10 Oct 2011, HSBC , Keith Chan , Hing Tang , Frank Henze , Marco Montanari , Asia Risk
Asia Risk Chris Jeffery, Editor
BOCI-Prudential Asset Management Hing Tang, Managing director and head of quantitative strategy business unit
Deutsche Bank Marco Montanari, db X-trackers ETFs and db-X Funds Asia
HSBC Keith Chan, Head of listed products sales, wealth management sales,
State Street Global Advisors Frank Henze, Head of SPDR exchange-traded funds, Asia-Pacific
Chris Jeffery, Asia Risk: The development of exchange-traded fund (ETF) business in Asia is being looked at very keenly by market participants, investors and regulators, so it’s very timely to sit down and discuss some of the pertinent challenges and concerns as well as the opportunities. First, what attracts investors to ETFs and what are the pros and cons of ETF investments?
Marco Montanari, Deutsche Bank: McKinsey published a research report in which it forecast ETFs’ assets to increase from US$1.5 trillion to between $3.1 trillion and $4.7 trillion by 2015. In the last 10 years, while mutual funds’ assets grew in the US by 5% per year, ETFs grew by more than 30%. In Asia in the last two years assets under management have doubled. So I think it’s definitely a very healthy business, a growing business. Competition is also becoming stronger, which is positive for investors.
Keith Chan, HSBC: The attraction of an ETF combines the benefit of an exchange-traded securities fund and an index-tracking fund. A fund, being exchange traded, helps to pool liquidity together for investors to easily access the market and buy/sell during trading hours. However, there has been a misconception about an ETF’s liquidity. When investors trade securities on the exchange, they will look at daily volume and bid/offer spread as a measure of liquidity. However, when they trade an ETF, they should not make the same kind of liquidity assessment. An ETF’s true liquidity should be as much as the ETF’s underlying asset. Even though an ETF may not have a consistent daily volume, because of the ability to create and redeem, and the presence of market-makers in the secondary market, an investor should be able to buy and sell an ETF with the same liquidity as the ETF’s underlying asset. When investors compare their mutual fund holdings with an ETF, I think they can easily identify the benefits of an ETF over a mutual fund. It is cost-effective, easily accessible on the exchange and there is a real-time net asset value (NAV). The benefits are easy to understand, but investors should not compare an ETF with a single stock listed on an exchange, especially when assessing liquidity. Rather, the ETF’s benefit becomes more obvious when compared with mutual funds in terms of accessibility, transparency and cost.
Hing Tang, BOCI-Prudential Asset Management: I would like to highlight one dimension that is paid less attention. The whole fund industry has to change the distribution model globally, and in Asia in particular. Banks or insurance agents are dominant in their distribution of funds as they charge very high fees. Although we still think that banks will be dominant in the next five or 10 years, given ETFs’ easy accessibility, I think this behaviour will change. The US is very successful in developing this market because people feel much more comfortable with trading online. They have a very developed financial advisory business, so they don’t need the banks to charge them high fees. But, in Asia we still need some time to develop this. So my hope is that our regulator will understand this, but my fear is that they want to turn back to this high-fee model.
Asia Risk: How is the investor profile changing in terms of the proportion of retail versus institutional investors?
Marco Montanari: According to our estimation, both in Europe and in Asia you still have 80% of institutional investors and 20% retails, which is different from the US, where, according to public data, it’s 50/50. But retail proportion will definitely increase. In some parts of the world, for example, Australia, institutional investors still think that an ETF is a retail product, which is strange when you look at who is buying ETFs in Europe or in Asia. The level of competition has brought fees down in a way that is beneficial even for institutional clients.
Asia Risk: Relative to North America and Europe, growth in Asia is relatively slow. What are some of the challenges that have prevented a more rapid pick-up and what are the differences and benefits of investing in ETFs in Asia compared to other parts of the world?
Frank Henze, State Street Global Advisors: I think there are three distinct reasons. One is that we don’t have fee-based advice. It’s like in Europe, we have commission-based product sales. That’s a huge enabling factor of ETF growth, particularly in the retail-oriented segment.
The second is that, funnily enough, it has been called a retail product, so that may be why institutions are shying away from ETFs. So that’s a psychological reason. In the US, Calpers owns $4 billion of ETFs and it is not a retail investor, so that is an important part of opening up the ETF business to get the professionals more involved.
And the third reason is that Asia is still at a different level, a different stage of investing. The US is the furthest in the development with regard to investing in pensions and retirement products, needing asset allocation and other techniques to achieve its investment goals. Asia is adopting them at the moment and that will drive a lot of the growth.
Hing Tang: I think this is a very important question. There are many challenges in Asia. I am perhaps the most pessimistic person in Hong Kong about ETF development. There are a couple of issues. First of all, we need retail investors. I think we have less than 20% retail investor participation on average. Korea is slightly higher. When I talked to a Japanese booker, I found that we were facing a big challenge, because we put a lot of effort in pushing cross-listing products. But the Japanese booker said “our investors trade in Europe, Japan, wherever they want to, online”. Most of the volumes come from and go to all of these big regions. Given most ETF investors are not day traders, their investment time frame may be one month and so they trade the US or European ETFs. In Asia, we need more definitive local products, like CSI 300, China A-Shares or Taiwan 50. They are so important because, other than these, if I want to buy a commodity ETF, there is no point to trade through the local exchange.
The third challenge is regulators. They think differently to us and they may see ETFs as a dangerous animal. Maybe because ETFs are traded on exchange, so they lose control. Basically everybody can trade ETFs on exchange whether they have knowledge or not and nobody gives them advice, so they may end up buying the wrong products. And, at the end of the day, if they lose money, they will come back to the regulator and complain.
Marco Montanari: To continue, contrary to Europe, Asian investors are used to buying ETFs listed in the US mostly because of the liquidity misconception. This is ignoring the taxation disadvantage of up to 30% on the dividend. Besides, in Asia the lack of homogeneous regulatory framework made it more difficult for a local provider to create a fund in one Asian country and have it authorised in the rest of the continent.
To conclude, a key element to boost the growth of the Asian ETF market is to bring back home the money that is being invested in ETFs listed in the US and in Europe because there are clear advantages in buying ETFs listed in Asia when trading Asian underlyings.
Keith Chan: From our experience, talking to clients in Asia, sometimes it is quite frustrating to hear that investors are trading ETFs listed in Europe and the US that have underlyings in Asia, as they won’t be able to trade the ETF very close to the real-time NAV in an Asian time zone. An ETF listed and traded in a different time zone with the underlying securities may cause tracking error. For example, ETFs with Asian underlyings that trade in the US will have a premium or discount depending on how investors believe the Asian market will open the next day. However, some Asian investors still trade the ETF in the US as they think it is more liquid, but in fact that’s a very big misunderstanding. Liquidity should be best when it’s in the same time zone as the underlying is trading. Given China is the biggest growth engine in the world, investors wanting to get into the Chinese or Asian equity space should in fact look at ETFs listed in the Asian time zone, even European and US investors, for some real-time access to the market.
Frank Henze: The regulation is also different. It disfavours certain techniques that are allowed elsewhere. Stock lending is one, the regulator here is more bearish in terms of products. The structures used here are different as well, with regard to the legal entities. We talked about execution, liquidity. I agree that one should trade local products, the local underlyings, which is the right thing to do. But I think liquidity in Asia is still low and that might entice people to go elsewhere.
Just one last point. Retail comes up quite a lot in this discussion and I think that’s an interesting one because, in my time in ETFs, I have not seen this type of investor playing a role as a significant growth engine yet. I’ve seen the retail end-investor as part of an advice centre. As an intermediary form, it is very important but I think we overburden the retail investor by forcing him to make a lot of choices. A lot of people have a problem with that and need advice to make those decisions. I think that is why a lot of commission-based practices are so relevant. They give the individual the comfort of buying a product that is right for them. I believe the intermediation part of retail is a very important part of ETF sales. Direct sales to retail is not as important as there still aren’t a lot of self-directed investors out there.
Marco Montanari: Also, in terms of product offering, ETFs that are mandatory provident fund (MPF)-compliant are mostly listed offshore, but most of the Hong Kong-listed ETFs are not MPF-compliant. This means that retail investors can buy them on the exchange in Hong Kong but an institutional investor managing an MPF-compliant fund cannot buy them.
Asia Risk: Are ETFs in China structurally different to those in other parts of Asia? What are the prospects for Asia when this market opens up?
Hing Tang: Yes, ETFs in China are traded at t+0. They have come up with structural differences. All other stocks are traded at t+1 but, for some strange reason, they allow ETFs at t+0 and there is zero settlement risk. The t+0 allows some arbitrages when traded heavily. Someone from the Shenzhen Stock Exchange told me recently there are less than 30 big players trading ETFs in China. They are called retail but they are more like prop traders. But there is a hurdle when the authorities want to develop the overseas ETF. With overseas ETFs, even in Hong Kong, the t+0 advantage disappears. That is the problem and is why they have been talking for years about this operational problem.
China is also a very good exception because it has closed the door. A mainland investor cannot buy overseas ETFs directly so they have to buy local products. The Chinese government’s thinking is very simple: there will be overseas products but managed by local companies and listed either on the Shanghai or Shenzhen stock exchanges. They wanted to push their qualified domestic institutional investor business, but they won’t allow an open-door policy in a short period of time. They will have to develop their own industry. So, I think China is a very exciting exception and I am sure that the ETF market will grow very rapidly there.
Frank Henze: If you look at China – as the future powerhouse of the region – to set the trend, I think whatever comes out of China as regulation would provide a framework for the region to become more unified in the way investment products are viewed. If I was to predict anything, it is that Ucits would become much less important here and that local regulation would become stronger.
Asia Risk: Is ‘discount’ or ‘premium’ a big concern in Asia while trading ETFs?
Keith Chan: In Hong Kong, the most active is the China A-Shares ETF and it started because of a boom in equity markets back in 2007. When a Hong Kong-listed A-Shares ETF premium exists, investors need to understand why, and how this premium and discount will change, because that can also affect your return. You can have A-Shares coming down 5% and then the premium also dropping, like it did recently, and then your return can go down 10% when the underlying is down 5%. So investors should understand, when premium does exist, what factors will come into the equation so that they are not just looking at the underlying. They also need to have a view of how the discount and premium may change.
In markets like the Chinese A-Shares market, which is restricted, we could see a premium when the demand is great. Premium or discount of an ETF depends on the accessibility of the underlying market, the liquidity of the underlying market and whether the markets are opened or closed. ETFs with Asian underlyings listed in the US could have a premium or discount due to their underlying market being closed during the US time zone trading hours.
Marco Montanari: It is important to mention that the liquidity of ETF does not depend just on the ETFs’ volumes but on the liquidity of the underlying market. ETF is a fund so it is a wrapper to get access to the underlying market. If the volumes on the ETFs are of $1 million and the underlying market trades 100 times more, then the underlying market should be able to absorb the volume of the ETFs and the ETF should add no premium.
Asia Risk: Turning to some of the regulatory questions, regulators in this region and in some other parts of the world seem to be concerned by certain aspects of the ETF market. What are they worried about? Are their concerns justified? And how is it affecting the development of ETF business?
Marco Montanari: On our side, there are two key points. First, ETFs are funds, they are not bonds. When you buy a bond you have 100% counterparty risk and you don’t have the same protection that you have to give with a fund. The second point is that funds or ETFs may use derivatives or may do securities lending and both of them involve counterparty risk. This does not just concern ETFs but also active funds. These are common market practice and give an advantage to the investors in terms of additional revenues or tracking efficiency. They are very well regulated and you have collateral that is given to mitigate the counterparty risk.
Frank Henze: The fact that it is a systematic risk is quite important because it’s what has been raised by the Stability Board and by others. We disagree with that because a systematic risk lies with the provision of derivatives, not with the funds. You have to take one step back and regulate that activity because that is where the risk ultimately lies. The fund is a wrapper. The concerns are right insofar as different structures carry different risk profiles in the way they are constructed. I think regulators are trying to put in place a disclosure regime and some sort of transparency regime that would enable investors to act, to know what these risks are and whether these risks are appropriate to them. I think that’s where the debate is moving to, which is healthy. That is the main difference between the products. What is the risk structure of your product? Are you happy with it? There are benefits, for example, some of the synthetic funds have lower fees or maybe a lower tracking error, but you pay with risk or you have to pay with the physical moving of stock, so you pay for more certainty. It depends what you are most comfortable with.
If you were to collateralise your products with cash, you would have a different cost base. It depends on your risk/return appetite. This question is easy for us to answer as our structured funds in the region have no counterparty risk. Our funds also don’t do securities lending. The equities underlying the portfolio derive a return even if there was a credit incident.
Keith Chan: I think the regulator should also work on better educating the market. It should organise annual conferences on ETFs and invite more discussions between product providers, distributors and other ETF participants.
Asia Risk: Turning now to the debates around the physically replicated ETFs compared to the synthetic ETFs – what are the pros and cons?
Keith Chan: Maybe I’ll start with HSBC’s approach. We are not against any single approach. Especially for Asia, where investors are still learning about the product, I think it is important to provide simple-to-understand products. So we started our product using a physical replication. If you are accessing simple, liquid markets using ETFs, physical replication makes sense and it’s cost-effective for investors. HSBC leverages on its strength and global presence, and offers ETFs with physical replication as much as possible when it makes sense to investors.
Frank Henze: We are talking about two structurally different products. A physical ETF holds physical debts and that’s costly, and there is a price you pay for the safety of the product. A synthetic ETF is managed differently, has a different cost structure and has been seen to be a bit cheaper, but then you have a different risk attached to that. Investors ought to be concerned with these factors.
You also have to consider what the provider does well. State Street Global Advisors is an asset manager. Our expertise is managing money and the costs for us to do that are relatively lower. And that is why we think that our products are very competitive, based on the way that we provide them. Some people say: well, we know investment banks have different abilities to provide returns and that’s what they are very good at. Everyone has to play to their own strength. And that’s where you can deliver benefits, whether it is on the physical or the synthetic side.
You have to be careful with certain points though, when the regulator requires you to have a certain tracking performance or that you can only deliver through a synthetic, you have to be aware that you buy that with risk in the structure. It’s a zero-sum game. I’m always sceptical of that, because you can’t see things that don’t exist. They do exist.
Hing Tang: I think the synthetic risk is one thing, another issue that concerns regulators is the complexity. Even though we, as issuers, don’t think the ETFs are complicated, regulators think that investors find them complicated. Even if you disclose a 200-page prospectus, investors still don’t understand the technicality.
Asia Risk: The Securities and Futures Commission in Hong Kong has recently introduced new rules to address counterparty risk. What are the new requirements? And what steps is the ETF industry taking to mitigate that risk?
Marco Montanari: All the domestic providers of synthetic ETFs will have to fully collateralise their counterparty risk on a daily basis. And, when they use equity collateral, use a buffer of 20%. So non-Hong Kong-based ETF managers like Deutsche Bank are not affected, but in any event we have been implementing 100% collateralisation since 2009.
Keith Chan: Since Lehman, investors are much more sensitive about potential risks of investment products. I think they are becoming more sophisticated and they have learnt a lot from this lesson. And so they are quite keen to understand more about investment products, especially counterparty risks. It is important for product providers and intermediaries to educate and increase product transparency to the market.
Asia Risk: How do ETF providers ensure that ETFs are fairly priced?
Marco Montanari: I think one of the mistakes that investors make when looking at the pricing of ETFs is that, instead of looking at the NAV as the starting point, they use the last trade price, which will change depending on where the ETF is listed.
Hing Tang: A related question is whether market-makers make money? Because, if this was a good business, it would attract more traders and market-makers, which would help develop the industry.
Keith Chan: I think market-making is part of the product’s service. Especially when the product is new to the market, it’s not whether it is profitable to provide the market-making, but it’s a service that affects the product provider’s brand. At HSBC, our traders understand this and are committed to protecting the ETF brand by making tight bids/offers with consistent liquidity. If you have a good reputation with investors having a good trading experience, then you bring in volume and you get more investors trading it.
Marco Montanari: The behaviour of a market-maker will depend on the liquidity of the underlying market. If the bid/offer of the underlying market widens, you cannot expect your market-maker not to widen the bid/offer.
Hing Tang: Another interesting issue is that market-makers have to pay stamp duty if the underlyings are more than 40% in Hong Kong stock, which really hurts. That’s why market-makers try to trade non-Hong Kong-related ETFs like A-Shares. It’s a very good example because they don’t have to pay stamp duty.
Asia Risk: We have recently seen several bouts of volatility, which perhaps we’ll expect to see more frequently as political issues take centre stage in a number of major markets. How has this affected the ETF industry?
Keith Chan: In a volatile market, investors tend to de-risk a little, and ETFs are the right product because you have a basket of shares, and products offering different asset classes for diversification, so you should see more demand for them.
Frank Henze: We’ve seen a demand for uncorrelated assets, and gold has provided a very good outlet for that over the last few months. Local Asian bonds performed in an uncorrelated way so people can take advantage of the limit of correlations between asset classes. Gold price and Asian currencies corrected recently as investors’ sentiment geared towards cash and increased the demand for the dollar but, fundamentally, both asset classes remain positive.
Asia Risk: What’s next for ETFs in terms of new products, formats, asset classes and the influence of technological trading advances in Asia?
Marco Montanari: When I look at the Asian market, we are investing to bring to the market new ETFs linked to all asset classes because we think that ETFs’ advantages go beyond the equity space. Having said that, Asian investors in the past preferred equity and local underlyings. So, on one side, we want to offer a comprehensive multi-asset product offering, but also local flavour ones. Giving access to different Asian markets is indeed the way to go for the future. We already have ETFs linked to Vietnam, Thailand, Indonesia and Malaysia, and we want to further expand our product range in this area.
Keith Chan: I think the key advantage of ETFs, is allowing you to access markets and different classes of assets very quickly and efficiently. Nowadays news travels fast; retail or institutional investors can quickly read news from anywhere around the globe and can use ETF to access markets and assets quickly in response. So, although in Asia, traditionally, equity is one of the key asset classes in the portfolio, the future growth of ETFs in Asia will allow investors to look at different country exposures or different asset classes in their portfolio. The education of investors is also important. So, yes, it will take time, but we are still very positive about this product in Asia.
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