In structuring any new exchange-traded fund (ETF), providers need an accepted and reliable benchmark on which to base decisions and peg performance. A typical starting point might be the Hang Seng Index and its subdivisions or one of the MSCI indices which track results across markets and sectors. As the benchmark moves, so goes the ETF and the relative value of its units. Investors don't expect miracles, and the funds are generally bracketed as 'passive'. The managers' job is simply to mirror the pre-defined index - assuming that will generate reasonable returns - and not attempt anything too flashy by playing hunches or aiming to multiply gains through short-term trades. New refinements, though, are adding a twist to the ETF format. For example, providers have seen that stoic dependence on indices that gauge established sectors and big-name stocks can lead to missed opportunities in emerging markets and fast-growth industries. And they realise that having an ETF based, say, on Hang Seng constituent stocks is, by its very nature, a mixed bag. In there, with a gung ho telecoms company, you could also get a scandal-hit property developer or an airline with spiralling costs. In what a broader index captures, risks and rewards balance out. However, with a few tweaks and a more precise focus, it is possible to retain the ETFs' key benefits, while increasing the chance of better long-term returns. 'People now question whether 'cap weighting' is the right way to build an index,' says Olivier d'Assier, managing director, Asia-Pacific, for Axioma, a company which provides advanced tools for risk analysis and portfolio optimisation. 'And while you can cut and slice the market any way you want, whatever you do, you create a lot of other exposures.' To illustrate, d'Assier cites the example of the S&P low volatility ETF. It is simply constructed and proving popular with retail investors in the United States. The 'problem' it had, as seen at the end of January, was that the premise and weighting meant 65 per cent of the portfolio was in just two sectors. Volatility in either of those undermines performance, and other biases - perhaps towards small cap stocks - could similarly appear. To forestall such unintended consequences and encourage more active ETF management, Axioma is behind a series of long-only large- and small-cap factor indexes. Developed for investment houses and financial institutions, there are two key aims: to identify and manage a portfolio's exposure to individual risk factors, and to create a more specific index against which to measure performance. 'We construct the benchmarks - for example, with some exposure to high volatility, but neutral on everything else,' d'Assier says. 'We give a list [of recommended holdings], impose some turnover restraints, and the fund managers then run the trades and the ETFs.' Changes are made, if necessary, after each quarterly review. This allows funds to circumvent avoidable risks and foreseeable declines, optimising benefits for investors within the investment parameters in listing documents. D'Assier tells retail investors to check the details of any ETF they are considering and not to be swept along by market sentiment or broad-brush impressions. 'You should ask yourself three questions: what is the ETF theme, how is this theme captured in the structure, and what other themes are captured that I don't want in the ETF?' The third of these questions, when put to fund managers, should spur their efforts to hedge out bias and other unwanted exposures. It is still the norm for structures to offer the 'usual basket' of stocks, whatever the prevalent theme. But as d'Assier emphasises, no practical barrier prevents providers from offering 'purified' ETFs which capitalise more fully on shifts in developed economies and the potential of emerging markets. A point to note about Asia, though, is that, for all the upbeat stories, the region's equity markets still lack depth. Therefore, investors should be wary about claims of runaway growth prospects or new access to untapped opportunities via about-to-launch ETFs. 'There may be only a couple of hundred stocks for managers to play with,' d'Assier says. 'So, it is harder and harder to differentiate, to search for new dimensions and ways to capture what others have not thought of.' This, he notes, will not stop some asset managers sitting in their office, 'guessing' what investors want to buy, and launching new products in the hope that they will 'stick'. 'Managers will keep coming up with the next product and looking for the next big hit,' d'Assier says. 'That's what they do.'
