Market vibrant but regulators hold key to fund growth
Category: China, Global
By Hui Ching-hoo
Asia set to overtake US and Europe on volumes
From left: Sandra Lv, Partner/Lawyer, Llinks Law Office; Tang Xian, Assistant Director, Fund Market, Shanghai Stock Exchange; Thomas Deng, Deputy General Manager, Invesco Great Wall Fund Management; Roger Liu, Head of Exchange Traded Funds Division, Mirae Asset Global Investments Hong Kong Limited; Yang Wen, Head of Product & Client Management, Securities & Fund Services, Global Transaction Services, Citibank, China, and Andrew Law, Head of Fund Services, Hong Kong and China, HSBC Securities Services
With the rapid development of exchange traded funds (ETF) in China, Asia Asset Management and ETFI Asia held their first ETF roundtable in Shanghai on April 27, bringing together a group of industry experts from local and foreign ETF sponsors, index providers and exchanges to share their perspectives on topics such as new product development, cross-border opportunities and regulatory changes.
Bryon Lake, global business development director of Invesco PowerShares Capital Management LLC, opened the first presentation, speaking about the evolution of ETFs within global markets and how ETFs can be deployed.
Mr. Lake noted that the ETF market is close to US$1.7 trillion in size globally. “If you look at the mutual fund industry in the US, it currently has approximately $15 trillion assets under management. The ETF market is just about 10% of the US mutual fund market,” he said. “Therefore, there will be a significant growth over the next 15 years, or even 20 years. In the first two months of 2012, total ETF assets were up by 12.8% or $195 billion. The ten-year accumulated average growth rate was 31.2%, representing a significant amount of capital going into this important investment vehicle.”
According to Mr. Lake, ETF products feature liquidity, flexibility and transparency. “Since the exchange credit funds are traded on the exchanges, investors can name the prices they like with a real time pricing system. That can ensure they get strong execution. For instance, there was a lot of volatility in the market during the financial crisis in 2008 and 2010, but these index products allowed investors to have greater control on pricing to mitigate the plight of the bearish market,” Mr. Lake added.
“The transparency features of ETFs enable asset managers to know exactly what their risk exposures are, so they can beef up their capabilities in terms of risk management for the portfolios.”
On indexing, Mr. Lake stated that this has expanded significantly over the previous decade. This resulted in a substantial growth in ETFs globally.
Although index providers like Dow Jones have a long track record in index compilation, Mr. Lake believes that most of the original indexes were created with limitations. For instance, the Dow Jones Industrial Average is a price-weighted index, which weighs the underlying components based on their trading prices rather than the size of the companies.
He added that ETFs can address the limitations. “Investors are demanding more variations on the ETF spectrum to solve the index limitation,” Mr. Lake said. “The market now has various types of indexes, such as growth-weighted indexes, value-weighted indexes, large-, mid- and small-cap indexes, equally-weighted indexes and fundamentally-weighted indexes. All provide unique exposures to marketplaces through ETFs.”
Mr. Lake expected about 53% of ETF users in the US to be institutional. “ETFs are typically used in asset allocation. One of the strategies is the core/satellite approach: investors use active managers for the core and overweight satellite investment ETFs. That allows them to have unique exposures to different asset classes, such as small-cap,” he said.
Commenting on the development of the Asian ETF market, Mr. Lake concluded: “It took eight to nine years for the US and European ETF market to reach $100 billion in size after the launch of their first ETF. The Asia ex-Japan ETF market has garnered assets of $63 billion so far. Therefore, I am very bullish that the Asian market is following a similar path to what we’ve seen in other markets.”
Institutional versus retail investors
Robert Hughes, managing director of index services at NASDAQ OMX Global Indexes, noted that the ETF market was off to a tremendous start early this year in terms of net new assets. “Given the continuing interest from ETF providers around the world for launching innovative new products and NASDAQ-100 Index-linked ETFs, we believe the ETF industry may continue to grow as regulatory regimes adopt ETF-friendly rules,” Mr. Hughes said.
He also noted that the global financial crisis had the unintended consequence of spurring growth in the global ETF market, as seen with the growth of new products and listings since the crisis began in late 2008. Since the downturn, the global ETF market has seen a threefold increase in ETF listings. According to Blackrock ETF research, there are now over 6,200 ETF listings across 53 exchanges.
Mr. Hughes is confident that the future of the industry will remain healthy, especially with increasing participation by institutional investors and retail investors and the continued diversification of products.
As for the Asian markets, BlackRock statistics indicate the number of ETFs in Asia Pacific ex-Japan currently numbers 339. “Many of the ETFs listed in these developing markets are sourced from the major global ETF providers. As these markets continue to develop, more local managers are likely to further develop their own ETF businesses, contributing to the growth of the markets in this region,” Mr. Hughes said.
Pointing to some of the benefits of ETFs to institutional investors, Mr. Hughes explained that institutional investors focus on liquidity in order to achieve their investment objectives. The ETF is a perfect tool to serve this purpose. For instance, the PowerShares QQQ ETF in the US has a three-month average daily volume of over 50-million shares.
He also said that index and product sponsors are evolving from traditional market exposures to creating more strategic and innovative products. “We are starting to see more innovative strategic indices coming to market,” Mr. Hughes said. For instance, NASDAQ OMX joined hands with Axioma to offer a family of equity commodity indexes. The new NASDAQ Axioma Equity Commodity Indexes are designed to track the performance of the spot price of the selected commodity through the use of equities.
However, regulators in Asia, North America and Europe have been extremely diligent in their reviews of new and existing products after the global financial crisis. Therefore, indexers, exchanges and product providers have to face a tougher regulatory environment.
Mr. Hughes concluded that the need for ETF education still exists and added that NASDAQ is committed to continuing to support that effort.
In the first panel discussion, market experts from the Shanghai Stock Exchange, Mirae Asset Global Investments, Citibank China and HSBC Securities Services expressed their views on the evolution of China’s ETF industry.
Tang Xian, assistant director of fund market at the Shanghai Stock Exchange, remarked that the country’s ETF market has been making significant progress in terms of product differentiation. Chinese ETFs were limited to a single market, either Shanghai or Shenzhen. The recent launch of the Harvest and Huatai-Pinebridge cross-market CSI ETFs marks an initiative to bridge that gap, Mr. Tang said.
He added that the regulator and the exchanges are now working on cross-border ETF products, with most of the global index providers such as Dow Jones having signed MOUs in Shanghai to pave the way for product launches. The imminent launch of Hong Kong’s Hang Seng index-linked ETFs by E Fund and China AMC will provide domestic investors with a platform to access the overseas market.
However, Mr. Tang admitted that cross-border and cross-market ETFs can do little to address the homogeneity of Chinese ETFs, saying the spectrum is still very narrow in the absence of underlying themes such as fixed income and alternatives, as well as currencies. The scope for Chinese ETFs is currently confined to equities.
Chinese ETF sponsors and regulators find it difficult to push ahead with product differentiation because the market lacks a fundamental infrastructure. For fixed income ETFs, for example, the trading volume for bonds is very illiquid.
Mr. Tang brought up alternative ETFs as another example, saying it is difficult for local fund managers to design index products like gold ETFs and oil ETFs because the commodities have yet to be securitised in China, despite their enormous growth potential. Mainland oil producers can make use of the commodity ETFs for price hedging.
Mr. Tang revealed that the exchange is mulling over introducing foreign oil ETFs to the Mainland market, but still needs more time to resolve technical issues surrounding the move.
Mr. Tang declared that the approval of margin trading and short selling for four Shanghai-listed ETFs in December 2011 was considered a breakthrough for the ETF industry. The volume of ETF short-selling now accounts for 50% to 60% of total turnover. ETF investors can hedge against the risk arising from short-selling through index options.
According to Mr. Tang, the threshold for ETF short-selling is relatively high. The short-selling participants have to meet certain requirement in terms of their company’s size; however, Mr. Tang said he had seen a strong demand among some institutions like insurance firms with ETFs in their portfolios to extract some alpha through short-selling. The additional profit they make from the borrowed securities lets their yields outperform some index funds.
Looking ahead, Mr. Tang noted that the exchange will unveil more policies over the coming months to regularise the industry landscape. Under current rules, all local indexes such as the SSE 50 and SSE 180 can only be awarded to one single index sponsor. In the future, it will loosen controls on this exclusive right.
“The indexes will be opened up to other product sponsors a year after the launch of the first ETF. That allows the market to be more competitive,” Mr. Tang said.
Thomas Deng, deputy general manager of Invesco Great Wall Fund Management, noted: “With the continuing development of the Chinese equities market, the advantages of ETFs will be more obvious. Mutual funds will find it hard to beat the indexes with the increasing number of listed companies. In contrast, ETFs are able to adhere more closely to market movements.”
From a fund manager’s perspective, Mr. Deng noted the managers have to build up a strong quantitative investment team in order to generate a better return compared to the CSI 300, as well as putting more emphasis on absolute return.
In terms of product diversification, Roger Liu, head of the exchange traded funds division of Mirae Asset Global Investments Hong Kong Ltd, explained that high issuance cost is a stumbling block hindering the development of new ETF products. “When we worked with the index providers on developing new products, we found that ETF market makers’ capability was stringently restricted in many Asian countries like Hong Kong,” Mr. Liu said.
Yang Wen, head of product and client management, securities and fund services at the global transaction services division of Citibank China, pointed out that China has yet to open up the ETF custody businesses to foreign custodian banks, but the Chinese regulator is expected to promote the liberalisation on a gradual basis, granting the licenses for local fund distribution to foreign players and then delegating the business to foreign custodian banks.
Mr. Yang understood that the Mainland regulator is eager to introduce the advanced technology from foreign banks, including Citibank, in order to bring the Mainland ETF market to a higher level. Citibank also participates in the advisory role for the RMB qualified institutional investor (RQFII) scheme, explaining the structural difference between Hong Kong-listed ETFs and Mainland-listed ETFs to the CSRC, SAFE and the People’s Bank of China.
Andrew Law, head of fund services, Hong Kong and China, at HSBC Securities Services, stated that one of the main difficulties for the RQFII ETF is to execute the onshore and offshore RMB settlement within the same day in order to avoid tracking errors. “The mechanism seems to be straightforward. However, looking deeper, there are various challenges. For example, the iShares A50 has 11 participants, dealers and issuers, so the regulator needs to have different collateral management for every one of them,” Mr. Law said.
From left: Yan Hong, Professor of Finance, Deputy Director, Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University; Marco Montanari, Director, Head of Deutsche Bank ETFs and db-X funds, Asia, Deutsche Bank, Hong Kong; Zack Liu, Head of Risk Management and Quantitative Investment, China Southern Fund Management; Yang Yang (Andy), Fund Manager, Senior Analyst, Harvest Fund Management, and Benjamin Rudd, Executive Director, Head of Overseas Investment, Ping An of China Asset Management (Hong Kong) Co., Ltd.
New investment strategies
In the second panel discussion, participants exchanged their views on the future trends of the industry globally and the challenges ahead for the Chinese ETF market.
For physical ETFs versus synthetic ETFs, Marco Montanari, director and head of Deutsche Bank ETFs and db-X funds, Asia, with Deutsche Bank Hong Kong, remarked that synthetic ETFs are commonly used in Europe and the US where more than 50% of index products are synthetic with the replication of investment banks’ indexes. The synthetic ETFs are growing in popularity in Asia: for instance, five out of the top ten ETFs in Singapore are synthetic.
He added that both physical and synthetic ETFs have a certain level of risk exposure. Overall, the success of ETFs is dependent on independent custodians and strong regulations.
On the challenges ahead for the Mainland ETF market, Zack Liu, head of risk management and quantitative investment at China Southern Fund Management, said that the market in China is less-developed compared to the US in terms of market liquidity. He suggested that market turnover can be significantly improved if the regulator lessens restrictions to allow index products to trade on a T+0 basis rather than the current T+1 basis.
Secondly, securities brokerages are not allowed to play as market makers for institutional investors in China. Transactions have to be executed through the exchanges. The Chinese ETF market is expected to grow at breakneck speed as the liquidity and market-maker problems can be addressed, he added.
In spite of the shortcomings, Andy Yang, fund manager and senior analyst at Harvest Fund Management, remains positive on the outlook of the market – Harvest launched the first-of-its-kind cross-market ETF in China earlier this year.
“We’ve worked on the cross-market ETFs for more than five years. Harvest can launch the CSI 300 ETF in Shenzhen not only because of our connection with regulatory institutions, but [also because] the firm has developed the most liquid listed opened-end fund (LOF) in Shenzhen. That helped us to convert the CSI 300 LOF into the feeders for the ETF,” Mr. Yang said.
On RQFII ETFs, Mr. Yang stated that the product is a good initiative that offers a channel for overseas investors to tap the Mainland market. However, he said the concept has yet to be tested thoroughly and questioned whether foreign investors will accept the product and if the market has sufficient liquidity for index replication.
Mr. Yang revealed that the Shanghai Stock Exchange intended to launch an RQFII platform along with Dow Jones a few years ago, but explained the plan had been scrapped as the product structure had proved to be too complex. In comparison, the implementation of the RQFII scheme is expected to be much smoother as an overseas RMB fund pool is taking shape.
“The success for the RQFII scheme hinges on whether overseas RMB can be transferred back to the Mainland swiftly and on whether transactions can be settled on a T+0 basis. In addition, the custodian banks taking part in the RQFII scheme should have businesses both in Hong Kong and the Mainland in order to carry out settlements efficiently,” Mr. Yang said.
“Four Mainland fund houses have submitted their RQFII ETF applications to Hong Kong’s Securities and Futures Commission (SFC). We expect the products will come to the market as early as July,” he added.
Speaking about the rationale of investing in ETFs, Benjamin Rudd, executive director and head of overseas investments at Ping An of China Asset Management (Hong Kong), claimed that active asset managers tend to add alpha to their asset allocation to improve absolute returns in a volatile economic cycle.
According to Mr. Rudd, ETFs enable the managers to change their portfolio composition more cheaply and rapidly. However, lack of diversity is the main problem ETF investors are facing in Asia.
The structure of the majority of products is relatively simple, featuring single country or single sector underlying themes. This can generate limited alpha, Mr. Rudd said. As a result, the firm has launched its own ETF products, Hong Kong mid- and small-cap ETFs to meet its investment objective.
Mr. Rudd noted that a wide variety of products is crucial for the China ETF market. “At the end of the day, what investors want are products with different risk exposures and different performances, so they can change their strategies more quickly,” he said.
Mr. Montanari pointed out that over 80% of investors in Europe are institutional. Of this, 20% to 25% of ETFs are owned by funds of funds. The proportion of institutional investors is similar to Asia ex-China, but the fund of ETF funds in Asia is not as popular as in Europe due to the divergence of regulations across the region. The usage of funds of funds is more widespread in Europe because their rules are uniform and consistent, he added.
In response to the fact that some asset owners tend to invest in index funds rather than ETFs because of the low transaction cost, Mr. Montanari argued that total expense costs are not the only factors investors consider: “They should also take factors like historical returns and volatility into account. ETFs have advantages over index funds in these regards,” he said.
Also, the expense ratio for the ETFs in Europe is tightening as a result of market competition, and the same situation will arise in Asia. Given that there are more than 20 ETF sponsors with a range of 2000 ETF funds in Asia, this will bring the expense ratio down, Mr. Montanari predicted.
Discuss: Market vibrant but regulators hold key to fund growth