Asian Investor: ETF series

Asian Investor, May 2012

It’s well-known that there has been a proliferation of exchange-traded products in Asia over the last decade, both in terms of assets and number of vehicles. But are they trading?

Liquidity is an awkward question beneath the steady improvements in headline numbers in Asia. According to State Street Global Advisors, ETP assets have grown tenfold in 10 years, accounting for US$105.8 billion from 445 funds by the end of 2011. That’s relatively minor in global terms; well under one tenth of the US$1.59 trillion in global ETP assets. But it’s significant, and growing fast, with 21% year on year growth in assets under management last year, much faster than in the west.

On first glance, the liquidity picture is improving too. According to Nils Friets, senior vice president and head of securities at Singapore Exchange (SGX), trading in ETPs Asia-wide has tripled in five years. But Friets’s own exchange is also illustrative of a common footnote to healthy trade numbers. The $3.65 billion of assets in Singapore’s ETFs are split between 94 different funds, an average of just $38 million apiece. And trading within them appears to be heavily dominated by a few names, such as the SPDR Straits Times Index ETF – which just passed its 10^th birthday with S$384.39 million of assets – and the Singapore listing of the SPDR Gold Shares ETF, which is the most actively traded ETF in Singapore and holds a 48% market share among all gold ETFs in Asia.

It’s not that Singapore is unusual in this. In Hong Kong, “the liquidity has been almost entirely focused on China product,” says Stewart Aldcroft, senior advisor at Citi Investor Services, which provides a range of services to ETF providers and is also a market maker for them. “Around 60% of turnover in Hong Kong has been in China ETFs; its volumes have just been reflecting the speculative value of being invested in Chinese shares.” Elsewhere, other products are dominant. “Korea sees an enormous amount of ETF trading going on, but it’s almost entirely domestically focused product and a high proportion of that is either inverse or leveraged,” Aldcroft says.

The positive spin on this is that a handful of highly liquid products is not a bad thing, at least as a starting point. “You can see there are products that bring liquidity to the market, and that’s important,” says Frank Henze, head of SPDR ETFs for Asia Pacific at State Street. “You need to have that trading core in place as an incentive for investors to come to the market. I’m happy if you start with a few that trade a lot and then move on to others, in a halo effect; you need the highly traded ones to encourage market makers to come.”

Friets at SGX argues that “the observation is valid, but the same would be true in virtually any market in the world. There is a concentration in the US. I’d like to see more trading for all products, and part of that relates to education, but concentration is normal.”

Still, a thinness of volumes in Asia is one reason that not all providers have chosen to list their products here. Credit Suisse, for example, has not listed any of its ETFs in Asia yet, instead encouraging investors to use its European products. “Given the fragmented nature of the Asian marketplace and the many barriers of entry, including regulatory and cost considerations, ETF offerings in Asia have been patchy,” says Joseph Ho at Credit Suisse Asset Management. ETF providers face restrictions in Asia that US and European markets often do not impose; Ho cites the example of not being permitted to undertake stock lending with underlying securities, while the absence of a UCITS equivalent scheme in Asia is also a limitation.

“Regional institutional investors have tended to make their ETF investments in overseas markets that offer fuller product sets and higher liquidity,” says Ho. This is Credit Suisse’s approach, offering what Ho calls a “mix and match” opportunity among a wide range of Europe-listed ETFs rather than cross-listing them in Asia. “In Europe, there are economies of scale and a large opportunity,” he says. “There is a single currency, at least among the EU countries, and the investment pool is the combination of many markets. If you do a listing in Hong Kong, in contrast, your investment pool is just that market.”

“Our view is that this is likely to continue in the foreseeable future given the lack of economies of scale among Asian markets,” he says. This approach means that Credit Suisse’s Asian client base for ETFs is largely institutional – since retail would need a broker that can access European securities in order to buy them – but Ho says institutional buyers in Asia are significant and growing. “Also in Asia there are a lot of private banks becoming active users of ETFs, using them as tools for portfolio construction.”

Others have listed products in Asia, but certainly haven’t felt the need to list everything there. “When we think about product development we think about it globally, not just within a region,” says Nick Good, head of iShares for Asia Pacific. “We continue to see our clients look globally for the right products. There are definite advantages in currency and timezone and familiarity, but many clients will look right around the world for the best products. We won’t necessarily launch something in each jurisdiction that exists.”

Set against that, “There are a couple of advantages when you list locally,” says Good. “First, it’s trading in-time zone; second, it’s trading in the same currency that market is operating in.”

Partly, that decision comes down to liquidity, not just of the underlying primary market but the likely secondary liquidity of the ETF itself. “You need a customer base that only buys local product, and generates sufficient liquidity,” Good says. “Australia is an example where you’ve seen that, with the big self-directed segment, the self-managed super funds. There are investment advisors who only want to buy Australian product and want access to global equities, and we can offer that in Australia very effectively.” It’s much more challenging with smaller markets.

It’s also not that easy from a logistical point of view. “Cross-listing sounds straightforward, but often the legal requirements for a primary domicile don’t align well with the legal requirements for a cross-listed location. That can be a challenge,” says Good. That varies from market to market; he highlights Singapore as an example of a market that has done “really good work” in allowing cross-listed US funds to be fungible with the US fund itself. “That facilitates global investors getting a much broader window of trading for ETFs. That fungibility is hugely valuable: it means it’s the same security whether you buy it in the US or here.”

Liquidity isn’t helped by the sales model around ETFs in Asia. “There is increasing acceptance of ETFs by professional investors, the fund management industry and by regulators,” says Aldcroft. “But the thing that hasn’t changed, and is probably the source of most frustration, is the extent of distribution of ETF products within the market.” Most fund products in Taiwan, Hong Kong and Singapore are distributed by banks or other financial advisory groups, which tend to represent around 80% of mutual fund distribution, and do so on a commission and trail model rather than fee for service – clearly penalising ETFs, which pay neither commission nor a trail. In Australia, ETFs only took off when the financial planning industry began to move from trail fees to fee for service; greater penetration for ETFs in Asia, and hence liquidity, may well depend on the same trend happening here.

It’s important to define what you’re looking for in liquidity. “There is a challenge when you are first trying to get them off the ground,” says Good. “The challenge isn’t that the liquidity isn’t there; the primary market liquidity for the products we launch is deep enough. But an ETF has two layers of liquidity: what’s trading on the exchange, the secondary, and the underlying assets, the primary.” On top of that, a lot of volume in ETFs is OTC, through institutions, so is not obviously apparent on exchanges.

But, at Deutsche Bank’s Marco Montanari, who heads DB x-trackers in Asia, points out, “we always tell investors that at the end of the day, liquidity depends on the liquidity of the underlying markets. The bid-offer of an ETF depends on the bid-offer of underlying markets. It’s just a fund buying underlying stocks.”

Asia does present some oddities around this, most obviously for A-share funds, where the quota system and consequent scarcity value cause ETFs to trade at a premium to the underlying index. “The price is based on the fact that foreign investors have limited access to China because they can only access it through the quota restricted system,” says Montanari. Also, in smaller markets, institutional trade can be limited by the size of the underlying market. “We launched ETFs linked to Pakistan and Bangladesh, and we tell clients it will be difficult to trade more than $1 million per day, because that is what the underlying market trades,” says Montanari. A market maker will typically not want a client to be trading too much because they will have an impact on the market; a typical limit is 10 to 20% of market daily volumes. “So if the market doesn’t trade that much, by definition investors will have more limited access.” But underneath all this is an unavoidable truth. “The most important thing is that ETFs are just an access product,” says Motanari. “They’re just a box full of stocks or bonds. We cannot ask ETFs to provide more liquidity than the underlying market; it’s not their role.”

ETFs pipeline

Asia remains a vibrant market for new product. Marco Montanari at Deutsche Bank says over 20 new providers entered the market in Asia, compared to two apiece in Europe and the US.

So far this year, Hong Kong stands out, with at least 20 new ETFs listed. The continuing evolution of policy around the RMB, such as the RQFII measures – a pilot program allowing qualified investors to invest RMB funds raised in Hong Kong into the mainland securities market, which was considerably increased in size in April – is likely to be a spur to product development. “You will have more China A-shares ETFs, and I think this is very interesting for Hong Kong,” Montanari says.

The rise and rise of fixed income funds is discussed on page xx; iShares alone launched four such products in Singapore last year and has added a further three in Australia so far in 2012.

Outside of Hong Kong and Singapore, other markets are evolving in different ways. The dominance of leveraged and short ETFs in Korea could be replicated elsewhere if regulations permit. In Japan, rules permitting these ETFs came into effect in April, while Polaris continues to try to persuade the Taiwanese regulator to do the same. That would be a spur for further development.

Sector and country-specific funds continue to attract interest. Indonesia and the Philippines, very much in vogue with world investors for their favourable economic story and ratings upgrades (complete in Indonesia, expected in the Philippines) are a natural magnet for new product.

Nick Good at iShares reports consistent interest in high dividend equity products, anything related to the RMB, and commodities. “There is obviously a lot of RMB tied up here in Hong Kong, and there is demand for the right kind of product to help investors get a good return on it,” says Good. “And the perennial favourite in Asia is commodity products.”

Another prompt for new product is simply the sheer potential for growth. Good says at iShares Asia represents about 7% of revenues – and that’s in terms of clients in Asia, not in listed assets. For example, Blackrock estimates that the total asset base for Asia for its ETFs is around $35-40 billion, but of that, only about $8 billion is locally listed, with the bulk instead offshore. That might be sovereign wealth funds buying European or US funds, or individual private wealth investors, or retail buyers with an HSBC account who can go online and buy US equities, including ETFs. In terms of total products Asia is also disproportionally small at iShares/Blackrock: 19 locally domiciled in Hong Kong and Singapore for Blackrock, alongside three in Australia, with a further three cross-listed in Singapore and 19 in Australia. That compares to over 500 worldwide. So a straightforward gradual roll-out of global products in Asia, whether cross-listing or filling in the gaps in the product set locally, should keep momentum going.

“There are a number of global names who are interested in setting up product and bringing it to Asia,” says Aldcroft. “Whether they bring global or domestic product or create something else will depend, but it’s clear there is a lot of activity among the big names in the industry.”

For some, the point is not launching a lot of new product so much as getting customers into what’s already there. “As an industry we are very focused on product: what is the next big product,” says Frank Henze at State Street. “We should turn that round. What products are going to be useful to clients in regard to the solutions they are seeking? What investment problems are they looking to deal with?” There are obvious spurs for new product, such as regulation. “Things that come to mind are the liberalisation of China, which will create opportunities in the currency and in bonds; or regulation changes, such as taxation changes in India. They happen on the back of economic development rather than an individual product that’s going to catch the imagination.”

Be that as it may, State Street, like others, still plans new launches. “We have new products in the pipeline, both local and cross-listed,” says Henze. “We offer 150 funds, and most of our institutional clients can buy any of the 150. But as the industry becomes more local, and there is more demand for locally domiciled and regulated products, we will go with the flow.”

Aldcroft, too, expects to see more demand for regional and domestic product. At the annual Citi ETF conference, last held in November, “one of the most frequent comments was the need for more sector indices both for the region and individual markets within the region. Whether it’s financials, trading, manufacturing, technology or property, if you are a professional investor who thinks you know better than fund managers, you will be interested in buying these ETFs because you think that’s the sector of the market that’s going to go up better than the others. As soon as you have a multitude of these, you will have professional investors wanting to buy them.”

It’s likely that other countries outside Hong Kong and Singapore, notably Korea and Taiwan, will provide growth momentum for new products, but neither are yet mature markets. In both cases they are heavily dominated by one local player: Samsung Securities in Korea and Polaris, which claims to have about 95% of the market (with Fubon most of the remainder), in Taiwan.

Polaris represents an interesting example. According to Frank Lin, manager at Polaris, they have 12 ETFs with combined assets of US$3.5 billion, and were about to launch another, based on China’s SSE 50 index using Polaris’s QFII quota, at the time of the interview in April. Like many providers, they have a flagship that dominates assets: one based on the Taiwan 50 index, and which accounts for US$2.8 billion in assets. It is by far the most heavily traded ETF in Taiwan, typically moving between eight million and 20 million shares a day; Polaris also has the second most highly traded product (based on China’s CSI 300, turning over six to 10 million shares a day) and the third (on the MSCI Taiwan index, doing two to four million shares a day). “In Taiwan it depends on the time: there are seasonal trading volumes,” says Lin. “During the dividend season, from about now to the end of September when underlying stocks go ex-dividend, we experience more transactions in the primary market.”

While Taiwan does have five providers, Polaris dominates, but is looking with interest at international providers like Blackrock/iShares and Deutsche Bank/DB-x who it expects to come and launch in Taiwan. In the meantime, Polaris is looking at new things to launch. It does have a fixed income fund, though it’s not the most popular fund in its range by any means; and it’s believed to be planning a precious metal fund (likely just gold). Beyond that, for about four years it has been trying to persuade the regulator to let it launch leveraged and inverse ETFs. Lin also says he expects more single-country ETFs in Taiwan. Broadly speaking, the outlook is good. “We are expecting the ETF market to grow three to five times within five years,” he says.

ETFs fixed income

In March, a small landmark arrived in the Australian ETF landscape. This market has been growing rapidly for several years, and hosts a mushrooming range of providers and funds, from commodities to international equities, oil to high dividend equities. What it has lacked throughout is fixed income funds, but in March, following an agreement between product providers, the regulator (ASIC, the Australian Securities & Exchange Commission) and the Australian Securities Exchange, manufacturers began launching their first fixed income products.

Within two days in mid-March, six funds were launched, three apiece from Russell Investments and iShares. Already there are government bond funds, semi-governments, corporate bonds, inflation index, treasuries, composite index products, and all of them at a remarkably low fee ranging from 0.24 to 0.28% between them. Within a week they had attracted A$81.46 million, according to Morningstar.

Maybe Australia is a special case: it is a high yielding market and its bonds are steady as well as lucrative. But certainly the Asia Pacific region is showing greater interest in fixed income ETF product. “You will see more and more fixed income ETFs coming to the market,” says Marco Montanari at Deutsche Bank. He says in the US, investors tend to put 70% of their money in equity ETFs and the rest in fixed income and commodities, whereas in Asia equity typically takes up 90%; redressing this imbalance will be a prompt for fixed income product in Asia.

Fixed income products are not straightforward, and are often illiquid. Frank Henze at SSGA points to its pan-Asian bond index fund. “That is a very complicated product involving government debt in the region, including Chinese bonds that are not traded,” he says. “Normally you try and produce a tradable vehicle based on liquid underlyings. But you don’t want to cut yourself short and just focus on the trading; that will mean local currency debt markets will not be popular, whereas they are as much a part of this industry as the liquid products.” Despite its complexity and lack of liquidity, the pan-Asian bond fund has close to US$3 billion in assets, he says, reflecting increasing client appetite for fixed income across the region.

“The first challenge is having expertise in fixed income so you can structure the fund so that you don’t face liquidity challenges,” says Nick Good at iShares, which listed four fixed income ETFs in Singapore last year. “That way as you mange the fund you can deal with exogenous shocks without impacting the fund, either in liquidity or performance.” He calls it “a judgement-based balancing act.” iShares is the biggest globally in this field, and takes some pride in the fact that its fixed income ETFs continued to trade after the Lehman collapse; Good thinks they make perfect sense for investors in Asia. “They’re priced on an exchange, they’ve got intra-day liquidity, they pay good yield, they’re transparent; they do everything you want them to and they are very compelling.”

RQFII, discussed in the ‘pipeline’ section, is likely to be a prompt for new ETFs, as is the dim sum bond market. In any new market it takes time for ETFs to follow, and the dim sum bond is a case in point: only really active for the last two years, it was characterised first by a wide range of issuers taking advantage of investors wanting yield as an alternative to bank deposits; then by the steady arrival of mutual funds; then the influence of that institutional capital being reflected in a more sober supply-demand situation, causing bond prices to come down and shifting the focus to more highly-rated issuers. It’s only very recently that any indices have started to appear. Now that the market looks rational and reasonably deep, it becomes a natural place for ETFs to be launched and to thrive.

Finally, fixed income ETF development is underpinned by continuing uncertainty about just what global or regional equities are going to do next. While the mood has certainly been better in recent months than in the second half of last year, it is likely that volatility and uncertainty in the stock markets has prompted a lot of people who might never previously have looked at fixed income to give it a second look – and ETFs are one of the easiest ways of gaining exposure.