Emerging as the winner - ETF?

THE Asian exchange traded fund (ETF) industry celebrates its 10th anniversary this year, a decade since Asia's first ETF - the Tracker Fund of Hong Kong - was launched. While the launch of that ETF was to allow the Hong Kong government to dispose of stock holdings acquired during the Asian financial crisis without causing undue market impact, the industry took root nevertheless. To date, ETFs exist in almost every Asian market with Indonesia the latest market to list its first ETF in 2008.

There are 114 ETFs in the Asia Pacific ex-Japan markets with assets under management (AUM) of US$36 billion, as at Q3 2009. In Japan alone, there were 69 ETFs with AUM of US$27 billion. During the year, 23 new ETFs were launched in Asia. Riding on the back of a strong technical recovery in global equity markets which started in March, Asia ex-Japan ETF AUM grew 47 per cent. This performance is better than the global trend which saw AUM hitting a record US$934 billion, representing growth of 31.3 per cent during the same period while most of the global markets these ETFs track are still miles away from their previous peaks. It is now an open secret that ETFs have emerged as the biggest winner in the financial tsunami.

However, there is still a little secret that has eluded even the keenest market watchers. Over the past 12-18 months, acceleration in new listings in such markets as Hong Kong and Singapore has quietly transformed these exchanges from their traditional roles as local trading centres to global investment hubs. Hong Kong and Singapore now boast 37 and 43 ETF listings respectively, representing a mixture of locally domiciled funds and cross-listed products. They cover a range of asset classes and geographic markets. This allows investors to conduct global investing in a convenient and cost-effective manner.

The table shown here represents the respective USD performance of those markets already covered by ETFs listed in Singapore. It doesn't take a lot of imagination to see the potential offered by the dramatically expanded range of ETFs. With more listings planned by various issuers, it is high time that investors take note of this recent development and make the most of it.

What is the risk of investing in ETFs?

Most ETFs are relatively simple products but recent evolution has led to more complex structures in response to increasing investor demand. At its core, an ETF is a simple index mutual fund that is also traded on an exchange. It is the public trading feature that gives an ETF the benefits of higher transparency, liquidity, cost-efficiency and convenience over its traditional mutual fund counterparts.

Since an ETF is an index fund and passively managed, an investor is exposed primarily to the systematic risk of the market and the currency tracked by the ETF. For example, an India ETF represents a portfolio of Indian stocks and the investor is thus exposed to the movements in the India markets and the rupee. Typically, potential currency movements should be taken into account when making overseas investment decisions.

An index fund, such as an ETF, represents the most direct means by which an investor can implement a macro view without the added active risk related to stock picking. Investors should note that taking on active risk is not necessarily compensated for by extra returns. The notion of 'high risk, high return' only holds true for choosing a higher risk asset class, such as equities over bonds. Unfortunately, to consistently pick the right stocks requires certain skills, not just luck. As such, ETFs are good news for the average investor who may not possess the specialised skills necessary to pick stocks or choose funds.

Unlike an actively managed fund where performance is based on how much it outperforms the market, the performance of an ETF is judged by its tracking error, a risk measurement of how well the ETF tracks its benchmark index. An ETF's tracking error is affected by its replication strategy, expenses and dividends. In layman terms, a one per cent tracking error translates into an expectation that the difference in performance between the ETF and its benchmark will not exceed one per cent roughly two-thirds of the time.

Liquidity risk - how easy it is to buy or sell an investment and whether the price would be impacted dramatically in the event of a fire sale - is a key investment decision. In this regard, ETFs excel with liquidity featuring the proven open-ended mutual fund structure and complemented by secondary trading on exchanges with market making support.

Today, it is impossible not to mention counterparty risk which had received scant investor attention until the bankruptcy of Lehman Brothers last year. Few investors realise that counterparty risk exists in every investment, even those always considered safe. For example, when you keep your money in a bank you automatically take on the credit risk of that bank. Holding government bonds carries sovereign risk - think Iceland.

In the case of an ETF, counterparty risks related to its manager and other service providers are mitigated by its mutual fund structure which mandates the ring-fencing and segregation of the fund's assets. Additional counterparty risk can also be introduced when the synthetic replication methodology is employed, especially those involving the use of derivatives such as swaps or access products. Such derivatives are used to gain access to highly restricted markets or to lower costs and achieve closer tracking. It is also important to note that the level of risk (per cent of net asset value or NAV) is often highly regulated and restricted.

In Asia, all swap-based ETFs cross-listed from Europe are UCITS (a pan-European investment directive) compliant with counterparty risk limited to 10 per cent of NAVs. Most other Asian-based ETFs that use access products issued by a third party feature counterparty risk limits of 10-15 per cent. This is achieved through diversification of issuers or asset collateralisation. An exception is a Singapore-listed India ETF that still relies on a single issuer for the India P-notes used and is thus 100 per cent exposed to the default risk of the third party issuer. It is interesting to note that the most successful ETFs in Hong Kong and Singapore are access product-based ETFs that carry third-party counterparty risks.

While the counterparty risk relating to ETFs employing synthetic replication are well-publicised, those seemingly normal cash-based ETFs utilising full replication can also be exposed to counterparty risk when engaging in stock borrowing and lending activities which are often hidden from investors. As such, investors are reminded to always look under the hood when it comes to risk evaluation. Investing inevitably involves taking risk. Risk should be evaluated on whether it is compensated for. Therefore, a holistic view is needed to balance the risks versus potential impact on performance, costs and efficiency.

Who uses ETFs and how to use them?

ETFs are best considered as simple and effective investment tools. As in the real world, more tools mean better capability to build more complex products. The global success of the ETF industry has been predicated on a wide range of products. Recent innovations have brought single commodities, currencies and strategy ETFs such as leveraged and short to the fold. Because of its stock-like trading convenience, ETFs are used by investors of all types. The ever-expanding array of ETFs allows investors to customise strategies to meet their respective needs.

At its core, an ETF provides exposure to a market whether it is a country, a region, an industry sector, a commodity, an asset class, or even a strategy. Since there are more than 1,800 ETFs listed globally, they present an impressive array of choices and opportunities to investors even when used individually. Using ETFs to access highly restrictive markets or simply to implement macro market views represent the most popular usage. The popularity of the India and China A-shares ETFs around the world and the surge in inflows into emerging markets and Asian regional ETFs are good examples.

When large numbers of different ETFs are trading and settling seamlessly under one roof, they become powerful asset allocation tools, especially for those investors for whom stock picking is not the priority. Even active managers sometimes use ETFs, for example, to effectively execute an asset allocation decision. In such a case, a decision to add 5 per cent Singapore exposure to a portfolio can be quickly met by investing initially through an STI ETF. The manager can then take his time to pick stocks and buy them at the right prices by selling the ETF to fund the purchases. In this way, the asset allocation decision is executed instantaneously without compromising on the stock prices.

The recent advent of commodity and strategy ETFs further provides investors with alternative options on hedging, leveraging and portfolio diversification. Holding an ETF is often more regulatory friendly and a great deal simpler than dealing with futures which involves many administrative burdens. Today, gold, oil and other broad-based commodity ETFs are used to hedge against the weakness of the US dollar, potential inflation, as well as for portfolio diversification.

Finally, we are beginning to see ETFs feature increasingly as underlying investments for derivatives and structured products. Trading ETF options is already popular in the US. Hong Kong recently saw a slew of warrants launched on popular ETFs such as the gold and A-shares ETFs. In the structured funds space, ETFs are replacing traditional benchmark indices as the underlying performance references because of the ability to settle physically (ie, client given ETF units) at maturity. In Taiwan, ETFs are now appearing on lists of underlying investments of investment-linked policies offered by major insurance companies.

Driven by strong global demand, ETFs are evolving quickly through innovations and expanded coverage of markets and asset classes. The number of ETF users is also increasing, attracted by their simplicity and flexibility. The result has been impressive with global ETF AUM at a record high and trading volume expanding continuously. ETFs now account for roughly 30-40 per cent of all turnover on US exchanges and, routinely, seven to eight of the top 10 traded securities are ETFs. In Asia, the industry is still young and there is a lot of room for growth. In Singapore, ETF turnover accounts for about one per cent of total turnover but that already represents a five-fold improvement from barely three years ago. With more products coming Singapore's way, the growth in ETFs and in their trading can only improve. Investors are urged to take note.