Hong Kong investors are increasingly becoming more adept and aware of the benefits of exchange traded funds (ETFs). As of the end of July, the total assets under management of ETFs in Hong Kong reached about US$10billion and the number of ETFs on offer has increased to 19 in a span of eight years. David Chai, head of global structured products, Asia ex-Japan at State Street Global Advisors Asia, outlines the benefits of ETFs. How do ETFs work? What are the main features? ETFs are open-ended index funds that list and trade on stock exchanges. They have characteristics of common stocks and are backed by baskets of securities designed to track indices. For example, in the case of our TraHK (Tracker Fund of Hong Kong) ETF, the objective is to closely match the performance of the Hang Seng Index. Each ETF share represents a beneficial interest that is composed exclusively of index constituents. Investors can gain immediate exposure to the largest stocks in the Hong Kong stock exchange through one transaction. Unlike investing in open-ended mutual funds, investors have the option to buy or sell ETFs at any time during the trading day. The unique creation and redemption mechanism ensures that ETFs trade closely to their net asset value. Because ETFs aim to track their designated index, investors are able to monitor their investments at any time. What are the main benefits of the ETF structure? The ETF is a passive investment strategy that offers investors diversification at a low cost. Such a strategy keeps turnover in the fund relatively low, leading to lower transaction costs and lower management fees. Tracking the index also provides the benefits of transparency because holdings and returns are known and publicly available. Define the range of asset classes that ETFs invest in to help diversify a portfolio To reduce risk in a volatile market investors should consider investing in different asset classes to increase the diversification of their portfolios. The stock market of Hong Kong offers investors a suite of ETF products that they can choose from. These range from single country and regional equities exposure to fixed income and commodities ETFs. Why are ETFs appropriate in the present volatile market? One way of controlling risk in a volatile market is to hold a diversified basket of holdings across asset classes from equities to fixed income and commodities. ETFs are tools that can help investors achieve this diversification in a cost effective manner. For example, historically, positive returns on bonds have helped to offset the effects of negative returns on stocks during market recessions. By adding bond investments to a stock-heavy portfolio, investors can potentially lower the overall risk of their total investments. Diversification can be further improved through exposure to many individual securities in the broad fixed income asset class. Fixed Income ETFs such as the ABF Pan Asia Bond Index Fund (PAIF) can be ideal for broadening exposure. PAIF was launched two years ago through a regional initiative to promote Asian local currency bonds. It is an ETF that is listed on the Hong Kong stock exchange and invests in local currency government and quasi-government bonds in eight Asian markets. What is the fund composition of the TraHK ETF and how do you decide the weighting? TraHK's investment objective is to provide investment returns that closely match the Hang Seng Index in price and yield. To achieve this investment objective, the fund invests all or most of the fund's assets in the constituent shares of the Hang Seng Index in the same weightings as they appear in the index. H shares now account for about 25 per cent of the index.