Exchange-traded funds come of age

Over the past 12 months, inflows into Asia-Pacific exchange-traded fund assets have risen by more than 50% to reach $136 billion. Some of this growth can be explained by a large number of new listings in Asia, up from 506 to 535 ETFs. While impressive, this is still less than half the number of ETFs listed in the US and less than one-third of those listed in Europe – highlighting the untapped future potential.

For the third year running, the Asia Risk and Deutsche Asset & Wealth Management Asian ETFs survey identifies key investor trends to better enable distributors to serve their clients. This year the survey has been expanded to cover a broader cross-section of investors.
Two key themes emerged from the 2013 survey – investor knowledge of ETFs has increased and investors have an appetite for an even greater array of ETF products linked to various asset classes.

Asian-listed ETFs
One of the most encouraging findings was that 63.9% of investors, compared to 46.8% last year, said they consider Asian-listed ETFs as they trade in parallel trading hours to their respective Asian markets.

Fewer investors responded that they do not consider Asian-listed ETFs, which is due to there being fewer Asian-listed ETFs compared to US and European – down to just 3.3% compared to 14.4% last year. However, Marco Montanari, regional head of passive asset management at Deutsche Asset & Wealth Management, believes providers have delivered on what clients wanted over the past year.

“It is interesting, as there are many new products in Asia this year and fewer investors are noting a lack of products. Asia is a younger market, so there is more demand and the rate of growth is stronger than in more developed markets. There are now more China-linked products, more frontier Asia and more Asia fixed-income products.”

Montanari cites the example of Germany, where more than 1,000 ETFs are listed compared to about 100 in Hong Kong.

Additionally, just 4.9% respondents said they do not consider Asian-listed ETFs due to lower trading volume, down from 18% last year, highlighting a better understanding of the Asian ETF market.

“Volumes are increasing and investors are learning that liquidity isn’t just driven by volumes on ETFs, but also the underlying liquidity of the market. It shows the market is maturing,” says Montanari.

The role of market-maker
A further positive development is highlighted by 76.7% of respondents who understood the role of a market-maker compared to 65% last year.

Tracking performance
Tracking performance of an ETF versus its benchmark has often been misunderstood but, in this area too, investor knowledge has improved.

When investors check the valuation of an ETF, many look at the ETF’s closing price on exchange but, if an ETF is, for example, linked to Japan but trading in Singapore when the Japan market closes, the Singapore market still has a few hours left to trade so the price will be based on market-makers’ estimation of where the market could trade based on correlation with other markets.

“If the trade in Singapore is at 4:00pm and markets rally in the last hour, then the closing price will be very high compared to the close in Japan few hours earlier. Investors may see a tracking error unless they look at the net asset value (NAV), which is a better indication than the closing price due to different time zones. This can be even more pronounced when the ETF is listed in Europe and tracks Asia,” says Montanari.

Last year, 78% of investors were looking at the closing price, down this year to 63%. In 2012, 22% of investors were looking at the NAV versus 36%, so more investors are looking at the right parameters. “In the past, too many investors were considering that ETFs were stocks instead of funds,” says Montanari.

Liquidity
An ETF’s liquidity is dependent on the underlying market liquidity, not just the liquidity of the ETF, and 42% of respondents confirmed they understand this, up from 35% last year.

Growth potential and exposure
The survey also reaffirmed the enormous growth potential for ETFs in Asia with 62% of respondents saying they would be increasing their exposure to ETF investments. Investors were also positive about a broad variety of products they wanted to see developed from smart beta ETFs, equally weighted indexes and Asian bonds.

“This is a strong example that the market is in a growth phase in Asia,” says Montanari. “The breakdown showed that over 90% of retail investors want to increase their investment in ETFs. This is outstanding and shows the potential of this product with retail investors, a client base that represents around 50% of the investor base in the US but is currently very low in Asia.”

Investor trends
Japan has been a big investor theme over the past six months, and Montanari says that leverage and inverse ETFs have recently been successful in Japan and Korea, which could also drive their development into other markets. Korea is also launching the first synthetic ETF later this year.

In Hong Kong and Singapore, meanwhile, the market has moved on from the physical versus synthetic debate in the ETF market. “There has been considerable education and transparency implemented so we have seen this mentioned less recently due to improvements by providers and changes from regulators like increased collateralisation of synthetic ETFs,” he says.

Furthermore, more than 90% of volumes in Hong Kong are on China-A shares underlyings and the most-traded ETF in the market is synthetic. “While structure is important, other factors such as tracking error, underlying provider and liquidity are of equal importance. It’s a mix of characteristics that drives the decision of investors,” says Montanari.

Abenomics has also led to significant volumes on Japan this year, mostly on currency hedged ETFs such as euro hedged products linked to MSCI Japan using foreign exchange forwards, according to Montanari.

“There has been less interest in non-currency hedged products as the currency has depreciated so, even if there’s a 20% profit on the market, you may lose 10% on the currency. The opportunity to mitigate currency risk has been appealing to investors looking for Japan exposure.”

The future
While the addition of a broader range of ETFs is appealing to investors, some restrictions do remain. For example, for fixed-income ETFs, many regulators require the country to have investment-grade status before they will allow such products to be launched. “This is one of the reasons why there is a lower number of Asian fixed-income products compared to the West. It is linked to a fear that a country may default, which would lead to a loss of investors’ money. But this is changing as more countries are getting an investment-grade rating. In the end, ETFs are just wrapper so they need a large liquid underlying market too,” Montanari says.

Additionally, if there is a cyclical change from bonds, the addition of inverse bond ETFs could also be beneficial to the market, and Montanari is also sanguine about the prospect of other fixed-income products.

“If rates rise, then inflation-linked bonds could become more popular for protecting against the risk of inflation. Also inverse fixed-income ETFs. We already have short ETFs on bonds, and innovations like these provide investors with the opportunity – independent of the market direction – to implement their views,” he says.

The flexibility of ETF investments, regardless of market conditions, means their future could be bright indeed, according to regulators.

The Monetary Authority of Singapore (MAS) is very positive about their development. ‘’With a total of 68 listings, equity-linked ETFs currently make up 75% of the ETF market in Singapore. In comparison, fixed-income and money-market ETFs make up 19% of the offerings available. We see potential for more offerings in the Asian fixed-income and currency sectors, as these are the core strengths of Singapore’s financial centre,” says an MAS spokesperson.

A recent speech by Alexa Lam, deputy chief executive of the Securities and Futures Commission in Hong Kong, also provided clues as to the future direction of Hong Kong’s ETF market. “As interaction between the mainland and Hong Kong increases and the two markets become more closely integrated, I believe we will see more ETFs that have a cross-border element. ETFs occupy a unique position in Mainland-Hong Kong financial co-operation.”

Montanari believes that, this year, investors have seen the flexibility of ETFs even when the markets have been driven less by fundamentals. “We have the highest recorded assets under management, but it is not yet the biggest market in Asia. Markets are currently being driven by macro events more than fundamentals such as the Federal Reserve stopping its bond-buying programme, so ETFs are a useful product to express the implications of this policy. But next year investors may be expecting this to change and for fundamentals to be more important,” he says.

View the full article with selected survey results presented as graphs in PDF format

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