investment strategy, Henze cautions investors that not all ETFs are structured in the same way and involve varying levels of exposure to risk. He says it is particularly important that investors understand how synthetic ETFs may use divertive instruments to replicate index performance.

'Investors should be aware there are ETFs that use synthetic strategies that may use derivatives to mimic the behaviour of indexes. When this happens, investors could find themselves exposed to the credit risk of the counterparties that issue the derivatives. In addition to the normal market risks, investors may not be aware of the amount of leveraging used with a synthetic structure. It is very important that investors fully understand how the ETFs they buy are structured and how they operate,' Henze says.

Aware of the chaos caused when Lehman Brothers derivatives products collapsed, the Hong Kong Monetary Authority (HKMA) has issued guidance to registered institutions that offer synthetic ETFs to customers. The HKMA advises synthetic ETF providers of the need to disclose all product features and risks to customers, explaining each factor of the key features and risks of the product. This includes the replication strategy, any embedded derivatives and the use of collateral.