The six leveraged and short exchange-traded funds (ETFs) listed in South Korea grew by more than 360% year-on-year in 2010, highlighting the compelling growth potential for the sub-sector in the Asia-Pacific region. As the Korean example shows – the six equity index-linked funds account for 50% of the daily ETF turnover on the Korean Stock Exchange – demand for this new trading vehicle is significant and growing. Samsung Asset Management’s Kodex Leverage ETF and Kodex Inverse ETF last year both ranked among the top 15 Asia-Pacific ETFs overall by volume, according to Deutsche Bank, signalling the time may have come for non-delta 1 products in Asia.
Nonetheless, it appears regulators in some of the region’s busiest ETF markets are unconvinced. While the Korean listings attracted $226 million of inflows last year, regulators in markets where retail investors suffered severe losses in relation to derivatives-based investment products have highlighted the risks associated with investment products that rely on derivatives or leverage to drive returns. Where traditional ETFs hold cash securities, leveraged and short products combine debt with derivatives instruments including swaps, forwards and futures.
Hong Kong and Singapore, for example, have followed warnings issued in 2009 by the Washington DC-based Securities and Exchange Commission and the
Financial Industry Regulatory Authority concerning suitability of leveraged and short exchange-traded products (ETPs) for buy-and-hold, retail investors.
“There is a common stance among regulators since the Lehman mini-bond problem who are being extremely careful in reviewing new products, especially in the retail space,” says Carole Lee, non-Japan Asia head of listed solutions at Barclays Capital in Hong Kong. “Asian regulators have not ignored the alerts issued in the US about leveraged and short ETPs and are doing their research about what rules to put in place before allowing exchanges to list these products.”
For instance, the Monetary Authority of Singapore (MAS) has publicly aired its
concerns about the products’ tendency to underperform the underlying benchmark over the long term (see box). “As the basis for calculating returns on leveraged and short ETF products is typically adjusted on a daily basis, investors who invest in these products for periods longer than a day may not get the returns they expect. This risk may not be well understood by retail investors,” says Jacqueline Ong, a spokeswoman at the MAS in Singapore.
Similarly, a September 2010 circular by the Hong Kong Monetary Authority reminded providers of their responsibilities in relation to the disclosure of risks associated with ETPs that employ derivatives or leverage to generate returns. Although the document primarily concerned synthetic ETFs that use derivatives to
gain market access to otherwise restricted underlying securities, the mention of
ETPs “where derivatives or leverage is involved” raised the prospect of similar
It is perhaps not surprising that most dealers outside Korea are eager to follow their cues from the regulators and downplay their excitement about the growth potential of both leveraged and short ETFs in the Asia-Pacific region.
“It’s not in the interest of anyone to introduce a product that is not generally understood. The Asian ETF market is much less developed than the European and US markets. Even without the leveraged and short issue, there are many misconceptions about ETF products. It’s important that we have a more mature market before more complex products are introduced,” says Marco Montanari, director and head of db X-trackers ETFs for Asia at Deutsche Bank, which has listed 65 delta 1 ETF products in the region since February 2009.
While the gateway markets appear in no rush to approve leveraged ETPs, Korea remains the only Asian market where asset managers can list leveraged and short products. In the year since it opened the market with its domestic equity Kodex Inverse ETF, Samsung Asset Management has emerged as the leading provider in the region, with its leverage ETF attracting $128.4 million of assets under management and the inverse product accumulating $116.03 million, according to Deutsche Bank.
The Korean non-delta 1 complex comprises three leveraged and three inverse products from four asset managers including Mirae Asset Financial Group, Woori Asset Management and KB Asset Management.
In Japan, meanwhile, where the Tokyo Stock Exchange (TSE) began listing ETFs in 2001, a culture of co-operation between the Financial Services Agency (FSA), the stock exchanges and fund providers has emerged during the past three years to actively promote the ETF market. According to Yasuyuki Konuma, a director of business development in the TSE’s listing department in Tokyo, this framework provides a stable platform for the prudent introduction of new products. “The government, exchanges and asset management industry are currently working together to understand these products and how they could fit into the Japanese market,” Konuma says.
The capacity of dealers to explain the long-term performance of leveraged or short products versus underlying benchmarks is at the centre of a feasibility study, which also involves the self-regulatory Japanese Securities Dealers Association (JSDA), alongside the FSA and exchanges. “There are several discussions going on within the JSDA in respect of sales practices, not just for ETFs, but also mutual funds and other retail-orientated investment products. It is the dealers’ responsibility to establish the best sales framework for assessing suitability,” he adds.
Although Konuma doesn’t expect a leveraged or short ETF launch in Japan before the end of the second quarter, he says that signs of a workable consensus are already evident and that a listing may come before the end of the year. “The debate around sales practices is progressing, and we are seeing increasing levels of
commitment in that discussion. I don’t think it will be too long before we see a short, or 2x leveraged ETF linked to a domestic index in Japan,” he adds.
While established ETF providers hustle to list the first leveraged and short funds, other dealers have developed an alternative approach using exchange-traded products that seek to avoid some of the problems associated with daily compounding. Currently being considered for listing by the TSE, the exchange traded note (ETN) format offers such a prospect.
First listed by Barclays Capital on the New York Stock Exchange in 2006 under the iPath brand, ETNs are senior, unsecured, unsubordinated debt obligations of the issuer and present a substantially different risk profile to the investor. They also offer another option for investors seeking leveraged index exposure, says Barclays Capital’s Lee.
“Instead of a daily or monthly ‘reset’ feature, iPath tracks a multiple of the performance over the term of the ETN according to a formula available in the product prospectus,” she says. “We publish the current multiple on an intra-day basis so that investors are aware of this factor before they buy the product. They know what they are getting into.”
Although ETNs will debut in delta 1 format, Lee is excited about the potential of the technology to impress both regulators and investors wary of downside bias: “From our experience in the US we expect leveraged and short products to attract investors who are willing to take on more risk compared to delta 1 products, especially investors with a sophisticated understanding of the underlying index.”
Box - The potential consequences of the downside bias
A quick internet search on ‘leveraged ETF’ will reveal a host of so-called articles decrying the potential peril for retail investors, in particular those that rely on buy-and-hold investment strategies. While much of this material borders on the hysterical, it is based on a crucial truth about the mechanics of a product that tracks the daily percentage change of underlying indexes.
The daily or monthly compounding method typically employed by leveraged and inverse ETFs creates a path dependency between the underlying and the fund, whereby day-to-day movements of the underlying index directly influence the performance of the fund in subsequent periods as fund managers rebalance portfolios.
This daily or monthly path dependency means that fund returns over a period longer than a day can diverge significantly from the underlying performance, particularly in volatile markets.
For example, during the historically severe volatility of 2008-09, the mathematics of daily compounding left many leveraged and inverse ETF investors in the US nursing losses, even in instances where underlying indexes had performed positively. In a 2009 regulatory warning, Leveraged and inverse ETFs: specialized products with extra risks buy-and-hold investors, the Securities and Exchange Commission and Financial Industry Regulatory Authority highlighted a three-times leveraged ETF that declined by 53% during a five-month period, against a gain of 8% in the underlying index. The 3x inverse ETF fell by 90% during the same period.
A further complication for unsophisticated investors comes from the fund managers’ obligation to maintain a constant leverage ratio. For leveraged ETFs that use swaps, forwards and futures to generate advertised return profiles, there is an issue when the underlying index increases in value, as the leveraged fund must increase its leverage ratio, thereby amplifying its losses in a falling market. The imperative to buy when the market is rising and sell when it is falling forces the fund to buy high and sell low, exacerbating the downside bias during periods of significant volatility.
Although US regulators have since toned down their rhetoric, perturbed by the potential consequences of the downside bias for non-expert investors, several of the largest US brokerage firms withdrew leveraged and short ETFs from their product offering. Marco Montanari, head of db X-trackers ETFs Asia at Deutsche Bank, says it is essential the same thing doesn’t happen in Asian markets.
“Daily compounding is embedded in these types of products, it’s a mathematical need of product that gives investors an additional way of hedging themselves or getting cost-effective exposure to an underlying market. After the complaints we have seen in the US, it’s essential that investors understand them before they buy,” he says.