Evolution through intelligent design
23 April 2014
Category: News, Asia
By Paul Mackintosh
Despite the post-tapering upsets and volatility of the global financial markets during 2013, and the continuing economic challenges in the global real economy, exchange traded funds (ETFs) appear to just continue forging ahead. As per data from ETFGI quoted in EY’s January 2014 Global ETF Survey: “At the end of October 2013, the global ETF/ETP industry had 5,042 ETFs/ETPs, with 10,053 listings, [and] assets of US$2.3 trillion, from 215 providers on 58 exchanges”. Yet ETFs themselves, in many cases offering transparent look-through to underlying exchanges and equities, obviously are going to reflect global volatility and stock market shifts when they are not actually being used to reallocate around these. Similarly, ETFs in Asia Pacific cannot avoid implication in the great emerging markets sell-off of 2013 and early 2014. ETF market practitioners and industry commentators give their perspectives on the changes and challenges in the recent past and on the horizon.
Last year was also an appropriate data point for evaluating the track record of the entire ETF universe, as it marked 20 years since the debut of the first Standard & Poor’s 500 Depository Receipts (SPDRs) in the US, and the effective creation of ETFs. It also was a good time to evaluate the growth and performance of the Asia Pacific ETF industry since the 1999 introduction of the Tracker Fund in Hong Kong, Asia’s first true ETF. As of April 2013, according to BlackRock’s ETP Landscape bulletin, there were 579 ETF funds in Asia Pacific with $150 billion under management. However, in 2013, the news was not all good and the macroeconomic circumstances were not always propitious.
Marco Montanari, head of passive asset management, Asia Pacific, with Deutsche Asset and Wealth Management, notes: “Performance generally speaking is linked to the underlying market, so last year emerging market ETFs didn’t perform very well. But this year to date, we have some ETFs linked for example to Indonesia, Vietnam and Thailand, and other markets that have done quite well in line with the underlying markets. Some of the markets that were the most penalised last year are reacting quite well.”
Geoffrey Post, head of international product development at Nikko Asset Management, gives some perspective on how ETFs have been used during this period, as it affects their performance. “What we observe is that ETFs are increasingly used as tools to up and down risk during risk-on and risk-off periods. What we’ve seen is significant outflows from emerging markets, both in terms of equities and bonds, and people have used ETFs as a quality source to reduce their exposure to emerging markets during that period. To the extent that there have been risks in emerging markets, we also see people using ETFs to access risk for those markets, though to date that’s been relatively limited.”
Jane Leung, head of iShares Asia Pacific at BlackRock, observes better news from the beginning of 2014. “Despite the dour emerging markets headlines, ETFs listed in APAC have had a good start to the year, with $3.5 billion of positive inflows in January, the vast majority of it into equity ETFs. Investors have started to regain interest in accessing China through ETFs.”
With the great emerging markets exit of 2013 partly driven by Ben Bernanke’s May declaration on tapering of quantitative easing, ETFs also reflected a more direct relationship to that event. “In terms of fixed income, clearly with concerns about tapering and low interest rates, we’ve seen significant assets going to short-duration bonds, and ETFs based on those, and also there has been signficant interest from Asian investors in interest rate-sensitive ETFs,” notes Mr. Post.
It should be obvious from some of the above remarks that ETFs are not simply being used for top-down portfolio construction but also on very short-term time horizons for on-the-fly portfolio readjustment. In other words, they are not simply acting as a mechanism to handle market volatility, but may also be contributing to it. Admittedly, this flexibility is supposed to be one of the attractions of ETFs, but it is interesting to observe nonetheless how they have played through the emerging markets sell-off, and what the current market views are on prospects in Asia Pacific and elsewhere as articulated through ETFs. So what were the beneficiaries, and casualties, of ETF asset flows in 2013, and how is this likely to continue into 2014?
Mr. Montanari sees the flows partly in terms of product development. “In terms of new products in the US, there is huge interest in foreign-hedged ETFs, mostly linked to Japan. We are seeing investors starting to consider FOREX-hedged ETFs as an important component of their portfolio,” he remarks. “In Europe, one of the key themes was the recovery of Southern Europe. So we saw inflows into fixed-income ETFs linked to Spain. These countries have reached pre-crisis levels in terms of bond spreads.”
“From my perspective, the European and the Asian markets have a great deal to learn from looking at the US market, which is clearly the most advanced,” says Mr. Post. Supporting this, the EY survey reported: “ETF markets in Asia – outside Japan – are dominated by institutional capital and are comparatively small and shallow. However, the rapid development of Asian markets suggests that they could leapfrog ahead of Europe in future.”
Ms. Leung has already remarked on how ETFs have offered access to China. She situates this in a broader context: “2013 saw the development of a wider ecosystem around ETFs offering exposure to China and a resurgence of ETFs in Japan – which is continuing.”
Mr. Post sees Asia Pacific as still relatively constrained by its immaturity, which makes the whole region more porous in investment flows. “In terms of Asia, the product range is relatively limited compared to the US and Europe. In part that’s due to the development of the industry; in part it’s due to the markets. And particularly if you look at the size of the markets outside Japan, they are very limited, and that creates challenges for ETF providers. It’s the reason why people are cross-listing and selling products that are listed in Hong Kong, for example, into other jurisdictions.”
Mr. Montanari looks to the outgrowth of fixed-income ETFs in Asia in the context of the broadening and deepening of the whole regional debt markets, especially for corporate bonds. ‘’We know that it’s going to take time, but we hope to see at least the start of a trend, which is also helped by the presence of more and more fixed-income ETFs in Asia linked to local markets like Korea, Indonesia, Southeast Asia, China and Hong Kong.”
Ms. Leung also sees market shifts in the year ahead being driven partly by changing patterns in user demand. “This year in Asia, we expect to see a shift in how ETFs are used, as insurers and private banks increasingly use ETFs as passive building blocks within blended active and passive products. These products provide specific investment solutions, which are accessible to retail investors. We also expect insurers to adopt ETFs on a greater scale in Asia for their own core balance sheet holdings; this is a global trend that is accelerating in the region.”
The innovation story
The preceding comments show that expansion into new regions cannot be isolated from product innovation in ETFs. PricewaterhouseCoopers, in its August 2013 report Opportunities in ETFs’ next phase of growth and innovation, cited innovation as one of the key future drivers for ETF success as follows: “As the underlying ETF investor base evolves, investors will buy innovative products that cater to their specific needs. For example, there was a recent announcement about plans to develop an ETF that could be settled across Europe – rather than only on a national basis – other innovations may focus on new investment niches, such as “smart beta” investment styles for financial advisers to use as tools in portfolio construction”.
“What we see as interesting themes are intelligent beta, a term that’s coming out of the US,” says Mr. Post. “In the large Asian markets, you have vanilla beta, but you have very little institutional products after that. In Japan, for example, there has been the introduction of the JPX-Nikkei Index 400, which a number of managers, including ourselves, have done ETFs on – so that is a first move towards an intelligent index.”
Ms. Leung also takes up the theme of fixed income: “A category that we see developing regionally as ETFs provide accessible liquidity to this asset class that is of particular benefit to investors such as insurers. From a global perspective, strategic beta is an exciting development. This encompasses ETFs that provide minimum volatility exposures or factors such as quality, value and size.”
Mr. Montanari outlines how this theme coordinates with the post-tapering environment. “Corporate debt ETFs were very popular in past years, but in a macro environment, where central banks are liable to stop tapering and increase interest rates, more corporate bonds can be penalised by movement of interest rates. Providers have reacted by launching products that provide the credit yield and risk, and not any kind of duration risk.”
“The other interesting application that I don’t see happening, yet which is an interesting one to watch, is a significant sea-change away from active management to passive: the belief in the virtue of passive low-cost investment,” Mr. Post adds. “That realisation is building. I think there’s much less faith in active management in Asia than there used to be. As a result of that, I think it’ll be very interesting to see whether we start to see ETFs being built on a low-cost efficiency basis, providing asset allocation but clearly no stock selection, at a low cost. And whether we see segregated account-type structures for private individuals similar to that but outside the fund structure – comparable to what we’ve seen in the US, where since the early 2000s we’ve witnessed a huge explosion in low-cost asset allocation ETF-only portfolios.”
2014 and beyond
The coming year looks interesting and rewarding, but certainly not devoid of challenges, for ETFs in Asia Pacific. China is obviously one focus area, especially in the aftermath of the changes to the renminbi-qualified foreign institutional investor (RQFII) scheme in March 2013. “We see certain markets opening up over time, particularly China. There are opportunities that are evolving,” declares Mr. Post. “There are a number of ETFs that have been launched this year off the back of the changes there, and RQFII obviously opens up opportunities in terms of equities and bonds onshore in China, with reduced liquidity issues that institutions previously encountered.”
“Asian ETFs are young, but the US and European ETFs are also young compared to the general mutual fund business,” observes Mr. Montanari. “We are in a business that is growing, we need to have more products and more providers, and hopefully more investors in the retail space will start trading ETFs. At the moment, institutions are mainly driving the growth; but for the market to grow and move up a gear, we need the retail investors to participate more. This is happening in Europe, particularly the UK, where there are steps being taken to transform the industry from commission-based to fee-based. This may happen in Asia in the next few years. Looking ahead, I think I can see the interest in Japanese and the emerging market ETFs coming back strongly.”
The EY survey concludes on an optimistic note. “We expect the low costs, liquidity, transparency and convenience of ETFs to allow the industry to continue to outgrow the wider asset management sector... we believe successful ETF markets have the potential to deliver benefits to economies and societies at large”, it declares. However, it continues: “This success and these benefits cannot be taken for granted... the ETF industry’s reputation – still in its formative years – could be permanently damaged by a well-publicised scandal”. Sobering words as 2014 unfolds.