22 April 2014
Category: News, Asia, Global
By Julie Kerr*
With very few emerging markets finishing 2013 with strong performance, there is already concern that this year will not fair much better. Withdrawals from North American-based ETF’s investing in emerging market equities and bonds has reached US$11.3 billion in the first two months of this year, which has already surpassed the total redemptions for 2013 of $8.8 billion. However, as investors continue to seek to capitalise on potential high risk-reward returns, the demand for good quality emerging markets products is still there.
It is not all doom and gloom though, as interestingly the best performing single-country ETF in 2013, with 57.7% growth, was a broad-based China N-Shares ETF, which is heavily weighted towards the technology industry. These returns were generated when the over all China market grew at just around 3%.
As investors in Asia become more familiar with ETF’s they recognise that in addition to being a low cost investment option, they offer a vehicle for managing access to new markets, which may otherwise be difficult or impossible to get exposure in.
Issuers certainly recognise the risks and challenges associated with emerging market (EM) products, however, particularly in Asia, they also see them as a key opportunity for industry growth, whereby home grown demand for exposure is developing. With an unprecedented number of new launches planned in the region for 2014, we can expect to see access to new markets as well as sector product launched this year.
Widely regarded as the most important market for off shore investment in Asia, Hong Kong has become the hub to many of the regions less accessible markets, most notably China. Prior to the launch of the renminbi qualified institutional investor (RQFII) scheme, offering physical access to China A-Shares, we had already seen the successful launch of a synthetic China A-Share’s ETF – offering investors their first opportunity to invest in the China A-Share’s market.
Over the last three years, the Hong Kong ETF market has seen its average daily trading turnover rise 54%, the China A-Share’s ETF’s have been at the heart of this growth with the launch of 15 RQFII ETF’s over the last two years, demonstrating the important role that ETF’s play in providing access to EMs, and their ability to meet the investor demand.
Following the success of the RQFII launches in Hong Kong, we have now seen since the tail end of last year, successful RQFII listings in the US, UK, Europe and soon to be Singapore, offering investors the ability to have direct exposure to China A-Shares on their preferred exchange.
The challenge of liquidity
Although low cost and flexibility are crucial to the overall appeal of ETFs, liquidity is increasingly seen as the most distinctive and important feature of the industry. Liquidity is particularly important to winning the confidence of institutional investors so achieving and maintaining liquidity is essential to growth and profitability. Lack of liquidity is the most frequent reason cited as to why fund launches fail – and in the case of EMs, lack of liquidity is often the main obstacle to developing the market. In many cases this can have the effect of driving local capital into more liquid US, or European listed ETF’s, artificially depressing the size of the local Asian ETF markets.
The need for liquidity underlines the vita role that market makers play in the development of the emerging markets. The more liquid the fund the more assets it is likely to attract.
Achieving scale AUM (assets under management) and liquidity will continue to remain the leading obstacle to the success of each new fund. It is generally accepted in the industry that a fund needs to be between $50 million to $100 million to be of a viable size. This becomes increasingly challenging with any new market whereby investor knowledge, and subsequent appetite might be somewhat lacking. This has put additional pressure on the issuers to put much more effort into their pre-launch preparation. While important, this is not just about seeding, it also means conducting due diligence into potential investor demand.
Managing the fragmented nature of the emerging markets has always been a challenge for the ETF industry when trying to achieve scale. In response to this we see a much more colligative approach from within the industry, whereby issuers recognise they need to work together for the overall success of market.
In addition, EY has found ETF sponsors looking to build a foothold Asia Pacific are working with local regulators. For one, the sponsors need to ensure they understand investor protections that are at the forefront of regulators’ concerns these days. Also, sponsors want to have a chance to explain to regulators exactly how their products work to allay any concerns that could crop up.
But until integration comes about through programmes such as mutual fund recognition between Hong Kong and China and the ASEAN passport scheme, sponsors are forced to take a market-by-market view. They have placed greater emphasis on advertising in the media to build brand identity with end user customers. And recent developments such as the successful launch of Alibaba’s Yu E Bao may offer alternative distribution platforms that may help in overcoming regional fragmentation. In January, Yu E Bao had deposits of 250 billion renminbi (US$40.24 billion) with 49 million users. They began offering a fixed-term product, with an expected yield of 7%, in February.
Outlook for Asia
Since the launch of the RQFII scheme in 2011, mainland Chinese managers have had a tool to raise offshore money that can be invested into Chinese shares. This was seen as an important first step to developing their international business.
Now, with the upcoming mutual fund recognition agreement between China and Hong Kong, which was announced in the Hong Kong budget at the end of February, that Securities and Futures Commission (SFC) and China Securities Regulatory Commission (CSRC) had reached a consensus on, Hong Kong will offer mainland China investors more persity and choice of investments, while mainland China will offer Hong Kong a sizeable investor market.
With mutual recognition as a key driver we are now seeing ETF managers look to understand more about the mainland Chinese investor, and where they would like to have access too, so we can expect to see listings of more new markets in Hong Kong.
Although this is extremely positive news for the ETF industry overall in the long term, we will have much more clarity over the coming weeks as to whether any of the existing ETF funds will be eligible to apply for a quota in the first wave, or if we will need to wait for a specific ETF agreement, in line with the Taiwanese and Hong Kong mutual recognition scheme.
While Hong Kong has proved itself to be a successful access point to China A-Shares, and has been dominating the ETF news in Asia to date, there have been also been other markets which have also been developing. In addition to China, we have also seen the international managers launch funds offering access to emerging markets, such as the Philippines, Vietnam, and emerging Asia funds listing in Hong Kong. In Singapore, funds providing access to Malaysia, Thailand, Eastern Europe, and Latin America and India have also been listed.
In addition to listing EM ETFs on the more mature exchanges to attract investor attention, we are also starting to see these markets launch their own ETF’s, with relative success. Indonesia, which has launched its first ETF in 2009 and now has four ETFS, has so far escaped the outflow trend that we’re seeing across most of the other emerging markets at the start of the year, this has been somewhat surprising given the slowdown in growth in the market.
The second sharia-compliant ETF was launched on the Malaysian Stock Exchange (KLSE) on March 21, which took their total to six. This shows the growing appetite for new investment options within Malaysia, which is now the second largest Islamic finance market, which meets sharia principles.
More recently the addition of the long-awaited, first ETF listed on the Philippines Exchange (PSE) in December 2013, has also gotten off to a reasonable start, with it being the second most actively-traded stock on the PSE when it first launched.
These are all leading indications that while international investors have been investing in emerging market ETF’s in the US, and Europe for some time, there is now an emerging home grown excitement around the products being offered, which in return has somewhat more sticky investment dollars.
On the horizon we would also expect Vietnam to soon follow in their footsteps.
Innovation is vital to successful fund launches and while there is a general move across the globe right now to physical ETFs, in an industry where first mover advantage can be key for the success of the fund, synthetics will still have a significant role to play when it comes to accessing new markets.
Importance of innovation
While local regulation is sometimes a perceived barrier to launching products, it is important to note that investor protection and innovation are not mutually exclusive.
Service providers are an integral part to the ETF industry, supplying infrastructure that promoters and traders need to make good on their promises to investors. Asset services are also expected to act as enablers for the further development of new ETF markets. Market participants expect service providers to help lower costs and improve liquidity, as well as meet increasingly complex tax and regulatory reporting requirements. With this in mind, it is surprising that most promoters across Europe and Asia do not feel that service providers do enough to support product and market innovation.
Price competition in ETF’s remains intense, however there are signs that attitudes to pricing have become more sophisticated as the industry matures, and investors become more familiar with ETFs. While management fees continue to be a consideration in any buying decision, investors understand that these do not always reflect the full cost of an ETF investment. We are now seeing a shift in emphasis away from management fees to focus much more closely on other charges to the fund, with much more weight being placed on tracking error, spreads and liquidity.
When we look specifically to the EMs, we see that investors have a general acceptance that having the ability to access new markets can often come at a higher cost. However, wide spreads caused by poor liquidity, can quickly eat into any gains made.
While volatility is perhaps the first concern that investors naturally have when looking to invest in EMs, there are other considerations and challenges that they need to be aware off. While in more mature markets, the recent tax reforms such as FATCA and EUFTT have been the biggest source of concern for managers; when dealing with emerging markets, the major challenges we have seen the industry face is tax transparency.
Tax uncertainty has been a dampener as far as foreign investments in some of the key emerging markets is concerned. For instance, one of the biggest challenges to the success of RQFII ETFs has been the uncertainty of capital gains tax treatment for foreign investment into Chinese equities. The tax position has not attained market-wide certainty, even today, and always forms part of an interesting discussion with anyone responsible for managing an active investment portfolio in China.
As regards Indian investments, most foreign funds have been relying on the Double Tax Avoidance Agreement between India and Mauritius for relief from certain Indian taxes. Discussions around the renegotiation of the aforesaid tax treaty and certain legislative changes in India, including the introduction of the General Anti-Avoidance Rules (GAAR), have led to uncertainty on this popular route for Indian investment. The initial budget announcements around introduction of GAAR a couple of years ago did have significant impact on investment flows into India and how these will ultimately pan out once GAAR becomes effective from next year only remains to be seen.
Managing these uncertainties is a complex process for all parties involved and understanding where the ultimate liability falls.
On a more positive note, the recent Hong Kong budget brought the welcome news that the long-awaited waiver of stamp duty would be extended to all Hong Kong ETFs.
Lessons to be learned
It is clear that EMs will play a pivotal role in the future development and growth of the ETF industry. As it stands today, AUM in funds listed across all EMs (Asia, Latin America, Middle East and Africa) stands at just U$140 billion, which represents just 6.10% of the entire ETF industry. These are young markets where sponsors can embed themselves with a growing retail investor class. In addition, EMs remain much less concentrated than those in the United States and Europe where a handful of incumbents hold claim over much of the market. As a result, there is less fee pressure at this early stage in the life of ETFs in emerging markets.
For investors, this means there will be a growing selection of ETFs to choose from in meeting their investment objectives, but they will need to keep a close eye on the depth of the underlying markets that the ETFs invest in as well as the liquidity of the ETFs themselves. What will make them successful is sponsors’ ability to navigate local fragmentation and work with local institutions to back new fund launches and achieve the scale and liquidity necessary for long-term viability.
*Julie Kerr is Director of Asset Management at EY.