ETF investment is gaining popularity among institutional investors in Asia. Asia Asset Management and ETFI Asia, in conjunction with Yuanta Securities Investment Trust Company (Yuanta SITC), Hang Seng Indexes, and Deutsche Asset & Wealth Management, organised a forum in Hong Kong on September 13 to discuss this trend and the challenges facing the Asian ETF industry.
As regards tailoring a customised portfolio for institutional investors, Paul Colwell, senior investment consultant with Towers Watson, remarked that the appetite for customised solutions is growing. For example, Towers Watson is moving customers away from market-style benchmarks into an investment stance whereby portfolios are more closely matched to preferences.
“There is a need for better solutions. We have been working with clients to find these, increasingly with passive management and less so in ETFs. We want to be able to assess the performance of any kind of customised portfolio and clearly ascertain the factors that come into play in identifying benchmarks,” he said.
Julian Liu, president and CEO of Yuanta STIC, admitted that his company’s experience in customised portfolio management had not been that encouraging. Rather, they find it easier to use the standard index, which is cheaper and easier from the underlying index futures perspective.
Vincent Kwan, director and general manager of Hang Seng Indexes Company, remarked that customised solutions and the index approach go hand-in-hand: “About 15 years ago, Hang Seng Indexes was calculating less than ten indexes. But today people are using market indexes; so fund and portfolio managers have tried to customise them for their customers, including calculating more than 30 index series all having special characteristics.”
In terms of investment techniques, Lippo Investments Management Ltd Chief Investment Officer Conrad Cheng reasoned that running an ETF requires tedious administrative work, including statistical techniques to replicate the return patterns for full replication and optimisation: “The participating dealer (PD) is important to ETFs. If the industry is to sustain and grow we have to work very closely with PDs.”
According to Mr. Kwan, the index provider also plays a role in this regard. These should ensure that they are capable of creating an index that provides sufficient levels of tracking error minimisation. It appears there are more constituent bases in individual benchmarks. As such, asset owners, fund managers and index providers must take all risk factors into account.
Speaking of the difference between actively and passively managed portfolios, Mr. Cheng notes that all is not as straightforward as it might appear. Institutional investors are still operating within customised benchmarks with different country exposures. For example, Hong Kong’s Mandatory Provident Fund (MPF) has a 70% allocation to equities with 30% in bonds in what are mainly classified as being under different countries. The ETF is an instrument through which the MPF may extract real alpha if country exposures have any genuine advantage over sector exposures.”
As for the development of cross-border ETFs, Mr. Liu said that the potential platform is already out there. It follows, therefore, that he believes the Greater China ETF project will materialise when the Shanghai, Shenzhen, Hong Kong, and Taiwan markets can forge a single front in capitalising on this latent reality.
On the panel discussing distribution strategies for ETFs, Christine Huang, director and head of ETF business, Greater China, with Invesco, contended that retail versus institutional is an ongoing debate in the ETF space. Retail investors had little understanding of ETFs in 2006. But recognition is now much improved. At the same stage of development in the US and Europe, ETFs were huge on the institutional side. But the ETF market has had a very short history in Asia.
According to Andrew Law, CEO at HSBC Institutional Trust Services (Asia), ETF market development is determined by four factors: population size; the wealth of that population; the features and maturity of the products offered; plus the availability of alternative investments.
Marco Montanari, head of passive asset management, Asia Pacific at Deutsche Asset & Wealth Management, said the success seen in the Korean and Japanese markets is related to leveraged and short index based ETFs: “We are interested in working with these types of products. But we also have risk concerns in the event something goes wrong. The ETF experience is somewhat different in Hong Kong in that ETF products are more value-add structured.”
Institutional investors account for as much as 90% of the Asia market, with the majority of their assets sourced from US and European ETFs. Ms. Huang points out that the US is a very sophisticated liquidity provider, and said it is likely to continue to grow and attract global money to trade vis-a-vis the US market. “By comparison, the Asian market is so fragmented that you must have a favourable incentive scheme to attract the flow back to your home market. Otherwise, the participants end up competing with US players.
“There are several ways to increase the size of the market,” she said. “Pensions play an important role in regard to flows. Their purpose is to lower the holding cost over the long term. ETFs are not cheap and they have to be traded via brokers. But is any other kind of trading arrangement possible? This may be something to explore. Not everyone today has a brokerage account to buy ETFs. We, for example, don’t necessarily use a brokerage account in Asia. Using bank channels rather than brokerage accounts is another route to explore.”
Kenneth Kok, executive director, Equity One Delta products sales, securities division with Goldman Sachs (Asia), said he isn’t seriously concerned where ETFs are listed; his task is to sell them. He doesn’t differentiate between synthetic ETFs and full replication either: “Both of them are products. It all depends on circumstances and what the clients want.
“People don’t expect premium to expand too much, but if investors are bullish on China they can wager on iShares FTSE A50 China Index ETF. That will drive up the NAV and premium which I call the ‘double happiness’,” he added.
He also pointed out that physical ETFs can gain compliance department approval more easily, noting that ETFs have shown themselves to be a winning product post-GFC because they are well regulated.
Despite the emergence of physical RQFII ETFs, Mr. Law said that the demand for synthetic ETFs is still there because of product familiarity and first mover advantages.
In the third panel discussion of the day, Chuah Su Cheen, financial services partner at Deacons, remarked that the majority of the risks in the ETF space are synthetic ETF-related, particularly in regard to transparency and the identities of their third counterparties.
Nevertheless, those risks have been mitigated to a certain extent by stringent SFC requirements in Hong Kong. In terms of the eligibility of the swap counterparty, the regulatory watchdog has imposed strict criteria stipulating that qualified institutions must be subject to ongoing supervision with a capital requirement of no less than HK$150 million (US$19.34 million).
In addition, asset managers and swap third counterparties have to be independent of each other. As well, the selection of swap counterparties and the breakdown of collateral has to be disclosed in ETF offering documents.
Ms. Chuah explained that net risk exposure to any single counterparty cannot be more than 10% of the fund’s NAV. Domestic equity ETFs have to be backed by up to 120% of their value in collateral. These ETFs also need to meet certain liquidity requirements to ensure they can be easily sold in the market without affecting their value.
From the market maker’s perspective, Howard Lin, head trader of ETF trading with Credit Suisse highlighted the imbalance between sell-side and buy-side on the part of ETF investors: “The market is very sell-side focussed. Despite an increasing number of ETF products being listed, about 80% of ETF trading is carried out between banks, participating dealers (PDs) and market makers. The participation of real investors remains very limited in Asia. This liquidity problem can result in ETFs being mispriced.”
He noted that ‘real’ market activities should be improved through marketing and education rather than just blindly launching more ETF products.
CFA Institute, Asia Pacific, Managing Director Paul Smith, pointed out that the risks involved in buying an ETF are exactly the same as the risks involved in buying a stock, although ETF investors may not apply the right intensity of analysis because of the indexation concept.
Mr. Smith also said that although ETFs provide good access to Asian emerging markets, investors should be more risk aware in that ETFs may fail to replicate underlying market movement in economic regimes with strict capital controls, such as Vietnam.
David Quah, assistant vice president, issuer and client services of the global markets division at Hong Kong Exchanges and Clearing (HKEx), said that some Asian emerging markets are proactive in learning from the experiences of more mature markets. For example, HKEx has shared its experiences with Vietnam on how to manage various risks related to ETFs.
In terms of the popularity of ETF products, Mr. Quah shared his view that ETF utilisation in Asia still lags far behind that seen in advanced markets such as the US, noting that the more than 1,000 ETFs listed on the US exchanges constitute more than 30% of stock market turnover. That compares to only 112 ETFs being listed in Hong Kong, which make up about 6% to 8% of total turnover.
As a participant in the event’s final panel, on the subject of “Using ETFs for Tactical Allocations”, Jackie Choy, an ETF strategist at Morningstar Asia, claimed that ETFs mainly serve as a tool for Hong Kong’s retail investors to access A-share equities. In comparison, institutional investors utilise ETFs for broader investment purposes including sector rotation, long-term investments, tactical strategies, and long-short strategies.
When asked what the key macroeconomic factors influencing ETF portfolio construction were, Mr. Choy said he sees this as being dependent on the types of strategies investors are looking at. “Different asset allocators have their own strategies and can use related ETFs to execute their investment theses. For example, a portfolio manager can make use of ETFs to extract alpha in the fixed-income space.
According to Priscilla Luk, director of research and design with S&P Dow Jones Indices, asset owners such as pension funds have increasingly been looking for countries or sectoral exposure over the past few years. As such, they tend to use country- or sector-tracked ETFs as building blocks in their asset allocation. They also seek advice from index providers when selecting the ETFs that best suit their investment styles. Furthermore, the availability of precious metal- and bond-based ETFs provides asset owners with easy access to commodities and fixed-income markets.
Ms. Luk pointed out that hurdles for issuing bond ETFs remain on the technical side because many corporate bonds in emerging Asian markets lack investment grades. It is therefore not easy to construct corporate bond ETFs because index providers do not have extensive databases in terms of bond valuation.
Robert Jones, managing director of FCL advisory Ltd, said that his company is mainly engaged in providing investment consultancy services for Mainland family offices. However, many family offices are value investors. He revealed they may avoid ETFs, especially when certain market sectors are overvalued. Also, they loathe the concepts of stock lending and the synthetic replication in the ETF space.
“Family offices tend to take the opposite view of most institutional investors,” he explained. “They never have a significant proportion of their allocations in fixed-income because the returns are too low compared to the other asset classes in their portfolio, such as hedge funds, alternatives, and commodities.”
In fact, ETFs amount to less than 1% of the portfolios of many family offices. Nevertheless, Mr. Jones remains positive that this asset class will gain more traction going forward.
Rick Adkinson, managing director of Private Capital, is even more upbeat. He says that many of his clients favour ETF products because of their high transparency and relatively simple structures.